Managerial Economics

We believe individuals are rationals and they make choices based

on costs and benefits
 Why should managers learn micro economics?
Run business efficiently, earn profits, make right choice. So should
learn micro economics while considering macro economics aswell
 Managers operate within market economy
Market economy : production and consumption decisions are decided based on
market, medium of exchange is money
Firms usually rely a lot on command and control systems rather than on incentives
and the logic of markets

good governance is very important for markets to function properly

costs of gathering and processing information and transportation costs among

others. In total, these are called transaction costs
Invisible hand plays a major role in coordination between
buyers and sellers
Invisible hand gets lot of support from visible
hand I.e., prices

Prices take centre stage in market economy.

Market does not function without price. They
direct behaviour of buyers and sellers.

Innovation is the main reason behind increase in

standard of living which in return is driven by
prices
 Production Possibility Frontier(PPF)

Even a most successful economy cannot go

beyond frontier

The cost of anything is what you have to give-up

the next best alternative: opportunity cost

Slope of the curve shows opportunity cost at

each point on ppt suppose c and d

Higher productivity= higher levels of o/p

C: high ppf than D, higher levels of investment-

> more goods -> higher standards in future
 Supply and demand curve

Prices determined through interaction between

demand curve and supply curve

Demand curve says price and quantity are

inversely related
 Demand curve

Quantity demanded: refers to

amount ppl wish to purchase at
particular price
Demand:All the possible prices and
their quantity demanded refers to
demand curve
Using absolute prices can be deceptive.

Decisions about buying and selling should be based on relative prices

 Factors that affect demand

1)Income

If normal good, the quantity increases at every

price…increase in demand

If inferior good(quantity does not increase with

income), effect is reversed
 Factors that affect demand

2)Prices of other goods

Milk and tea are complementary products. If tea prices increases, tea consumption decreases, I/e., milk prconsumption also
decreases

Milk and orange are substitutes. If orange juice price increases, people switch to drinking more milk, so milk consumption
increases
 Factors that affect demand
Many other factors:

Taste/ Preferences

Population(more population….more demand)

Seasonal effect…based on weather, we choose preferences..more tea consumption in winter than summer

Expectations….If we think milk price is going to increase, we will buy more, demand increases(Eg
Housing)

Availability of credit(Homes, cars)

Derived Demand(For many business customers are other firms(Eg: Steal, cotton)
Supply Curve

If price is high, suppliers would like to

produce more and sell more, for more
profits
Similarly, if price is less, suppliers
would like to produce less and sell less,
as will be less profits
 Factors affect Supply
Input prices

Technology

Available of credit

1st supply curve graph is if input price increases,

supply curve also increases

2nd graph is w.r.t technology, as more

technology is available, banking services and
such are more available at same price…so
supply curve decreases
 Week2
Demand, Supply & equilibrium
 Market Equilibrium

Demand curve shows, how much buyers would

like to buy at certain prices

Supply curve shows, how much suppliers would

like to sell at certain prices

Amount at which sellers would like to sell,=

buyers would like to buy(this is equilibrium
price)
 Disequilibrium Price

Price above Equilibrium price -> quantity

supplied exceed quantity demanded ->surplus…
so sellers reduce prices to attract buyers

Price below equilibrium price -> quantity

demanded exceed quantity suppled ->
shortage…buyers will offer to purchase for high
price….so prices increases
 Comparative statistics
Deficient in supply shift left wards of So.

This results to shortage and increase price from

P0 to P1 to maintain the equilibrium
As there is less rainfall for farmers, supply
decreases. Which lead to less income for their
family

Consider clothes are normal goods, so decrease

in income..means decrease in demand for
clothes….so surplus…so lower sales…lower
prices(Pe to P1)
As more population, more consumption of
rice..demand increase(Do to D1)

As bad monsoon, less supply of rice…supply

decreases(So to S1)

Equilibrium shifts from (Po, Qo to P1, Q1)

Price increases, quantity decreases

Population increases, demand increases(D1)

Monsoon bad, supply decreases(S1)

Price increases, quantity increases

So whenever less supply, more demand…..price

always increases
Demand increases

Supply increases

If demand shifts more than supply…price

increases, quantity increases
Demand increases

Supply increases

Supply increases more than demand…..Price

decreases, quantity increases
 Relevant markets
Market must be competitive, otherwise analysis would not be valid

Any industry where there are handful of firms, unlikely to be competitive

Relevant markets:

More finely u define a market, more likely it is to be uncompetitive..simply

because of reduction of sellers and buyers

Demand and supply curves provide a powerful tool with which to analyze market
conditions and possible changes in the business environment.
 Elasticity in demand(Ed)
Measure of responsiveness.

Measure of how sensitive is quantity demanded is to

change is in price..

We measure using slope of demand curve

Flat demand curve(high slope)…more responsive to price

changes than steep demand curve(less slope)

Price elasticity w.r.t demand

An elastic in demand is one in which the change in

quantity demanded due to a change in price is large

An inelastic demand is one in which the change in

quantity demanded due to a change in price is small.
 New Elasticity formula

Arc Elasticity of Demand formula

 Point Elasticity of Demand

To measure elasticity at particular point in

demand curve we use this formulae

(deltaQ/deltaP)=slope

Slope of demand curve is -ve always..it is

downwards.

Price elasticity of demand is always negative

 Different values of elasticity
0< Elasticity of Demand(Ed) <1 =>demand is
inelastic

Elasticity of Demand(Ed) >1 =>demand is

elastic

Elasticity of Demand(Ed) =1 =>unit elastic

with a linear demand curve, the slope remains

the same everywhere(since straight line) but the
ratio of quantity to price changes
 Price Elasticity & Income

If Ed>1, prices reduced, quantity increases more

than in proportion to decrease in prices..so
revenues go up

The new curve, y-axis(Revenue)

 Price Elasticity Demand and Revenue

Revenue= Price * Quantity

If price is increased…..Q should decrease…..if

% Change in Q < %change in P…..R is
increased..another way of saying…R increases,
demand is inelastic

If P goes up, %change in Q> %change in

P….Demand is elastic…Revenue decreases

%change in P = % change in Q….Revenue

remains same
 Factors affecting price Elasticity of Demand
2)Proportion of income spent

Demand for food….inelastic

1)Availability of substitutes…more Wheat, grass….elastic
substitutes..more easy to buy other
products….Elasticity is high…so Elastic Basmati rice…even more elastic
Demand
Salt, match boxes…in elastic
Food, fuel, electricity…less substitutes….Ed
price is low since change in prices w.r.t these If a good takes a relatively small portion of our
necessities doesn’t have other option to other income or budget the elasticity will be low
substitutes..so we would buy only these…hence
Elasticity is low(Elasticity is change in quantity
Education..is necessity…so elasticity should be
w.r.t change in price)….Inelastic Demand
low..but take up large portion on budget…so
elasticity should be high
 Factors affecting price Elasticity of Demand

3)Time to react

For most goods, the elasticity of demand is

higher with the passage of time.
Effects of Tax on markets
Effects of Tax on Supply& Demand Curve

Initially, equilibrium price=5, equilibrium

quantity =10(S0,D0 curves)

Due to sales tax added 1rupee, now the selling

price is 4, and for 4 rupees the supplier would
not like to sell 10, he would sell only 8

This leads to new supply curve(S1)..so now the

new equilibrium price is 5.5, and quantity is 9
 Elasticity and Taxes
S0,D0…supply and demand curve initially. Here
considering the case where Demand curve is
steep..when demand curve is steep, it is
inelastic.i.e., with increase in price, quantity
doesn’t differ much(P0,Q0)

As suppliers pay the tax, new supply curve is S1.

(P1, Q1)

And at quantity Q1, u can see Ps..supplier price

P1..amount paid by consumer..so here tax paid

by consumer is more than tax paid by supplier
when the demand curve is inelastic
 Buyers Surplus and Sellers Surplus

Sellers would like to sell when price is more than cost of producing..for more seller surplus
Buyers would like to buy as low price as possible..for more buyer surplus
 Buyers Surplus

The coffee price for 1st cup is 10/-

For 2nd cup, the buyer is not willing to pay 10,

he is willing to pay 9..similarly for other cups

So the total value of the product is 40

But the price would be 30(since he would pay all

at last )

Buyers surplus= 40-30=10

Buyers Surplus with demand curve

Buyers surplus is the area shaded just in green

It is the area below demand curve, and above

price

price= blue=30
Sellers surplus with supplier curve

Suppose, seller willing to sell 1 unit at price of

2..2nd unit at 3 /-…….

Sellers accept price of=20

But he is getting revenue=30/-

Sellers surplus= 10 ..part shaded in red

It is the area above the curve and below the price

Buyers and sellers surplus together

Blue triangle represents by how much buyers are

better off from the price which is there in the
market….buyers surplus

Red triangle represents by how much sellers are

better off for participated in market….sellers
surplus

Sum of buyers+sellers surplus= welfare of

society
Effect of govt intervention on market outcome
If govt thinks P0 is high, it should be lower..eg rents..it
makes price P1

Now the quantity demanded is Qd, quantity supplied is

Qs..theres shortage…the quantity they would give is Qs only

Now the consumer surplus is blue+(red+blue)- small blue

triangle(blue+black)

Buyers surplus= only red- small red triangle(red+black)

Now the quantity supplied & quantity brought and sold(both

Qs) are less than equilibrium quantity

So the black is the area which has been lost

Because of interference of govt in market…there is loss…

benefitted for ppl for less rents, suppliers has loss as they r
selling for less rents..loss for also for ppl who r willing to pay
above equilibrium price, sell for equilibrium price has no
transactions takes place..so lost to the society
 Effects of Taxes on Market outcome and social
welfare
Price at consumers pay=Pc

Price at sellers receive=Ps

Before the taxes…buyers surplus= blue, sellers

surplus= red

black= tax collected by govt

Small blue+ red triangle= deadweight loss from

taxation

Loss from tax comes because ppl change their

behaviour..they won’t be willing to buy or sell..those
small blue and red triangle

Taxes reduce welfare ..but govt need tax ..so tax

goods which have low Ed and possibility of Es(I.e.,
no much quantity change when price changes)
Week3
What determines Productivity decisions

Inputs means, labour …infrastructure, tools,

etc

So technology and cost determines

productivity decisions
 The Production Function

Relationship between inputs and output

It shows Max amount of o/p it can produce with

given input

In comes to steel, agricultural products, its easy

to describe o/p

When it comes to services, its difficult to

describe o/p
Measure of Productivity
Behaviour of Avg and Marginal products

Eg:Batting scores, avg

Eg: Grades, avg

Law of Diminishing Returns
No of workers to hire and quantity to be produced

Should consider 5
workers and quantity of
24 units for max profits
 Introducing value of marginal product

Value of marginal produ

Graphical approach of no of workers to be hired
Consider previous table from pg 56

L2 is the right amount of labour to hire

L1, we can get more profit..so not

Never choose a level of labor which is to the left of the

maximum point of the value of marginal product curve

We can remove left part from max value due to law of

diminishing
Multiple Inputs
Getting back to Equilibrium
If labour costs go up, will use less labour
and substitute labour by capital

Cranes and labour, labour needs to work

with cranes.We need both for the work to
be done, crane and labour are
complimentary

At some levels, all inputs are substitutable

but at the level of factory and business,
amount of substitutability differs
 Productivity in the Long Run

Since many inputs are variabled here in the long

run.

In long run issue is right combination of labour

and capital
 Scale and scope of Production

How size effects productivity

Economies of scale eg: suppose u started with

small restaurant, u have one person to do all
works. It grows and now u have separate cashier,
chef etc.

Diseconomies of scale eg: with more restaurants

and growth ..more difficult to manage more
cooks, front office ppl. So special manager to
manage all these ppl..with increase in more
restaurants..more managers
 Economies
of scale

What about economies of scope? Well, if you know that increasing the
size of your operations is going to give you higher productivity then it
sometimes makes sense to go and adopt or do things, produce things,
which are different from your current line of production.

For example, you might produce both cars and tractors because by doing
so, by producing these two different products jointly in one factory allows
you to benefit from economies of scale. So economies of scope is like
exploiting economies of scale or economies of size by producing more
than one output.
 Costs in Language of Economics
Explicit costs: out of pocket costs
Costs in economics mean opportunity costs
Implicit costs: not usually thought of as costs
Cost of anything is what we have to give up
instead Cost of going to clg is fee we r going to pay,
travel,accomadation, food etc…explicit costs

During earning agree, we willl not work, the

amount we would have made if we were
working those years of going clg is implicit costs

cost= implicit+explicit cost

Historical cost vs Replacement costs

Will consider replacement costs as better

measure of calculating

Eg: ancestral land…considering history, it won’t

be high price…If replacement cost…the land is
of high price

Sunk Vs Fixed costs

Eg: license to run business..is sunk cost. Fixed

cost eg is equipment..since these doesn’t change

Since sunk costs are not recoverable, they should

not be considered while taking decision
 Different types of costs

Total cost:

Average cost:

Marginal cost
 Avg costs in short run

If quantity produced Q=0;

TC=FC
Shape of Avg fixed and variable cost curve

when productivity is going up, the average

variable cost will decline and then eventually as
productivity starts declining because of the law
of diminishing returns, your average variable
cost will go up. Remember, the downward
sloping part of the U-shape may not exist, but
average variable cost must go up because of the
law of diminishing returns.
Shape of avg total cost curve
Marginal Costs

Since short run, law of diminishing role plays

here, and productivity is inversely proportional
to cost. So u shape curve
Avg costs and Productivity
Variable cost= Labour cost=
w*L

Avg product= Q/L

 Marginal costs and productivity

according to the law of diminishing returns, marginal product in the short run must eventually decline. So, in
other words, what should happen then is that the marginal cost must after some point increase.
 Linking avg and marginal costs
when the average variable cost is declining,
the marginal cost is less than the average
variable cost. And when the average
variable cost is increasing, the marginal cost
is higher than the average variable cost. And
of course, the two are the same—equal to
each other when the average variable cost is
at its minimum

When the average total cost is declining, the

marginal cost is less than the average total
cost and when the average total cost is
increasing, the marginal cost is higher than
the average total cost. And the gap between
the average total cost and the average
variable cost is given by the average fixed
cost
 Putting all costs together

Let FC=100..AFC=(100/4,100/9,…….)

Let wage rate=25..VC=(1*25,2*25,…..)

AVC= VC/Q=(25/4,50/9,…..)

MC=(25/4,25/5,25/6…..)

ATC=AVC+AFC=(31.25,16.66…..)
 Costs in the long run
SAC1= Short size restaurant

SAC2= Medium size restaurant

SAC3=Long size restaurant

If producing less than Q1..stay with SAC1

The costs would be far lower if you are

producing between Q1 and Q2, if you are
producing with SAC2 rather than SAC1 or
SAC3

If would like to sell more than Q2. Then

obviously, you should go for the big size
restaurant
 Shape of long run avg cost curve
initially as an establishment starts out small, it
experiences economies of scale. And then after a
point, all these economies of scale go away and you
probably have pretty much constant returns to scale.
And then, finally, as the size of the establishment
gets too big, then you have diseconomies of scale.
So, consequently, you would expect your long-run
average cost curve to also be U-shaped but to be
much more shallow in nature. So, initially, costs or
average cost would come down because of
economies of scale remain fairly constant for a
while, and then eventually start increasing again as
the size becomes too large.

Large scale of manufacturing, large economies of

scale

For services, diseconomies of scale enter arena much

earlier.
Week4
 Different types of markets

Now, monopolistic competition sort of borrows

some of the features of perfect competition and
some of the features of monopoly and produces
sort of a workable model which is a lot like
perfect competition. Whereas, oligopoly has a
situation where there are a few producers in the
market and the hallmark of an oligopoly of
course is that producers, realize that they are
interdependent.
Assumptions of a Perfectly competitive market

Product is homogenous

So, when you say that the product is homogeneous, it's not merely that it's physically the same. But it's
like perfectly substitutable, it's like you're selling the same stuff at the same location, at the same time
with. Okay so, homogeneity is a very fairly strong assumption.

There are many buyers and sellers

Free entry and exit from business

Perfect information
Demand in a Perfectly Competitive Market

No ability to effect price

Because product is homogenous. Widely

available, there is no chance it is higher than
market price
 Price in a perfectly competitive market

What price does a competitive firm charge?The

market price. The equilibrium market price
 MC=VC/MP
AVC=VC/Q
Let FC=50; AFC= FC/Q
ATC=AFC+AVC
TC=ATC*Q
Let Price=5; TR=Price*Q
Profit=TR-TC
MRP=MP*Price..should stop acquiring labour at point where MRP=Wage
As long as Price> Marginal cost, we can produce..so should be stopped at L=6, Q=72
 How much should a perfectly competitive firm
produce

When Price=Marginal cost

Should produce Q2, since we can’t maximise

profits if it is Q1.
 Profits in Perfectly Competitive Market

Derivative of cost function is marginal costs…

C’(Q)=marginal cost

SOC: To check maximum…if maximum, the

derivative is negative.

-C”(Q)<0….slope of the curve should be

increasing

FOC…first order derivative…w.r.t Q

Soc: second order derivate to check max value

 Graphical approach of profits in perfectly
competitive market

The shaded region is profit

 Losses in Perfectly competitive market

ATC> price….then loss

Max profit is synonymous with min loss

If not even meeting operating expenses, by

producing making more losses..worth to stop
producing

AVC<=price..there is hope to produce and make

produce

We can produce as AVC<price

 Supply curve of a perfectly competitive firm

Since we won’t produce the quantity less than

the point Q2 in marginal curve, will stop
drawing
 Perfect competition in Long Run
No fixed cost

In long run in perfectly competitive environment we will

make 0 economic profits

No profits no loss

If particular market is profitable, new firms enter the

market, the supply curve shifts to right S1, the price
decreases P1..but whole quantity increases because all
the firms combined quantity will be more…this will
continue till we reach min point of ATC P2.

In the end, what will happen? All those who are efficient,
who are inefficient are not making money will anyway
have to leave. The firms which are efficient, who have
the right costs, well, they will also find themselves in not
such a good position. They will—because price is equal
to minimum of average total cost, profits will be equal to
zero. So, there will be zero economic profits.
 LRM
SRA
C
SRM C
C
Demand increases..profit increases..but in LR
competitive industry, those profit goes away AC

Price = min of LRAC=LRMC

price= Long run incremental cost (as min of

LRAC is difficult to calculate)
Increasing, Decreasing and Constant Cost Industry
average total cost curve with time, it actually moves
up. As the industry expands, it requires more and
more resources to get these resources, it nee ds to buy
them from somewhere else, pay people more, and so
consequently, its average total cost increases. This
need not always happen. So, this is an example of
what we call an increasing cost industry. So, the end
result will be that the prices will not again come down
to its original level but, the price will now be slightly
higher than what it used to be once the industry has
expanded.

Similarly, you might have a constant cost industry

where this does not happen. And, it could be that this
particular industry, even though it's perfectly
competitive, it's still small relative to the, you know,
all the labor that is there.Decreasing cost industry is
possible theoretically. If u have to survive in
competitive industry, u have to be efficient.
Conditions for perfect competition

These factors should be considered.

Monopoly