Managerial Economics

1. MANAGERIAL
ECONOMICS
Dan Ayebale (PhD)

2. Topic one: introduction
What is managerial economics?
 It is an area of study that applies economic
thinking [theory] and decision sciences to
managerial decision making.

3. In this definition two important
concepts need clarification:
 Economics and manager.

4. Who is a manager?
 ”...all individuals who direct the effort of others,
particularly those who delegate tasks within an
organization such as a firm, a family or a club,
purchase inputs to be used in the production of
goods and services such as output of a firm,
food for the needy, or shelter for the homeless,
or are in charge of making other decisions
such as product price and quality.”Baye (2009,
p.3)

5. What is economics?
”The science of making decisions in the
presence of scarcity.” (2009, p.3)

6. Relationship between economics
and managerial economcis

7. Definition of Micro-economics
 Microeconomics is the study of economic
tendencies, or what is likely to happen when
individuals make certain choices or when the
factors of production change. Individual actors
are often broken down into microeconomic
subgroups, such as buyers, sellers and
business owners. These actors interact with
the supply and demand for resources, using
money and interest rates as a pricing
mechanism for coordination.
ead
more: Microeconomics http://www.investopedi
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8. Micro-economics cont...
 Microeconomics is the social science that
studies the implications of individual human
action, specifically about how those decisions
affect the utilization and distribution of scarce
resources. Microeconomics shows how and
why different goods have different values, how
individuals make more efficient or more
productive decisions, and how individuals best
coordinate and cooperate with one another.
Read
more: Microeconomics http://www.investopedi
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9. Macro-economics
 It focuses on the perfomance of the whole
economy.
 In this area of economics, it is the economy
wide phenmena that are studied such as:
 Inflation
 Unemployment
 Rate of growth
 National income and Gross domestic product
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10. Econometrics
 Area of study that test assumptions or models
through statistical trials. This involves the use
of statitical and mathematical theories.
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11. Mathematics
 This is a science that studies numbers,
quantities, equations, shapes and the logic of
the relationships between them.
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12. Purpose of managerial
economics
 This area of study aims at equiping managers
with skills of making sound decisions to
overcome scarcity (i.e., when faced with time
constriant, limited financial resources, debt
pressure and options because of competition,
among others).

13. Baye (2009, p.2)

14. The story of Ralph in our reference textbook
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15.  What are the key principles advanced by
managerial economics to support managerial
decision making?
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15

16. From economic perspective an
effective manager should:
1. Identify goals and constraints
2. Recognize the nature and importance of
profits
3. Understand incentives.
4. Understand the market, particularly the
different forms of consumer-consumer,
consumer-producer rivalries and the role of
government in the market.

17. From economic perspective an
effective manager should:
5. Recognize the time value of money. In this
case the NPV concept can be utilized.
6. Understand how to evaluate decisions using
the marginal analysis.

18. Example to illustrate how to use the
marginal analysis
How about the problem presented on p.31?

19. Calculating the NPV
Go to page 18 for
illustration

20. Some basic tools in economic
analysis
 Let us look at some key basic tools employed
in economics
 Equations
 Functions
 Tables, Graphs
These are used to illustrate relationships between
variables
In each case there is a dinstinction between
dependent and independent variable (s)

21. The relationship between the
variables can take different forms

22. Functional form of the
relationship

23. Example from business side

24. Topic two: Demand and supply
 Here our focus is on applying demand theory to
understand the the effectiveness of our price for a
product or service, procurement decisions, whether or
not our output is the best or not, quantity and rrevenue

25. What are the key managerial
questions in this example from the
economics perspective?
 How important are gasoline prices to the sales
of SUVs and other types of automobiles?
 How should the auto manufacturers respond to
the increasing price of gasoline?
 Are manufacturer incentives (i.e. price
reductions) an effective response?
 What are the combined effects of incentives
and increasing gas prices?

26. But why bother with these
economic questions?
I am only charged with day to day running of
the organization (routine guy). Why be
bothered by economics?
Let us learn something from this quote:

27. Theory of demand and
supply
 What is certain is that:
 When the manager is poised to take a decision
he or she is challenged by the invisible but strong
market forces. If you can master these trends you
will be an effective manager regardless of
whether you are in manufacturing or service
sector.
 Economics gives us principles to help us unmask
the trends caused by these forces.
 The principles to help us with this analysis are

28. But should the forces of demand
and supply be a concern?

29. If demand and supply are
important:
 What are they?
 What are the principles that economics gives
in the analysis of the demand and supply
market forces?

30. We begin with demand

31. Graphical representation of
demand

32. Other than the price that cause a shift along the same
demand line there are other factors that will instead shift
the demand of your product or servicee independent of
the price
These are factors that are usually outside the
firm’s control. Watching the trend of these
factors can help managers make the right
decisions regarding pricing, developing the
right relationships and hiring, among others.

33. Change in demand vs. Change in
quantity demanded

34. Some demand shifters
 Income: How does this factor affect demand?

35. Demand shifters
 The effect of substitutes
 The role of advertising
 The change in population structure
 The effect of consumer expectations

36. Other concepts...
The demand function
 This is one way of representing all factors of
demand starting with the price of a commodity or
service.
Specification of demand funcition

37. Using demand analysis to establish
the consumer’s surplus

38. Illustration of the concept

39. So how would this help me in my
day to day decision making?
Have you ever known how smart companies
decide on prices to charge?
Other factors help constant, the consumer
surplus logic can be used to decide on the
price

41. The second set of Market forces that
determine price: Market Supply
41
 We now turn to the second set of forces that
determine price in the market: market supply.
 Recall here we are interested in the business
environment where the economic freedom in
high. And thus, it is market forces of supply
doing the pricing and rationalization of the
good or service.

42. What is market supply?
42
 ” Total quantity all producers are willing and
able to produce at different prices, other
factors held constant” (Baye, 2010: 46)
 This can be depicted in a graphical form. The
graph shows the relationship between quantity
supplied and price. Other factors held
constant.
* It gives the amount a company is willing to
provide or sell at the prevailing market price.

43. Other factors that are important in
influencing the supply of a product
or service
43
 These include but not limited to:
 Input prices
 Technology or government regulation
 Number of firms
 Substitutes in production
 Taxes
Collectively, these are called supply shifters.

44. The law of supply, quantity
supplied and change in Supply
44
 The law of supply states that ”as the price of a
good increases, the quantity supplied of the
good or service will rise, other factors held
constant.”
 The movement along the supply curve is
known as change in quantity supplied. While
the change in the position of a supply curve is
called change in supply.

45. Change in supply
45

46. A focus on some of shifters of
market supply
46
1. Government
regulation:
 How is the East-
African community
formation likely to
influence market
supply in a number
of industries?
It will result into
reduction in costs. And
therefore increase
supply. How will this
happen? Through
reduction in tariffs and
removal of barriers to
investment.
Specifically, changes in
this regulation will make
it possible to produce at
a lower cost within the
region and thus increase
supply.

47. 47
2. The factor of substitution in production:
 Take the example given in the textbook of a
car assembly plant.
It is possible for example to have an
assembly line that can both accomodate
small cars asssembly and assembly of
trucks. This is an example of substitution in
production.
In this case ”automakers can convert a truck
assembly plant into a small car assembly
by altering its production facility” (Baye,
2010:48).

48. 48
3. Effect of taxes:
 Two types of taxes are discussed: excise
and Ad valorem taxes.
Excise tax is in terms of a fixed amount and
charged per unit of output. On the other
hand, Ad valorem tax is charged according
to the value of a product and it is charged
in percentage.

49. Illustration of the effect of excise
tax (p. 48)
49
 The tax is $0.20 per
litre of fuel. What
would be the effect?
 With this tax the
supplier would be
willing to supply
original amount only
when he or she
receives additional pay
of $0.20.

50. Some interesting questions to
interprete the curve
50
How much would the
producer be willing to
sell at the original price
given the tax?
What would be your
conclusion on the effect
of excise tax on the
position of the supply
curve?

51. Examining the effect of Ad valorem
tax
51
 This is a percentage tax, e.g., sales tax. Take
the example from our main textbook of 20%
tax charged.
 What effect would it have?

52. 52
 When a 20% tax is
imposed, the price
required to produce
each unit goes up
by 20% at any level
of output.
 This effect will be
higher for higly
priced goods.

53. 53
6. Producer’s expectation:
”selling a unit of output today and selling
it later are substitutes in production”
(p.49)
Therefore if the price is expected to be
high tomorrow and the good is durable
what will happen to supply? Where will it
shift?

54. Supply function
54
 This gives a
summary of the
factors that
influence supply. In
general form it
would be
represented as
follows:
In the specific form it can
either be linear or non linear.
An example of a linear supply
function

55. Producer surplus
55
 It is given by the
area above the
supply curve but
below the market
price.
It shows the amount in
excess of that
necessary to motivate
the supplier to sell a
good or service (p.51)

56. See the following excerpt from
our textbook for the application
of producer surplus
56

57. Demand, supply and
competitive price and quantity

58. Price floor and price ceiling: Using
Government regulation to determine who
gets to or not to consume a product
This is where government sets limits within
which prices are allowed to rise or fall.

59. Price ceiling illustration

60. How do you deal with this
situation?

61. Price floor and related effects
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This can include
lobbies for
government to
legislate minimum
prices for goods or
service. The most
common form of
price floor is the
minimum wage.

62. Application of joint analysis of
demand and supply forces
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This curve explains the likely effect
of the market changes in the car
rental sector reported in The Wall
Street Journal. In the Journal it is
reported that consumer’s income
will most likely rise by about 2.5%
over the coming year. And the
number of individuals over 25
years in the same period will be at
its highest point ever.
What are the implications of the
change in these market
conditions? Use the graph to
illustrate your answer.

63. An interesting illustration of the
importance of demand and supply
apparatus in informing managerial
decisions

64. Answer
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65. Topic three: Quantitative demand
analysis
 The focus here is
on:
 Estimating the
magnitude of
relationships
between demand
and associated
factors.
 Emphasis is on
giving precise
quantitative answers
to demand and
 Examples of questions faced by
managers answered under
qauntitative demand analysis
(see Baye , 2009):
 How much do we have to cut
price to acheive 3.2% sales
growth?
 If we cut price by 6.5% how
many units will we sale?
65

66. Quantitative demand analysis
 Notice that by being
able to answer
these questions, we
are able to address
issues related to:
 Inventory
management
 Revenue
management
 Strategic analysis
 Pricing decisions
66

67. We work with the concept of
elasticity
 In this chapter, the
key concept that we
introduce is
elasticity of
demand.
 This is a tool that we
employ to make
forecasts and
therefore make the
necessary
predictions to
answer the
aforementioned
questions.
67

68. What is elasticity?
 This measures
responsiveness of
one variable to
changes in other
variables (Baye,
2010)
 Two aspects are
important in
interpreting
elasticity:
 The sign—positive
vs. negative
elasticity
 Magnitude, which
can be greater than
1 or less than 1
68

69. Types of elasticity
A. Own price elasticity
This is helpful in
determining the
impact of the price
increase or decline
on firm’s sales or
revenue
 This measures
responsiveness of
quantity demanded
to change in price.
69

70. Computing own price elasticity
(Baye, 2010:76)
70

71. Some of the terminologies used in
elasticity
 Elasticity greater than 1 in absolute
terms: Elastic
 Elasticity less than 1 in absolute terms:
Inelastic
 Elasticity equal to 1: unitary
71

72. Elasticity and total revenue (Baye,
2010:77)
 What do you need
to do with the
table?
 To estimate price and
quantity using the
Qdx=80-2Px
 To calculate own price
elasticity
 Calculate total revenue
 Explain the pattern of
own price elasticity for
this demand function
What do we observe?
Elasticity increases in
absolute terms as
price increases
72

73. Other interesting observations of
managerial interest
 Observe within the
revenue column
when own price
elasticity is less than
1 as price increases
TR also increases
and beyond 1 it
decreases. Why is
this analysis
important?
 The answer to this question will
help us understand the point
where price and quantity give the
73

74. The relationship btn total revenue,
price and elasticity or total revenue
test
74

75.  How can we use this
to boost your cash
flow?
 Price cut or price
increase
The decision about this starts
with getting information from
the research department .
This will furnish the manager
with estimates of own price
elasticity (assume that this is -
1.7)
 After knowing this
the manager can
then determine if the
cut in price say by
5% will give a
favorable outcome.
Answer:
-1.7=change in Qdx/-
5
75

76. Another type of elasticity: Arc
elasticity
 See the example of
inside business 3-1 in
our major textbook.
What are the limitations
of arc elasticity?
 It is only an estimate
 The assumption made
here is that the demand
curve did not shift between
the given period.
76
This is an estimate for own
elasticity of demand that is
best on two points of price
and quantity of a
commodity. See the
formulae in the section
below

77. Another type of elasticity: cross
elasticity
 This shows the
responsiveness of
demand for the
good to changes in
price of a related
good.
 Formulas for
computing cross
elasticity (see the
description of these
formulas in Baye
(2010:85)
77

78. Interpretation of cross elasticity
 For substitutes EQx
Py would be greater
than zero
 For compliments
EQx Py would be
less than zero
 See the example of
cross elasticity in
Baye (2010:86)
78
This concept plays a big role
in pricing decisions of a firm
selling different products.
See the example in Baye
(2010) on the relationship btn
Burger and soda

79. Another important type of
elasticity is Income elasticity
 This takes us back to
the debate on the
different types of
goods and services.
It is computed using
the following
formulas.
 Example:
79
For a normal good what would
be its income elasticity of
demand? How about for the
inferior good or service?

80. An interesting case

82. Quiz
Describe the major factors that are likely
to affect the own price elasticity of
demand. Use the appropriate illustrations
in discussing your arguments.
82

83. Topic four: The theory of individual
behavior
Introduction
 Is the understanding of individuals’ behavior or
prediction of individuals’ behavior part of good
managerial skills?

84.  As a manager you deal with many workers or
clients all with different minds, values or thoughts.
 Would you entirely agree with the view that:
”That it is all out of good luck that one is able to
accurately predict workers or consumers behavior and
make a right decision”
What do you think?

85. Let me give one scenario: Take this
example

86. Modeling consumer behavior
 Specifically we draw on consumer behavior for
valuable insights into how managers can
acheive success in motivating a particular
response from consumers or workers.
 We offer tools for modeling consumer
behavior.

87. Some definitions
Consumer: A person who purchases a good or
service
Consumer opportunities: goods and services
a consumer can afford.
Preferences: goods and services a consumer
will actually consume.

88.  Indifference curve: A diagramatic
representation of bundles of two goods where
the consumer has the same level of
satisfaction.

90.  Marginal rate of substitution: This refers to the
slope of the indifference curve. It gives the rate at
which a consumer is willing to substitute one good
for the other while still maintaining the same level
of satisfaction.

91. Assumptions of the model
 We assume two goods X and Y
 We also assume that the consumer can order
his or her preferences such that it is possible
to have the following options: X>Y, i.e., X is
preferred to Y or Y>X, i.e., Y is preferred to X
and X῀Y, i.e., the consumer is indifferent
between the two goods or services.

92. Properties of the model
 The consumer’s ordering of the different
bundles of X and Y is assumed to satisfy four
basic properties: completeness, more is better,
diminishing marginal rate of substitution, and
transitivity

93. Properties continue...
 Completeness: What is assumed in the model
is that preferences of the consumer have to be
complete.
 The model works with the logic that the
consumer knows well about the bundle of goods
at hand and if A>B then will not indicate B>A at
the same time.
If there is no clear demonstration of
completeness then it becomes difficult for a
manager to predict the individual's behavior

94. Property 2: More is better:
This means that X and Y are seen as "good" and
not "bad" to the consumer. From the figure below
this means that bundles of X and Y represented
by A, B and C would be preferred to D.

95. Property 3: Diminishing marginal rate of
substitution
As a consumer obtains more of good X, he or she
is willing to give up less of Y to obtain another unit
of good X decreases. This is why the indifference
curve is convex from the origin. But why give up
less of Y? This is simply because to the
consumer Y is now more scarce.

96. Property 4: Transitivity
According to this property if bundle A>B and B>C,
it should then follow that A>C. The implication of
this is that indifference curves do not intersect
each other.
This assumption eliminates the possibility in
the analysis a situation where a consumer is
not able to make a choice.

97. How can the property of transtivity
be illustrated?

98. What valuable information do we
have so far?
While we know that understanding individuals
preferences can be complex for reasons related to
the fact that "human beings use complicated thought
processes to make decisions and that the human
brain is capable of processing vast quantities of
information" (p.118), hence making it very difficult to
understand what they are capable of doing or
preferring, we so far have the following insights to
address this complexity for managerial purposes:

99.  Tools to precisely represent the individuals likely choice
between bundles of two goods or services. This is given by
the indifference curves.
 Some framework of understanding ordering of preferences
of individuals. See figure of the family of indifference
curves.
 We can also identify circumstances under which a manager
can ably inquire into the preferences of consumers. This
task is guided by the properties of preference ordering.

101. Budget contraint
This is another important aspect in modeling
preference of the consumer behavior. Note that
though there are several constraints we restrict
ourselves to the budget constraint.
The budge constraint helps the decision maker to
know the bundles of X and Y that are affordable to
the consumer at a given price and income.

102. M=PxX + PyY

103. Budget line
 With this budget set information we have a short hand to
demonstrate a number of things related to consumer
behavior under the following conditions:
 When the price of X decreases
 When the price of Y increases
 When the income increases
Note that this analysis can only be complete when we have
good knowledge about the nature of products we are making
reference to. Is the good or service normal or inferior or
luxurious?

104. Changes in price

105. Changes in income

106. Managerial implications so far
 With the above information let us see how a manager
armed with that information can outsmart competition.
The ramification of the above concepts combined is that
the objective of a consumer is to choose a bundle of
goods that maximizes his or her utility. But this has to be
within the budget set: one that is affordable.
 Armed with this knowledge the decision maker now can
predict the behavior of a consumer in response to
different utility enhancing circumstances.

107.  From the conceptual point of view when
presented with the following diagram, which
bundle of goods X and Y would be most attractive
to the consumer? Or lead to a more desirable
outcome?

109. A more complex situation of
income and price substitution
effects

110. Can this information be helpful in
compensating workers during a period
of inflation?
How can you utilize this analysis to
manage the type of products that you
sell in a particular business cycle
circumstances?

111. Another example: Buy one get one free (limit
one free pizza per customer)

114. Assignment
 What is the effective way of acquiring inputs
for production?
 How can you ensure that the human resources
in the company give the maximum or optimal
effort in the production process?
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114

115. Topic five: Theory of production
115
 In this section we find out ways through which
managers can optimally choose the quantity
and types of inputs to use in the production
process.
 Specifically, in relation to getting the right
quantity and mix of employees and optimally
substituting among these and other inputs.

116. Important definitions
 We will start by
defining the concept
of technology.
For every output
there is a form of
technology available
for producing it.
 And a key
managerial decision
is how to exploit the
available technology
to full potential.
116

117. The production function
 The technology for
turning inputs into
outputs is
summarized in a
production function
 Q=F(K,L).
 Specifically, this
shows the maximum
amount of inputs
that can be
produced from a
given level of input.
117

118. Short-run optimal production
decisions
 A short-run period represents that time when
there are fixed factors of production.
 On the other hand, a long-run period is that
time horizon where it is possible for managers
to adjust all the factors of production.
118

119. Measures of productivity
 Productivity is one
of the important
concepts of
managerial decision
making.
 Some of the
measures of
productivity include:
 Total product (TP): This is the
maximum output produced
with a given amount of inputs.
 Average product (AP): This
gives the amount of output
produced per worker with the
given inputs.
 Marginal product (MP): This is
the change in output
attributable to last unit of
input.
119

120. The relationship btn TP, AP and
MP (Baye, 2010: 57 & 159)
120
An important principle in production: It is not worth
to operate in the range of negative MP.

121. Role of manager in production
process
A. To ensure that the
firm operates on
the production
function.
What does this
entail?
 This involves giving
the right incentives
to ensure that
managers and
workers give their
maximum effort. These
incentives are discussed in detail
under the topic of principal-agent
problem.
121

122. B. To ensure a firm
uses the correct
level of inputs.
What does this
entail?
 This involves
operating on the
right level of the
production
function.
Assume the output
price is US$3
and each unit of
labor is US$400.
How many units
of labor should
be hired to
maximize
122

123. Answer
 To answer this question
involves establishing the
benefit of hiring an additional
worker. This is established
using the following formulae:
 VMP=P *MP. Using the
formulae to address the
concern of interest:
3*MP(labor)=VMP
The profit maximizing point is that
point where VMP=w in the range
of diminishing MP
123

124. Isoquants, Isocosts and optimal choice of
inputs for a given level of output
 In this section we
learn about tools
that can help us
establish the optimal
choice of factors of
production in the
long-run
 In the long-run
managers need to
establish the best
combination of inputs
that can be used to
produce a given level of
output.
124

125.  Isoquants define
that combination
of inputs that yield
the same level of
output.
 Isocosts on the
other hand, give
the combination of
inputs that would
cost the firm the
same amount.
 The knowledge
of Isoquant and
Isocost is
important in
helping us
establish the
input usage that
minimizes
production
costs.
125

126. A note on Isoquants
 The Isoquants are convex
because the inputs are not
perfect substitutes.
 The rate at which labor
and capital can substitute
for each other is called
marginal rate of technical
substitution (MRTS). And
this is the slope of the
Isoquant.
126

127. A note on the Isocost
 The graph shows
the Isocost line. For
the two factors of
production it is given
as:
 wL+rK = C
127

128. The principle
 To minimize the cost
of producing a given
level of output the
marginal product per
dollar spent should
equal for all factors
of production
128
The principle is
summarized in the diagram
below

129. The cost function
 This part clarifies
more on the cost
structure of the firm.
It gives more details
on the cost of the
production for
managerial decision
making than
information given in
the Isoquants.
 The table in the next
slide summarizes
the likely behavior of
the different
operational costs of
the firm in the short-
run
129

130.  With this summary, it
becomes easier for
managers to have
manageable information
to make an optimal
decisions on how costly
it is to continue with
production.
 Notice that in the short-
run the only costs
variable in our example
is labor.
130
The table shows the cost
function. It is based on a
function that ideally
summarizes the minimum
possible costs of producing
each level of output when
variable factors are being used
in the cost minimizing way

131. The summary of information above
in graphical form
 What does the
graph suggest?
131

132. Relationship btn costs
 What is the meaning
of each of these
types of costs?
 What are their
respective
implications for
management?
132

133. Graphical representation of these
costs
 What is the long-run
structure of these
costs?
 Distinguish with
examples between
economies of scale,
economies of scope
and cost
complementarity
133

134. Self-paced learning
 Drawing on the theory of market structures, explain
how a company can effectively position itself to
compete in the following settings:
1. Perfectly competitive business environment
2. Monopolistically competitive market environment
3. Oligopolistic competition
4. Monopoly environment
In your answer I should be able to see clearly the
principles guiding your argument derived from the
theory, and how an organization can utilize those
principles in the different business settings to manage
its pricing, production, inventory, marketing campaign
decisions as well is its product strategy (low-cost vs.
Differentiated high end products).
8/15/2023
134

135. Topic seven: Managing in
competitive and monopolistic
markets
 The aim is to help you understand how to
manage in different business environments
and understand how to make optimal
decisions relating to pricing, output level, and
advertising, among others

136. Managing in Perfect competitive
market
The key conditions of this market environment
include:
 There are many buyers and sellers in the
market, each of which is small relative to the
market
 Each firm in the market produces identical
product
 Buyers and sellers have perfect information
 There are no transaction costs

137.  In this market setting a firm has no power to
exert influence on price: all firms are expected
to sell at a market price.
 If the firm does not sell at this price consumers
will purchase from a firm charging a lower
price

138. An example close to what we are
refering to

139. Market vs. Firm’s demand curve in a
perfectly competitive environment

140. Some insights into the diagram
 The individual firm’s demand curve is
perfectly elastic. It is therefore difficult for the
firm to charge a price different from the market
price.
 So then managerial flexibility is in the area of
adjusting output levels.

141. Short-run output decisions
 In the short-run there are fixed factors of
production. An example could be a payment
made for a lease say for a period of one year.
 This is the cost already incurred and cannot be
erased at least in a year (short-run). But in the
long-run this can be changed say by renewing
or not renewing the lease.

142. Now faced with fixed costs, the challenge is a
firm maximes profits in the short-run?
 The decision in relation to profit maximization is to
do with setting the right output and not price
 And specifically how to determine the right output
to produce--given the inputs that are variable such
as labor.

143. The graph below provides insights
into the information needed to
make a conclusion on the price

144. What does the diagram imply?
 Profit is given by vertical distance between the
cost function and the revenue line.
 At the point of the most optimal profit the slope
of the cost curve equals exactly the slope of
the revenue line. This point is given by point E.
 That is a point where MC=MR=P

145. Key conclusions
 In a perfectly competitive firm, the manager
must equate the market price with marginal
cost to maximize profits. P=MC (Q). An
alternative way of representing the condition in
the earlier curve.

146. Minimizing losses in Perfect
competition
Sometimes losses in the shortrun are inevitable.
But if these continue in the long-run, the best
thing for a firm to do is to exit. So then what
are acceptable losses in the short-run?
The graph below helps us to make that
decision in the perfect competition
environment

147. The graph shows a point for acceptable losses
operating in the short-run in perfect competition. This
is when the firm despite the loss can still cover its
variable costs.
In geometrical terms this would be the case if the
Pe>AVC. At this point for each extra unit sold, the
revenue generated is greater than increase in cost.

148. When does the firm then shut
down?
 This should happen when the price is below
the AVC.

149. General principle producing under
perfect competition in the Short run
 To maximize short-run profits, a perfectly
competitive firm should produce in the range of
increasng MC where P=MC, provided
P>=AVC.
 If P<AVC, the firm should shut down its plant
to minimize losses.

150. A mathematical demonstration of
the example

151. Long-run output decision
 In the long-run, in perfect competition firms
would enter (leave) the market where there are
profits (losses) in the market.
 Observance of profits in the short-run attract
more firms in attempt to pertake in the profits.
 What will then happen to the market supply
curve?

152. The adjustment continues until economic profits are zero. As
shown in the figure below the firm just receives enough to
cover the ACs of production

153. General rule for operation in the
long run under perfect competition
 A firm needs to produce a level of output such
that P=MC and P=minimum of AC

154. A nalysis of production and pricing
under monopoly
 Under monopoly, a single firm serves an entire
market for a good for which there are no close
substitutes.
 In this case there is not direct competition
between firms for the same customers. An
example could be the only petrol station in a
village.

155. Another example

156. What is the market demand curve
for such a firm?
 We know that a monopoly firm may have the
power to charge a given price but will not have the
power over what consumers will buy at that price.
 This means that a monopoly firm will have a
downward sloping curve.
 In addition for this case of market environment the
firm’s demand curve is the same as the market
demand curve.

158. How can a manager exploit
monopoly power to maximize
profits?
Let us have some building blocs to our analysis.
 For a monopoly MR is less than the price charged.
Why?
This is because according to the demand curve that a
monopoly is faced with, to sell one more unit the price
has to be reduced.
Why?

159.  This is because MR<P. For example if a
monopolist sells 1 unit at shs 4, then TR=4 (Q*P)
and therefore MR= dTR/dQ.
 To sell one more unit the monopolist would have
to reduce the price say to shs3. In this case TR=6
 MR=dTR/dQ=shs2
 Which is less than the price charged. Essentially, the
price for a monopolist depends on the quantity
produced. The result is the inverse demand curve.

160. Inverse demand curve in
functional form
P(Q)=a+bQ. Unlike in the earlier
conceptualization of demand
where demand depended on
quantity, in this case price is the
dependent variable while quantity
is the independent variable.

161. The optimal output decision for
a monopoly firm
 The following are the revenue and cost
functions of a monopoly firm.

162. Some explanations for the
curve
 The vertical distance between revenue and
cost functions reflect the profit to the
monopolist at different levels of output.
But is it possible for a monopolist to have
losses?

163. A loss will occur when output is
less than higher than point B

164. Alternative representation of
profit maximizing output level
for monopolist
A profit maximizing monopolist should produce the output
Qm such that the MR=MC. Meaning where MR>MC, a profit
maximizing monopolist should continue to increase output.