Optimizing Business Decisions: Managerial Economics Insights

BITS Pilani
Pilani Campus
Managerial Economics
MBAZC416
Sidharth Mishra
Associate Professor, Department of Management
sidharth.mishra@pilani.bits-pilani.ac.in

BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Introduction - Part 1

BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Agenda
• Introductions
• Flipped classroom
• Course objectives
• Textbooks/ Resources
• Evaluation scheme
• Overview of Managerial Economics

BITS Pilani, Deemed to be University under Section 3, UGC Act
Sidharth Mishra
• BE (NIT, Rourkela), PGDM (IIM,Ahmedabad)
• 25 years in the corporate sector in the consumer and the start up sector with
tenures in leading companies like LG, Samsung and HCL.
• Associate Professor (Department of Management), BITS, Pilani since
November, 2018.
• sidharth.mishra@pilani.bits-pilani.ac.in
Instructor
4

Textbook/ Resources
R1 Managerial economics by Keat and Young, Pearson, 7th Edition,
2018
R2 Samuelson & Nordhus, "Economics", Tata McGraw-Hill Edition,
16th edition, , 1998
R3 Petersen, Lewis and Jain, “Managerial Economics”, Pearson
Education, , 2006.
R4 Hirschey, “Economics for Managers”, Thompson, , 2006
R5 Suma Damodaran, "Managerial Economics", Press, 2006
T1 “Managerial Economics” Truett and Truett by John Wiley
and Sons, 4th Edition, 2004

• Scope
• Cost
• Nature of Costs (Fixed, Variable), Marginal costs, Cost Variation
• Revenue
• Demand, Demand Variation
• Profit
• Profit Trends, Conditions for Maximum Profit
• Customer
• Utility, Choice
• Production
• Stages of Production, Economic Production
• Market
• Monopoly, Oligopoly, Perfect Competition etc.
• Business Models
• Collusion, Cartels etc.
• Decision Process
• Game Theory
Scope and Objective
6

Objective
7
Fundamental Equation of Business
Profit = Revenue – Costs
A shop keeper sells 1000 kg of rice at Rs. 50 per
kg. The cost of running his shop is Rs. 20000 per
month.
Revenue = 1000 X 50 = 50,000
Profit = Revenue – costs = 50000 – 20000 =

Evaluation Scheme
No Name Type Duration Weight
EC-1 Quiz-I Online - 5%
Quiz-II Online - 5%
Assignment Online - 10%-15%
EC-2 Mid-Semester Test Closed Book 2 hours 30%
EC-3 Comprehensive
Exam
Open Book 3 hours 40%-45%

Introduction
(MBAZC416)
Fundamental Questions
–What is Managerial Economics?
–Why Managerial Economics?
–What kind of issues does it help
address?
–How can it help managers to make
better decisions?

Fundamental economic problems
• Three questions that managers face:
– What to produce?
– How to produce?
– How to distribute?
• Scarcity of resources
• How does economics answer these questions?
(MBAZC416)

• Imagine a car manufacturer producing only one model of car (Model T) priced at US
10,000 at which they were able to find 5000 customers.
• For selling additional volumes they have to start giving freebies (additional warranty,
0% finance, free services)
• For selling more they have to initiate price-cuts. After the given volume they would
be able to sell by lowering price.
• At the same time their costs would also change (material cost would go down
because of bulk discounts, service and repair costs would go up etc.). There would
be an ideal level of production where they would be able to make maximum profit.
• How many Model Ts should I produce? Should I develop new models with my spare
resources?
• The concept applies equally well to your neighborhood burgher joint or dosa seller.
Imagine
11

Managerial economics
(MBAZC416)
Definition
Managerial Economics: the
application of economic theory and
methods to business decision-making.
Business: Any situation where there is a
transaction between two or more
parties

Managerial Economics: How is it useful?
(MBAZC416)
• While economics attempts to describe how the economy
works, managerial economics deals with its impact on
businesses and how managers can handle them for the
benefit of their firms as well as the society.
• It prescribes rules for improving managerial decisions
• It helps managers recognize how economic forces
affect organizations
• It links economic concepts with quantitative methods to
develop vital tools for managerial decision making

Scope of marketing whatisamarket?
• The word market traditionally refers to the market place –
the location or area where buyers and sellers meet.
• In economics, market is described as a collection of
buyers and sellers who transact over a particular product
or product class.
• In marketing the word “market” is used to describe various
grouping of customers. For example while referring to the
automobile market we mean the set of people interested
in buying an automobile.

Relationship with economic theory
(MBAZC416)
• Microeconomics
– Focuses on individual consumers and firms
– Theory of the firm
– Theory of consumer behaviour (demand)
– Production and cost theory (supply)
– Price theory
– Market structure and competition theory
• Macroeconomics
– Aggregate variables such as GDP, GNP,
Unemployment, Inflation, etc.

• Traditional Economy
• People centric
• Little division of labor
• Limited Resources
• Little Surpluses and Little wastages
• RURAL ECONOMY
• Command Economy
• Dominant central authority (Government) takes production decisions
• Many Resources
• Works well under enlightened leadership
• Rigid, slow to change and hence prone to crises.
• COMMUNIST SOCIETY
Economic systems
16

• Market Economy
• Little Government regulation
• Regulation through supply and demand
• Growth Oriented
• Unequal distribution of economic power
• Prone to recessions
• CAPITALISM
• Mixed System
• Combines the characteristics of market and command economies
• Most industries are private while public services (law and order, health, education etc.) are under government
control.
• Economy is REGULATED (not controlled) by the Government
• Challenges of right balance between the Government and market forces.
• GLOBAL NORM (Most countries in the world follow this system)
Economic systems
17

1. Managerial Economics – Scope
2. Market Environment
3. Factors of Production
4. Market Function
5. Approaches used in Economics
6. Types of Profit
7. Theories of Profit
8. Types of Enterprises
Agenda
18

Managerial Economics: aToolfor
ImprovingManagementDecisionMaking
Managerial Economics (MBAZC416)

What is the best “choice”
(MBAZC416)
• Understand the economic environment in which firms operate
– We will be exploring several case studies throughout the course
• Consider alternatives
• Make optimal choices to maximize (objective)
u Profit
u Market share = Sale/ Market Size
u Managerial interests
u Brand Value, Check the competition, Employee Retention
u Government influence
u National interests
u Providing employment, Inflation under check.
u Social and environmental benefits
At different points of time,
firms can have differing
Objectives.
Often firms follow multiple
Objectives.
Social Entrepreneurship

Monopoly
• One dominant player (Indian Railways)
• No substitute
• High Barriers of entry
• Seller is price maker (seller decides the price)
• Firm can charge any price to its customer without giving any notice.
Oligopoly
• A few sellers but many buyers (Steel Companies, Oil companies,
Ecommerce)
• High Entry Barrier
• Firms set price collectively (cartelization)
Market Environment
21

Monopolistic competition
• Many sellers who offer similar but not substitute products (products are
differentiated)
• Low Entry Barriers
• Firms are price makers
• Overall business decision of one company does not affect the competition
• Restaurants
Monopsony
Many sellers, but one or only a few buyers
Armament industry, Tobacco farmers
Market Environment
22

Perfect Competition
• Many firms produce identical products
• Sellers and buyers have all relevant information to make rational decisions
about the product being bought or sold.
• Many buyers are available to buy a product and many sellers to sell a
product.
• Firms can enter and exit the market without any restrictions.
• The neighborhood vegetable vendor.
Market Environment
23

• Firms are price takers. They have to take (accept) the market price. Else they
would lose customers.
• The price is decided by supply and demand.
• A firm in a perfect competition market would be small to the point its output
would not affect the overall supply or impact the prevailing price.
• In the long run, perfect competition firms would react to profits by increasing
production and losses by decreasing it.
• In the long run equilibrium conditions would prevail (here firms are not
increasing decreasing supply) when the firms are making zero profits or
losses.
Characteristics of perfect competition
markets
24

• Land
• Labor
• Capital
• Entrepreneurs
Factors of Production
25

Market Operation
Government
Manufacture
r
(Producer)
Consumer
Resource
(Land,
Labour,
Capital)
Intermediary
(Retailer)
Money
Resources
Services
Goods, Taxes
Services
Taxes
Resources
Money
Goods, services
Money
Goods, services
Money
Resources Money
Goods, Taxes
Services

The Decision-Making Process
(MBAZC416)

Summary
• Managerial Economics helps business leaders and policy
makers to make optimal decisions
• Leverages economic analysis for concepts such as
demand, cost, production, profit and competition
• Bridges the gap between theory and practice
• Provides tool sets to make optimal decisions
(MBAZC416)

Application of concepts using Case Studies
(MBAZC416)
• Multinational production and pricing
– How does Ford or GM decide where to produce its cars
(multinational factory locations) and where to sell
(multinational markets)
• Market Entry
– How do major bookstores decide where to set up shop,
assess demand and profitability, assess and react to
threats from online stores
• R & D Decisions
– How does a pharma company decide whether to invest
in traditional biochemistry based research or to pursue
biogenetic approaches (such as gene splicing)

Positive and Normative economics
(MBAZC416)
• This is also referred to as is/ought distinction
• Positive statements
– Factual statements
– It can be verified by empirical study or logic
– Based on a study of 500 firms, it can be inferred that
private owned enterprises are more profitable than state
owned ones.
• Normative statements
– Value judgements
– It can’t be verified by empirical study or logic
– We should focus on growth through state owned companies
are private firms lead to concentration of wealth which is
detrimental to democracy.
• Relevance of the distinction to the study of managerial
economics

The study of psychology as it relates to the economic decision making
processes of individuals and institutions.
Rational Choice Theory
When individuals are presented with various choices under condition of scarcity
they choose the option that maximizes their individual satisfaction.
It assumes that human beings are capable of rational decisions.
Behavioural Economics explains that is not often the case. Individuals often get
swayed by extraneous factors to make “irrational” decisions.
A man struggling with weight problems should avoid sugar-rich food. The same
person would get swayed by a television ad and consume carbonated soft
drinks.
Behavioural Economics
31

Opportunity costs
(MBAZC416)
• Scarcity and choice are central to the
economics discipline
• In the face of scarcity, we make many
decisions
• Follow one course of action and forgo some
other course of action
Opportunity cost is the highest valued
alternative forgone whenever a choice is
made

1. Ram chose to start a business ignoring two job offers. The first one would
have offered a salary of Rs. 100,000 per month. The figure for the second
one is Rs. 150,000 per month. What is his opportunity cost of starting the
business?
Answer: Rs. 150,000 per month
2. Dr. Usha started her clinic for which she had to vacate a part of her
residential premise from which she was getting a rent of Rs. 20000 per
month. She also chose to quit her job at a local hospital where she was
getting a salary of Rs. 100,000 per month. What is her opportunity cost?
Ans: Rs. 120,000 per month
Illustration Opportunity Cost
33
Opportunity cost is the highest valued alternative forgone
whenever a choice is made

Definitions of Profit
• Business or Accounting Profit: Total revenue minus the
explicit or accounting costs of production.
• Economic Profit: Total revenue minus the explicit and
implicit costs of production.
• Opportunity Cost: Implicit value of a resource in its best
alternative use.
(MBAZC416)
FUNDAMENTAL EQUATION OF BUSINESS: PROFIT = REVENUE - COST

Explicit and Implicit Costs
35
Basis Explicit Cost Implicit Cost
Definition The cost that involves
outflow of cash due to
use of one or more
factors of production
(Land, Labour, Capital)
The cost that does not
involve any cash outlay.
(Opportunity Cost)
Nature Out of pocket expense Imputed (projected)
costs
Occurrence Actual Implied
Recording and
Reporting
Yes No
Impact Objective Subjective
Example Salaries, Rent,
Advertisement, Bank
Interest
Return on owner’s
capital, Cost of owner’s
work, Rent of owner’s

At the end of the year, Dr. Usha found that she has made a revenue of Rs. 10 Lakh. Her
expenses on electricity, consumable and the salary of one assistant is Rs. 6 lakh. What her
accounting profit / loss? What is her economic profit or loss?
Ans: Revenue =
Explicit Cost =
Implicit (Opportunity) Cost = Rent + Salary = 20000*12+100000*12 = 14.4 L
Accounting Profit = Revenue – Explicit Cost = 10L – 6L = 4L
Economic Profit = Revenue – Implicit cost-Explicit Cost = 10L – 14.4L – 6L = -10.4L
Illustration
36
Dr. Usha started her clinic for which she had to vacate a
part of her residential premise from which she was getting
a rent of Rs. 20000 per month. She also chose to quit her
job at a local hospital where she was getting a salary of
Rs. 100,000 per month. What is her opportunity cost?

Theories of Profit
• Risk-Bearing Theories of Profit
– Firms make profit because they take risks.
• Frictional Theory of Profit
– Firms make profit because the perfect competition equilibrium is never reached.
• Monopoly Theory of Profit
– Firms make profit when they enjoy monopoly.
• Innovation Theory of Profit
– Firms make profit when they innovate on products or costs.
• Managerial Efficiency Theory of Profit
– Firms make profit by managing their businesses well, eliminating wastages etc.
(MBAZC416)

Social Function of Profit
• Profit is a signal that guides the allocation of society’s
resources.
• High profits in an industry are a signal that buyers want
more of what the industry produces.
• Low (or negative) profits in an industry are a signal that
buyers want less of what the industry produces.
(MBAZC416)

1. Making decisions
(MBAZC416)
39
• The role of the managers is to make
decisions
– Business firms come in all sizes
– No firm has unlimited resources
– Short-run and long-run decisions
• Managerial Economics: How to make
decisions that make sense for the
operation of the firm

2. Decisions are among alternatives
(MBAZC416)
40
• Choices are always among alternatives
• Example-buying a new computer
• A job can be done by many, but some may
be better at it than others-cost differs

3. Decision alternatives have costs and benefits
(MBAZC416)
41
• Working Vs. Pursuing further studies
• What we consider when making our decisions?
• Benefits: benefit gained from studying – enhanced knowledge
and capabilities, which lead to better career opportunities in
the future
• Cost - cost of giving up short term promotions and increments
• Choosing to study- additional benefit gained from further
studies exceeds the additional cost
• Opportunity cost

4. Objective of management is to
increase the firm’s value
(MBAZC416)
42
• Profit is the difference between TR (Total Revenue) and TC (Total Cost)
• Different types of organizations/ firms
– Proprietorship Firms
• Sole proprietorship
– One owner
• Partnership Firms
– More than one owner
– Joint Stock Firms
• Private Limited Firms
– Shares are in private hands and not publicly traded.
• Public Limited Firms
– Shares are registered at stock exchanges and available for public trading
• Problem - Managers attempt to maximize own interest while shareholders increase
own benefit
• Principal –agent problem

5. The firm’s value is measured by
its expected profit
(MBAZC416)
• Example: consider two companies using different
production process
• Which one would be the better company?
• This can be easily evaluated based on excepted profits
• Present value of the expected future profit stream
Total Profit = Total Revenue – Total Cost

6. Firm’s sales revenue depends on
demand for its product
(MBAZC416)
• Some goods are highly price sensitive while other goods
are less price sensitive
• Demand for a product is a function of a number of factors
in addition to price

7. Firm must minimize cost for each
level of output
(MBAZC416)
• Total Profit (TP) = Total Revenue (TR) – Total Cost (TC)
• Important factors:
– Technology of production
• Labour Intensive, Capital Intesive
– Input prices
– Factors of production
– Different levels of technologies

8. Firm must develop a strategy consistent
with its market
(MBAZC416)
• We will study the various market structures and the
appropriate strategy for each of these situations
• Selling identical products
• Differentiated products
• Example - airline industry, software industry, etc.

Value of the Firm
The present value of all expected future profits
47
Managerial Economics (MBAZC416)

9. Firm’s growth depends on
rational investment
(MBAZC416)
• Decision to invest in new plant or equipment or develop a
new product
• The process of evaluating new investments of the firm-
capital project analysis or capital budgetting
• Capital project - calculating the expected stream of
benefits it will produce for the firm

10. Successful firms deal rationally and
ethically with laws and regulations
(MBAZC416)
• Various business laws and regulations
• Case of Enron or closer hope the collapse of Satyam
highlight the consequences of unethical behaviour

Course Objectives
No Course Objectives
CO1 Gain insights into the scientific and analytical methods,
techniques and tools of economics.
CO2 Gain basic understanding of the underlying concepts and
building blocks related to managerial Economics.
CO3 Understand the application of these concepts in business and
economic policy using suitable examples, case studies,
simulation, etc.

Expectations
• Replay prerecorded digital content before class
• Attend all “live” classes else replay recordings
• Review the relevant chapters from textbook before and
after class
• Do the homework and assignments in a timely manner
• Make sure you have access to laptop/ computer with
Excel; we will need it for experiential learning components
in subsequent classes. (Excel 2007 or later versions
preferred.)

Flipped Classroom
Week before
class
• Replay recorded lectures
• Review relevant study materials/ pre-class assignments
• Case study (if applicable)
In “Live”
Class
• Review important and advanced/ difficult concepts
• Active Learning - Application/ Problem solving
• Experiential learning – Excel modelling, Case study discussion,
Simulation
After Class
• Active learning - problem solving
• Discussion forums
• Peer learning

1. Concise Thinker
2. Problem Solver
3. Focus
4. Ability to correlate
1. Across subjects (economics to finance, physics to chemistry)
2. Real Life
5. Discipline
6. Enjoy
7. Inspiration
Seven Habits of Successful Students
53

BITS Pilani
Pilani Campus
MBAZC416
Sidharth Mishra
Associate Professor, Management – Off-campus
Email: Sidharth.mishra@pilani.bits-pilani.ac.in

BITS Pilani
Pilani | Dubai | Goa | Hyderabad
Theory of the Firm
and Related Concepts – Part 1

Agenda
• Introduction
• Nature of the firm
• Forms of Business Organizations
• Motivations
• Major theories of the firm
• The Basic Profit-maximising model
• The Agency problem
• Measurement of Profit
• Enron case study
Managerial Economics (MBA

• Elementary Laws of Economics
• Diminishing marginal utility, productivity
• Cost and Quantity Relationships
• Law of Demand and Supply
• Revenues and Costs
Agenda
57

Theory of the firm: Introduction
• Managerial Economics is primarily concerned with the application of
microeconomic principles for the effective management of business
firms
• In order to do this in an effective manner we need an overarching
“Theory of the Firm” that explains why firms exist, their structure, how
they behave, and what their goals are, etc.
• Firms are complex organizations that are difficult to model but as with
any modelling the key is to focus on the important factors and
eliminate the unimportant factors
• There are a number of theories (i.e. models) that attempt to model the
business enterprise and we shall review the key ones in this segment

The Nature of the firm
• Two fundamental questions:
– What are organizations?
– Why do they exist?
• Economic organizations
– Organizations occur at many different levels
• Business organizations
– Sole proprietorships
– Partnerships
– Joint stock company

Forms of Business Organizations
Sole
Proprietorship
Partnership Company or Joint
Stock Company
60
Managerial Economics (MBA ZC416)

Why do such organizations exist?
• Firms exist as an alternative to the market price mechanism
• Possible motivations:
– Benefits of Cooperation
– Specialization
• Business organizations are independent legal identities
• They can enter into binding contracts
• Firm contract bilaterally with suppliers, distributors, workers,
managers, investors, and customers
• Alchian and Demsetz - firm is a nexus of contract, wherein extra
output is provided by team production
– The contracts bring in predictability.
– Team production brings in specialization and benefits of cooperation
through synergy and economy of scale.

The nature of the firms: areas of economic theories
• Transaction cost theory
– Cost associated with undertaking transactions in different ways
– One of the first theories developed in this area
– Ronald Coase proposed this in 1937
• Information theory
– Concept of bounded rationality, asymmetric information
• Motivation theory
– This examines the underlying factors that cause people to behave in certain
ways
• Agency theory
– Conflict between Principal and Agent
• Property rights theory
– This examines the nature of ownership, and its relationship with incentives to
invest and bargaining power
• Game theory
– The strategic interaction of different agents

Transaction
• An exchange of goods or services (Transaction)
• It can be performed in three different ways
– Trading in spot markets
– Long-term contracts
– Internalizing the transaction within the firm
• Transactions costs refer to the costs that are not directly
associated with the actual transaction but rather enable the
transaction to take place
– Acquiring information about a good or service (e.g., price,
availability, durability, servicing, safety) are transaction costs
• Minimize the external and internal transaction costs

Transaction cost theory
• According to this theory the major goal of the firm is to have lower
costs than the market
• Related to the problem of co-ordination and motivation
• Co-ordination costs (Coasian costs)
– Search costs - Both buyers and sellers have to search for the relevant
information before completing transactions
– Bargaining costs - costs required to come an acceptable agreement
– Contracting costs - costs associated with drawing up contracts (managerial
time and legal expenses)
• Motivation costs (Agency costs)
– Hidden information - in a transaction, one or several parties may have more
information than others (example second-hand car market)
– Hidden action - when contracts are completed the parties involved often
have to monitor the behaviour of other parties

The Agency Problem
• Agency theory examines situations where agents are
charged with carrying out the desires of principals
• Maximize their own individual utilities
• A conflict of interest between principal and agent
• There is a misalignment of incentives
• Agency theory is concerned with designing incentives
so as to correct in the most efficient manner
• Two aspects
– The nature of contracts
– The problem of bounded rationality

Contracts and bounded rationality
• Contracts - method of conducting transactions
• Complete contracts - eliminate the agency problem
• Impractical to draw up a complete contract. To make a complete
contract, we need the following
– Foreseeing all the possible eventualities
– The eventualities must be accurately and unambiguously specified
– No desire to renegotiate the terms of the contract
– Observe freely the behaviour of other parties to ensure that the terms of the
contract are being met
– The parties must be willing to enforce the contract if the terms are not met

Nature of contract in reality
• Pragmatically, contracts tend to be incomplete, because of
bounded rationality
• Bounded rationality: people cannot solve problems perfectly,
costlessly and instantaneously
• The disadvantages of incomplete contract
– Hidden information: one party to a transaction has more information
regarding the past that is relevant to the transaction than the other
party or parties
– Adverse selection: only the products or customers with the worst
quality characteristics are able to have or make transactions and
others are driven from the market
• Hidden action (the problem of moral hazard):the behaviour of a
party cannot be reliably or costlessly observed after entering a
contract

• Utility is the total satisfaction derived from consuming a particular good or a
service.
• Marginal Utility is the added satisfaction that a consumer gets from having
one more unit of a good or service.
• Imagine a thirsty person drinking water. Marginal Utility is the utility derived from each additional glass of water.
• Law of diminishing marginal utility states that all else remaining equal, as
consumption increases the marginal utility (the added satisfaction
consequent to the incremental unit of consumption) declines.
• Exceptions: Hobbies (stamp collection, coin collection etc.), Addictions, Money
Law of diminishing marginal utility
68

Productivity: It measures the output per unit input such as labor, capital or any
other resource.
Labor Productivity =
Sales productivity =
Law of diminishing marginal productivity
69
labour Input
(manhours)
Output
(units)
Change in input
(hours)
Change
in output
(units)
Ratio*
(Marginal
Productivity)(u
nit/hour)
0 0
10 10 10 10 1
20 17 10 7 0.7
30 22 10 5 0.5
40 26 10 4 0.4
0 10 20 30 40
0
5
10
15
20
25
30
Productivity Curve
Output (units) Change in input (hours)
Change in output (units) Ratio (unit/hour)
*Ratio = Marginal Productivity =Change in output / Change in input

Explicit Costs : These are out-of-pocket expenses like rent, wages, ram materials,
electricity etc.
Implicit Costs : Opportunity costs (The highest value alternative forgone when a choice
is made.)
Accounting Profit = Total Revenue – Explicit Costs
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Example
Dr. Manisha is employed at Kailash Hospital as a consultant on a salary of Rs. 100,000
per month. She is planning to leave her job and devote herself full time to her own
private practice. The place she has chosen for her clinic would cost her Rs. 20,000
per month as rent. Other miscellaneous expenditure (electricity, telephone,
stationery etc.) would total Rs. 15000 per month. She would need an office
attendant at a salary of Rs. 10000 per month. Her consultation fee is Rs. 500 per
patient and she expects to see 15 paying patients on a day. Assume there are 25
working days in a month. Calculate the accounting and the economic profits.
Costs and Profits
70

Solution
71
Accounting Profit = Total Revenue – Explicit Costs
Total Revenue (per month) = (Consultation fee/patient)*(Patients/day)(Working days/month) = 500*15*25 = 187500
Explicit Costs = Rent + Wage+ Miscellaneous Expenses = 20000+10000+15000 = Rs. 45000
Accounting Profit = 187500 – 45000 = Rs. 142500
Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)
Implicit Cost = Opportunity Costs = Rs. 100,000
Economic Profit = 187500 – (45000+100000) = Rs. 42500

Marginal Cost
72
Marginal cost is the change in total costs that arises when the quantity
produced changes by one unit.
It is the cost of producing the next car in an automobile factory, the cost
of tutoring the next student at a coaching center or the cost of treating
the next patient at a hospital.
Marginal Cost (MC) = (Change in total cost)/(Change in output)
=
Marginal Cost for nth item, MCn = TCn – TCn-1
MC2 = TC2 – TC1
Units
produced Total Cost Marginal Cost
1 10 10
2 18 8
3 25 7
4 31 6
5 38 7
Cost Schedule
OUTPUT
MARGINAL
COST
Restaurant – Idlis
Total Cost1 = Rs. 10
Total Cost2 = Rs. 18
Marginal Cost of the Idli2 =(TC2-TC1)/ 2-1 = ΔTC/ΔQ = (18-10)/(2-1) = 8

• Marginal Cost is the change in total cost of production that comes from
producing one additional unit.
Examples
1) A match box maker incurs a fixed cost of U$ 10,000 per month in his factory. The cost of wood and
chemicals per match box is U$ 0.05. Find the marginal cost of production if he is producing 100,000
match boxes in a month.
Solution: Total Cost = 10000+ 0.05*100000 = U$ 15000 (TC1), Total Production = 100,000, Marginal Cost
=15000/100000 = U$ 0.15
2) The matchbox maker plans to increase production by 50000 match boxes. For this he has to build a
new factory shed and buy new machines which would require an additional investment of U$ 6,000
per month. The cost of wood and chemicals remain unchanged. What is the marginal cost of
production for the second lot of match boxes (50,000)?
Solution: New total cost = 10000 + 6000+ 0.05*150000 = U$ 23500 (TC2)
Change in Total Cost = 23500 – 15000 = 8500 = TC2-TC1, Change in output = 150000 –
100000=50,000
Marginal Cost of Production = 8500/50000 = U$ 0.17
The entrepreneur may worry about this increased marginal cost of production. Usually, new factories would
employ the latest technology and their marginal cost should be less.
• We shall shortly see that the Marginal Cost should be equal to marginal revenue for optimal production.
Marginal Cost of production
73

Total Costs include all economic costs of production.
They have fixed and variable components. We also have
opportunity costs.
• Fixed Costs are accounting costs which do not change with
the level of output.
Example: Lease Rentals, Furniture and fittings
• Variable costs change with the level of production.
Example: Cost of Raw material, packaging etc.
We have already examined opportunity costs.
• Total Cost = Total Fixed Cost (TFC)+ Total Variable Cost (TVC)
Petrol pump
Lease Rental : Rs 100,000 per month
Cost of Electricity = Rs. 10000 per month
Cost of manpower = Rs. 40000 per month
Cost of petrol = Rs. 100 per liter. Find the fixed, variable and total costs if the pump is selling 10000 litres of petrol per month.
Total Costs
74

75
Marginal Product, Marginal Cost Law of Variable proportions
Marginal Cost Declines
Marginal Cost Increases
Some of the reasons for the initial decline in Marginal Cost
1. Synergy 2. Experience Curve 3. Volume Discounts
Source: toppr/com
Marginal Product (Marginal Output)2 = (Total Output)2 – (Total Output)1
Marginal Product (Marginal Output)n = (Total Output)n – (Total Output)n-1

Average Total Cost
76
Average Total Cost (ATC) is the Total Cost divided by the number of goods produced (or output quantity Q).
Average Total Cost = Total Cost / Q = [Total Fixed Cost (TFC)+ Total Variable Cost (TVC)] /Q
ATC = (TFC+ TVC)/Q = TFC/Q + TVC/Q
ATC influences price and hence is an important constituent of the supply curve.
Costs in a Rice Store
Cost

• Cost Analysis
• ATC, MC, AVC (Average Variable Cost) etc. change.
• Demand Supply Curve
• Revenue Analysis
• Profit Maximization
Agenda
77

Cost trends Variable, Marginal and Total Cost
78
• Marginal cost first reduces with increase in volume (volume discounts) and then increases (law of diminishing margina
• Marginal Cost curve touches the ATC and the AVC curves at their lowest points.
P
P’
ATC3 = (2*ATC2 + MC3)/3
If MC3 = ATC2, ATC3 = ATC2
If MC3 > ATC2, ATC3 > ATC2
Units = Output Units
* Marginal Cost at output 1 = 150 – 100 =50

General Proof MC,ATC,AVC
79
MC Curve crosses the ATC and AVC curves at their
lowest points.
ATCn+1 = TCn+1 / (n+1) = (TCn + MCn+1 )/(n+1)
= (n*ATCn + MCn+1 )/(n+1) = [((n+1)-1)ATCn +
MCn+1]/(n+1)
= [(n+1)ATCn - ATCn +MCn+1 ]/(n+1)
= (n+1)ATCn/ (n+1) + (MCn+1 – ATCn)/n+1
= ATCn + (MCn+1 – ATCn )/n+1
If MCn+1 > ATCn the term on the right would be +ve.
ATCn+1 > ATCn

Variable, Marginal and Total Cost Example
80
Solution
ATC10 = Rs. 5
TC10 = 5*10 = 50
MC11 = 6
TC11 = TC10 + MC11 = 50+6 = 56
ATC11 = TC11 / 11 = 56/11 = 5.09
The Average Total Cost of production of 10 items is Rs. 5. The marginal cost of production of the 11th item is Rs.
What is the average total cost of production of 11 items?
ATCn+1 = (TCn + MCn+1 )/(n+1)
MC11 = TC11 – TC10 ATC11 = TC11 / 11
TC11 = TC10 + MC11 = TC10 + 6
TC10 = ATC10 * 10 (ATC = TC/ Q; ATC10 = TC/10)
= 5*10 = 50
TC11 = 50+6 =56
ATC11 = 56/11 = 5.09

Illustration Minimum ATC
81
Output Fixed Cost Marginal Cost Total Cost
Average Total
Cost
0 20000 0 20000NA
1 20000 5000 25000 25000
2 20000 4500 29500 14750
3 20000 4300 33800 11267
4 20000 4500 38300 9575
5 20000 4700 43000 8600
6 20000 5000 48000 8000
7 20000 5200 53200 7600
8 20000 5800 59000 7375
9 20000 6500 65500 7278
10 20000 7200 72700 7270
11 20000 8000 80700 7336
12 20000 9000 89700 7475
13 20000 10000 99700 7669
Note that ATC goes on the increasing mode after MC exceeds it.
Quantity of production
Average
Total
Cost
0
5
10
15
20
25
This illustrates how the ATC curve
reaches its minimum precisely
where the MC curve interests it.

The Costs MC, AVC, AFC, ATC
82
Example
Ref: Khan Academy
*Also referred to as the Marginal Productivity of Labor (MPL). We shall cover this in greater
details while studying production.
FC Labour
VC
(variable
cost)
TC (total
cost) ΔTC
Output
(kgs) ΔQ
MC=
ΔTC/ΔQ AVC AFC ATC
5000 1 2000 7000 2000 10 10 200 200 500 700
5000 2 6000 11000 4000 25 15 267 240 200 440
5000 3 9000 14000 3000 45 20 150 200 111 311
5000 4 12000 17000 3000 58 13 231 207 86 293
5000 5 15000 20000 3000 65 7 429 231 77 308
5000 6 18000 23000 3000 70 5 600 257 71 329
The monthly cost structure of a firm is given. Monthly costs of a firm
ATC = total cost/output, AFC = total fixed cost/output, AVC = total variable cost/output

Law of Demand and Supply
83
Law of Demand: If all other factors remain equal, the higher the price of a product, the less people would demand it.
Exceptions : Veblen Goods (exclusive, high quality, prestige value items), Giffen Goods (Low price goods with few sub
Law of Supply: If all other factors remain equal, higher the price, the higher the quantity supplied.
The Supply and Demand Curves shown in this
diagram are straight lines which can be
represented by simple equations like
P = 60 – 0.01*Q where P = Price, Q = Demand
The equation gives the mathematical relation
between the two elements (variables) price and
demand so that if you know one you can work out
the other.
For example, if asked to find the price corresponding
to a demand of 4000 units, you can simply plug in
the numbers to the equation and get P = 60 – 0.01*4000
= 20.
The general equation is P = a-b*Q where a and b are
constants.
Please note that a real life demand curve would be influ
E

Effect of shifts in demand and supply
14/02/2016 MBA ZC416
Shifts in demand:
Demands shifts refer to changes in demand caused by factors other than the price of the good. (The change
caused by the price of the good is referred to as movement along the demand curve). Any of the following factors
or there are combination can cause a demand shift.
1. Change in customer income 2. Change in prices of related goods (substitutes or complements)
3. Change in customer tastes or preferences.
Shifts in supply
Improvement in production techniques, Fall in prices of factors of production, reduction of taxes, Acts of God.
In the following slides we shall study two cases of such shifts and their impact on equilibrium price and quantity
demanded.

Case –I Supply decrease, demand increase.
14/02/2016 MBA ZC416
Price
Quantity
Si
Di
Df
Sf
E
Ef
S and D represent the original supply and demand curves. A
decrease in supply pushes the supply curve to the
left while an increase in demand shifts the demand curve
to the right (from D to D1) causing a change in the position
Of the equilibrium point from E to E1. Consequently, equilibrium
price rises from OP to OP1 while demand increases marginally
From OQ to OQ1.
O
Pi
Pf
Q Q1
Ei

Case II Supply increase, demand increase
14/02/2016 MBA ZC416
O X
Y
S S1
D
D1
E
E1
P
P1
A big increase in supply is accompanied by a relatively lower
Increase in demand as shown in the accompanying diagram.
The supply curve (S) moves by a long distance to the left (to S1) as
shown in the figure while the demand curve moves by a smaller distance
The equilibrium point shifts from E to E1 leading to a fall in
equilibrium price from OP to OP1. The demand increases from OQ to OQ1.
Q Q1

Law of Demand and Supply
87
• Demand Curve is sloped downwards as we move from left to right (negatively sloped) while supply curve is sloped upw
Supply Curve is sloped upwards as we move from left to right.
• Demand Curve meets the price axis at P1 and the quantity axis at P2. P1 represents the maximum price (choke price) b
which there would be no demand for the product. P2 represents the maximum demand possible at zero price. P1 is det
by the limits on income and wealth of consumer while P2 is caused by the limits of time and the law of diminishing mar
P1
P2
A
B
Product: Face Mask
C
D2
S2
Q

Demand Curve
88
P1 (60)
Q1 = 6000
P = 60 – 0.01Q, P in U$, Q
in units
Q=0, P = 60 (choke price)
P=0, Q = 6000 units
(saturation demand)
Demand Equation
P = a-bQ
Q=0, P = a
P=0, Q=a/b (saturation
demand)
MR = a-2bQ
Q=0, MR=a ( = choke
price)
MR=0, Q= a/2b (half of
saturation demand)
Marginal Revenue
Demand Line
P = 60 – 0.01Q Toothbrushes
P = Rs. 40 , Demand/ month = ?
P = 60 – 0.01Q
P = 40
40 = 60 – 0.01Q
0.01Q = 60 – 40 = 20
Q = 20/0.01 = 2000 units

• Total Revenue (TR) = Output (Q)* Price (P)
• Average Revenue (AR) = TR/Q = (PQ)/Q = P(see example to understand Price)
• Marginal Revenue is the increase in revenue that results from the sale of one additional unit
of output. This is dealt in more detail in the following slide.
• MRn = TRn – TRn-1 MCn = TCn – TCn-1
• Example
Revenues
89
Output(units
)
Price
(per
unit) TR MR AR
1 6 6 6 6
2 5 10 4 5
3 4 12 2 4
4 3 12 0 3
5 2 10 -2 2
Quantity of output
Price
1 2 3 4 5
0
5
10
15
-5
6 5 4 3 2
6
10
12 12
10
6
4
2
0
-2
Revenue Curves
Price TR MR

• Marginal Revenue is the increase in revenue that results from the sale of one
additional unit of output.
• Marginal Revenue (MR) = =
• Examples
• A firm sells 100 items at a price of U$ 10 each to a buyer. What is the marginal revenue of the 80th product? On one
instance, the firm made a mistake and shipped 101 units to the buyer. The buyer refused to accept the 101st product at
the same price citing storage problems at his end and offered U$ 9.99 for the whole consignment instead. The slight
change in price, the buyer argues would help rent him a temporary shed to store the products? For the 101st piece?
a. The marginal revenue of the 80 the product is the additional revenue resulting from the sell of the 80th product in
the original batch which is equal to U$ 10.
• MRn = TRn – TRn-1 MR80 = TR80 – TR79 = 10*80 – 10*79 = 800-790 = 10
b. A firm generally produced in batches of 100 items which they sold to the customer for U$ 10 per piece for the whole
produce. On one occasion they produced a batch of 101 items. However the customer said the would accept the whole
batch at U$ 9.99 per piece only. What is the marginal revenue at the production of the 101st piece?
Additional Revenue generated by the 101st piece = 9.99*(101) – 10*100 = U$ 8.99
• MR101 = TR101 – TR100 = 9.99*101 – 10*100 = U$ 8.99
Marginal Revenue
90

The Basic Profit - Maximizing Model
91
• The most common objective of the firm
– Basic profit-maximizing model: MC=MR Profit = π
– We start by defining, Profit (π) = R – C
– Pi is at a maximum when its first derivative with respect to Q is equal to zero
– d(π)/dQ => dR/dQ – dC/dQ = 0
– => dR/dQ = dC/dQ
– => MR = MC
– Intutively, if MC is higher than MR it means the cost of producing the additional unit
exceeds the revenue that unit is going to fetch. This is a loss making proposition
and the firm would not produce that extra unit.
– If MC is lower than MR, every additional product would fetch a profit and the
company would go on producing. The company would stop producing when MR =
MC.
• Assumptions of basic profit-maximising model
– The firm has a single decision-maker.
– The firm produces a single product.
– The firm produces for a single market.
– The firm produces and sells in a single location
– All current and future costs and revenues are known with certainty.
– Price is the most important variable in the marketing mix
– The firm operates in a perfect competition market
Quantity of output
Cost/Revenue
Marginal Cost
Marginal Revenu
P
A
B
C
O
MR = CA
MC = CB
Marginal Profit = CA- CB = AB
D
E
F

Demand and Marginal Revenue Curves
92
P1 (60)
Q1 = 6000
P = 60 – 0.01Q, P in U$, Q
in units
Q=0, P = 60 (choke price)
P=0, Q = 6000 units
(saturation demand)
Demand Equation
P = a-bQ
Q=0, P = a
P=0, Q=a/b (saturation
demand) Marginal Revenue
Demand Line
MR = a-2bQ
Q=0, MR=a ( = choke price)
MR=0, Q= a/2b (half of saturation deman
MR = 60-0.02Q
Q=0, MR=60
MR=0, Q=60/0.02 = 3000

How to find MR equation if demand equation is given.
93
Demand Equation is P = 60 – 0.01Q a=60, b=0.01 P= a-bQ a=60, b=0.01 MR Equation : P
= a-2bQ
MR Equation is P = 60 – 2*0.01Q = 60 – 0.02Q
Price
Quantity
1000 2000 3000 4000 5000 6000
10
20
30
40
50
60
Demand Line
P = a – bQ ------- Demand Equation
MR = a – 2bQ
P = 60-0.01Q
MR= 60 – 2*0.01Q = 60 – 0.02Q
Q = 40 – 20P - Demand Equation
Q = 40- 2*20P = 40 -40P (This is wrong.)
20P = 40-Q
P = (40-Q)/20 = 2 – 0.05Q ---
MR = 2-2*0.05Q = 2-0.1Q
P = a-bQ
MR = a – 2bQ
Q =0, MR = a
MR=0, Q = a/2b
MR = 0
a-2bQ = 0
Q = a/2b
Pchoke = a , Qsaturation = a/b
O
P1
P2
MR Line
OP2 = OP1/2

• Demand Line : P = a – bQ (At Q=0 choke price = a, At P=0, Q= a/b)
• Total Revenue TR = PQ = (a – bQ)*Q = aQ-bQ2
• Marginal Revenue = d(TR)/dQ = d(aQ-bQ2)/dQ = a-2bQ (At Q =0, MR = choke
price = a, At P=0, MR = a/2b) (We shall derive it without using calculus in example)
This proves that the MR curve cuts the demand axis at the half way point of the
demand line.
• For maximum total revenue, d(TR)/dQ= marginal revenue = 0 which occurs at Q =
a/2b
• The maximum total revenue = a2/4b (obtained by substituting Q = a/2b in the
TR expression.
For revenue maximization, MR=0. Profit maximization, MR = MC
Revenue and Demand curve
94

Cost and revenue curves
95
O P2
O
OA = OB/2
X
Y
Z
W
Note: At the profit maximization point MC = MR
which means d(TC)/dQ = d(TR)/dQ
Slopes of the tangent to the total cost curve and the
Total revenue curve would be equal. This means they
would be parallel to each other.
Average Total Cost = Total Cost / Quantity of Production. (Q)
Q’
P’
Z’
Y’

Cost and revenue curves
96
O P1 P2
Points to be noted
1. OP1 = ½ OP2. The MR line intersects
the x-axis at a point half way
down the distance where the demand
Line cuts it.
2. TR is an inverted parabola with its
maximum value at the level of output
where MR = 0. TR = 0 when demand is 0.
Points to be noted
3. Marginal cost curve cuts the ATC line at
the latter’s lowest point.
4. Profit it maximum at the output level
(Q1) where the MC curve cuts the MR line.
5. As a profit maximizing monopoly firm seeks
Equal MC with MR (price), the MC and
the supply curve would be identical.
Maximum Total Revenue
output
Price/cost
Y
Z
L
K

Example-1 Profit Maximization
97
Question: On a particular day, a carpenter sits down to make chairs. The marginal cost and market prices at differe
of production is given in the following table. Find out his profits (marginal as well as cumulative) with each level of p
How many chairs should he produce to maximize his profit? Does it prove the MR=MC conclusion?
Output
Marginal
Cost (MC)
Cumulative
Cost Mkt Price
Total
Revenue
Marginal
Revenue
Marginal
Profit =
MR-MC
Total
Profit
1 1000 1000 1500 1500 1500 500 500
2 900 1900 1400 2800 1300 400 900
3 875 2775 1275 3825 1025 150 1050
4 925 3700 1187.5 4750 925 0 1050
5 985 4685 985 4925 175 -810 240
6 1100 5785 800 4800 -125 -1225
Illustration – Sequential Production* Illustration – Batch Production*
* The carpenter produces one chair after the other • The carpenter plans for the total output and produces
one go.

Example -2 Profit Maximization
98
Fixed Cost Patients
Variable
Cost
Total
Variable
Cost Total Cost
Average
Total Cost Price
Total
Revenue Profit
Cumulative
Profit
50000 100 100 10000 60000 600 1000 100000 40000 40000
0 100 90 9000 15000 150 900 90000 75000 115000
0 100 200 20000 20000 200 800 80000 60000 175000
0 100 300 30000 30000 300 700 70000 40000 215000
0 100 400 40000 40000 400 600 60000 20000 235000
0 100 500 50000 50000 500 500 50000 0 235000
0 100 600 60000 60000 600 400 40000 -20000 215000

Consumer and Producer Surplus
99
Price
Quantity
D1
D2
S1
S2
Consumer Surplus
= Area of triangle D1FE
E
F
G
Producer Surplus=
Area of triangle S1EF
O
D1 D2 is the demand line. S1 S2 is the supply line which also represents the marginal cost of production.
Area under the supply curve is the Total (variable) cost of production.
Total Cost of
production = OGES1
MC = d(TC)/dQ
TC = ʃ MC*dQ = Integrand+ K
The integrand represents the Total
Variable Cost, K is the fixed cost.
F1
D’
D3
F2

Inefficient Market Deadweight Loss
100
(Price)

Profit Maximization Farmer’s Agitation
101
Price
Output
A B
C
E
D
O F
I
H
Minimum Support Price (MSP)
is the price at which the
Central Government sources
select food grains (paddy, wheat)
from farmers which are stored
In Food Corporation of India
Warehouses.
P
G
Demand Line
MR MC
MC = d(TC)/dQ
TC = integration of MC*dQ

Example
102
Question: The demand curve for a product is given by the equation Q = 100 – P. Draw the demand, marginal revenue a
the total revenue curves. Determine the marginal revenue at a production levels of 40 and 60 units. Find the production
which total revenue is maximum?
Solution2: (You can straight use the formula that if demand equation is P=a-bQ, MR = a-
2bQ.
Q = 100-P (given)
P= 100-Q, Marginal Revenue = ΔTR/ΔQ
Total Revenue at production Q (TR) = P*Q = (100-Q)*Q = 100Q-Q2 – (1)
Total Revenue at production(Q+ΔQ) (TR+ΔTR)= 100(Q+ΔQ) – (Q+ΔQ)2
= 100Q+100ΔQ – (Q2+ 2QΔQ+ ΔQ2)
= 100Q-Q2 + (100 – 2Q)ΔQ – (2)
(ΔQ2 is ignored)
Change in Total Revenue (ΔTR) = (2) – (1) ΔQ =0.1, ΔQ2 = 0.12 = 0.001
= (100 – 2Q)ΔQ
Marginal Revenue Δ(TR)/ΔQ = 100 – 2Q
Marginal Revenue at 40 production = 100-2*40 = 20
Marginal Revenue at 60 production = 100-2*60 = -20
Maximum Total Revenue
Total Revenue = 100Q-Q2
= 2*50Q-Q2
= 2500 – 2500+2*50Q – Q
= 2500 – (502- 2*50Q+Q2)
= 2500 – (50-Q)2
This is a non-negative number
as a square and has its minimum value
Q = 50
Solution1: Q = 100-P, P=100-Q, TR= Q*(100-Q)= 100Q-Q2 For max revenue, d(TR)/dQ = 0, d/dQ(100Q-Q2) = 100-2
Q = 50, TR =100*50-502 = 2500

Example Costs
103
Output (Units)
Marginal Cost
(MC)
Total Cost
(TC)
Average Total
Cost (ATC)
1 20
2 30
3 15
1.Total Fixed Cost is U$ 100. Complete the following table.
Hints
1. TC1 = Total Cost for producing the first unit = Total Fixed Cost + Marginal Cost1
2. TCn = Tcn-1 + MCn

Question-2
104
The following table shows the total cost of production of a firm at different levels of output. Fill up the blank table bas
on information given below.
Output
(Units) 0 1 2 3
Total Cost
(U$) 60 100 130 150
Output
(Units)
Total Cost
(U$)
Total Fixed
Cost(TFC)
Total
Variable
Cost (TVC)
Average
Variable
Cost
(AVC)
Marginal
Cost
(MC)
0
1
2
3
Hint1 : TFC0 = TFC1 = TFC2 =….TFCn
Hint2: TCn = TFCn+ TVCn
Hint3: MCn = TCn – TCn-1
Output TC TFC TVC AVC MC
0 60 60 0NA NA
1 100 60 40 40 40
2 130 60 70 35 30
3 150 60 90 30 20

THANK YOU

BITS Pilani
Pilani Campus
MBAZC416
Sidharth Mishra, B.E, PGDM
Associate Professor, Management - Finance
Email: sidharth.mishra@pilani.bits-pilani.ac.in

BITS Pilani
Pilani | Dubai | Goa | Hyderabad
Theory of the Firm
and Related Concepts – Part 2

Measurement of profit
109
• Two problems associated with the measurement of profit
– Ambiguity in measurement
– Restriction to a single time period
• Bankruptcy of Enron in 2001 highlights these issues
• Restating their earnings
• Accounting profit is an ambiguous term
– gross profit
– net profit
– operating profit
– earnings before interest
– depreciation and tax
• The above definitions involve estimates rather than precise
measures for a number of reasons relating to GAAP

Manipulation
110
• Scope for managers to manipulate the firm’s accounts
– boost the share price
– personal earnings of the managers (CEO and CFO)
• It is difficult for shareholders to comprehend easily
• an agency problem combined with moral hazard
• Auditing: protect shareholders and potential investors
• Restriction to a single time period
– It is more appropriate to consider the long-term profits of a firm
– The stream of profits over some period of time
– Value of the expected future cash flows
– Discounting

Enron: The Fall Of A Wall Street Darling
111

Elasticity measures
• Price Elasticity
– Already defined in the previous slide. [ΔQ/Q]/[ΔP/P] = (P/Q)ΔQ/ΔI . [dQ/Q]/[dI/I] = (I/Q)dQ/dI
– If the demand curve is exponential and given by Q=aP-b , price elasticity would be constant and
shall be equal to –b.
– It has been empirically observed that price elasticity is different for price increases and price
decreases.
• Income Elasticity
– Defined as [ΔQ/Q]/[ΔI/I] = (I/Q)ΔQ/ΔI = (I/Q)dQ/dI
– As consumer income increases demand shifts for better quality or “superior” products.
– Superior products show income elasticity greater than one while those with elasticity less than zero
are referred to as inferior products.
– Normal products have income elasticity between 0 and 1.
• Cross price Elasticity
– Defined as (dQx / dPy)(Py/Qx) where x and y refer to different goods [dQx / Qx ]/[dPy / Py ]
– If positive, price increase of good y leads to an increase in demand of good x. hence x and y are
substitute goods (rice and wheat). If negative they are complementary goods (cars and petrol)

The rise of Enron: a brief history
It was founded by Kenneth Lay, former CEO of Houston Natural
Gas
Transporting and selling gas
In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey &
Co., to lead a new division -- Enron Finance Corp.
Skilling was made president and chief operating officer of Enron in
1997
From the pipeline sector, Enron began moving into new fields
In 1999, the company launched its broadband services unit and
Enron Online, the company's website for trading commodities,
which soon became the largest business site in the world.
113

Growth of Enron
Growth for Enron was rapid.
In 2000, the company's annual revenue
reached$100 billion US.
It ranked as the seventh-largest company on the
Fortune 500
And the sixth-largest energy company in the
world.
The company's stock price peaked at $90 US.
114

Enron: Revenue
115

Fall of Enron
Cracks began to appear in 2001
In August of that year, Jeffrey Skilling announced his departure
Lay resumed the post of CEO
Chief financial officer Andrew Fastow was replaced. Many new
entities were created, and debts were kept separate from Enron's
books
In October 2001, Enron reported a loss of $618 million— its first
quarterly loss in four years
116

Enron’s stock price
117

Enron: Stock price falls
118

Bankruptcy of Enron
Tried to negotiate with its rival Dynegy
The negotiations failed
The company was left with no choice
On Dec. 2, 2001, it filed for bankruptcy protection
More than 4,000 people were laid off at Enron's Houston
headquarters
Arthur Andersen, who had a large portion of their revenue coming
from Enron’s audit and consulting fee, was tempted to ignore the
issues
119

Multiproduct strategies
120
• In practice, firms produce multiple products
• This complicates the analysis because:
– Demand and Cost interactions
• How to firms maximize profits given these interactions?
– Product line profit maximization
– Product mix profit maximization
• PC World case study highlights the underlying challenges
and issues in a multiproduct strategy

Demand Analysis
and Elasticity of Demand
MBA ZC416, Managerial Economics

Agenda
• Introduction
• Circular Flow of Economy
• Concept and Definition of Demand
• Law of Demand and its Exceptions
• Concept and Definition of Supply
• Elasticity of Demand and its types
• Factors affecting elasticity of demand
• Measurement of elasticity
• Significance of elasticity of demand
• Consumer Theory

Focus Areas
• Demand and Supply
• Elasticities of Demand
– Price Elasticity of Demand
– Income Elasticity
– Cross Elasticity
• Consumer Choice
– Budget Line
– Consumer Satisfaction Curves (Indifference Curves)
– Law of Choice (Law of Equi-marginal Utility)

The Circular Flow of Economic Activity
Labor services supplied by households
flow to firms, and goods and services
produced by firms flow to households.
Payment for goods and services flows
from households to firms, and payment
for labor services flows from firms to
households.

Input Markets and Output Markets:
The Circular Flow
• Input and output markets are connected through the behavior of both firms
and households.
• Firms determine the quantities and character of output produced and the
types and quantities of input demanded.
• Households determine the types and quantities of products demanded and
the quantities and types of inputs supplied.

A household’s decision about what quantity of a particular
output, or product, to demand depends on a number of
factors, including:
§ The price of the product in question.
§ The income available to the household.
§ The household’s amount of accumulated wealth.
§ The prices of other products available to the household.
§ The household’s tastes and preferences.
§ The household’s expectations about future income,
wealth, and prices.
Demand in Product/Output Markets

Quantity Demanded ?
• The amount (number of units) of a product that a
household would buy in a given period if it could buy all it
wanted at the current market price.

Changes in Quantity Demanded vs.
Changes in Demand
• The most important relationship in individual markets is
that between market price and quantity demanded.

• Changes in the price of a product affect the quantity demanded per period.
• Changes in any other factor, such as income or preferences, affect demand.
• Thus, we say that an increase in the price of Coca-Cola is likely to cause a
decrease in the quantity of Coca-Cola demanded.
• However, we say that an increase in income is likely to cause an increase in
the demand for most goods.
Changes in Quantity Demanded vs.
Changes in Demand

What is Demand ?
• A relation showing the quantities of a good that
consumers are willing and able to buy at various prices
per period, other things constant.

Demand for commodity implies
• Desire to acquire it
• Willingness to pay for it
• Ability to pay for it

Types of Demand
• Consumer goods vs. Producer goods
• Firm vs. Industry
• Autonomous vs. Derived
• Durable vs. Perishable
• Short-term vs. Long-term

Representation
• The general ‘law of demand’
• Demand table or schedule
• Demand graph
• Equations
– Q = f (P)
– Q = f (P, A, Y, Ps,...)
• A linear demand function Q= a+bP

LAW of DEMAND
Law of demand As price rises, quantity
demanded decreases. As price falls,
quantity demanded increases.
It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus,
and to expect quantity demanded to rise when price falls, ceteris paribus. Demand
curves have a negative slope.

Demand Schedule
Demand schedule A table
showing how much of a
given product a household
would be willing to buy at
different prices.
TABLE Anna’s Demand Schedule
for Telephone Calls
PRICE (PER CALL)
QUANTITY DEMANDED
(CALLS PER MONTH)
$ 0 30
.50 25
3.50 7
7.00 3
10.00 1
15.00 0

Demand Curve
A graph illustrating how
much of a given product a
household would be willing
to buy at different prices.
FIGURE Anna’s Demand Curve
P
1200
Tan 1200 = -1.73

Factors determining demand
1. Housing demand decreases with increasing interest rate.
2. Demand for Maruti Cars fell with the launch of Hyundai.
3. Demand for 15 year old cars has collapsed in the used segment.
4. Demand for ice cream decreases during winter.
5. AC sales were affected this year because of summer showers.
6. Demand for landline phones decreased with the advent of mobile
7. Demand for cars have gone down with increase in fuel price.
8. Demand for tea has increased with increase in price of coffee.
9. There was a massive demand for food grains in the early stages o
10. Demand for Tandoor Roti is less down South.
11. A family shifted to full cream milk after their son found an MNC jo

Alex’s Demand Schedule for Gasoline
Price
(per unit)
Quantity Demanded
(Good X)
8.00 0
7.00 2
6.00 3
5.00 5
4.00 7
3.00 10
2.00 14
1.00 20
0.00 26
Alex’s Demand Curve
The relationship between price (P) and quantity demanded
(q) presented graphically is called a demand curve.
Demand curves have a negative slope, indicating that lower
prices cause quantity demanded to increase.

CALCULATING TOTAL REVENUE
TR = P x Q
total revenue = price x quantity
In any market, P x Q is total revenue (TR) received by producers:
Profit = Revenue - cost

MARGINAL REVENUE
• It is the additional revenue added by an additional unit of
output.
• In other words marginal revenue is the extra revenue that
an additional unit of product will bring a ﬁrm.
• Marginal revenue is the derivative of total revenue with
respect to demand.

Example
• TR = 100Q−Q^2
• MR = d(TR)/dQ = 100-2Q
• When Q = 60, MR = -20

Demand curves slope downward
• Law of Demand: The negative relationship between price and
quantity demanded: As price rises, quantity demanded
decreases. As price falls, quantity demanded increases.
• It is reasonable to expect quantity demanded to fall when price
rises, ceteris paribus, and to expect quantity demanded to rise
when price falls, ceteris paribus.

1. They have a negative slope.
2. They intersect the quantity (X) axis, as a result of time limitations and
diminishing marginal utility.
3. They intersect the price (Y) axis, as a result of limited income and wealth.
Other Properties of Demand Curves
The actual shape of an individual household demand curve whether it is
steep or flat, whether it is bowed in or bowed out depends on the unique
tastes and preferences of the household and other factors.

Normal goods Goods for which demand goes up when income is higher
and for which demand goes down when income is lower.
Inferior goods Goods for which demand tends to fall when income rises.
Substitutes Goods that can serve as replacements for one another; when
the price of one increases, demand for the other increases.
Complements or Complementary goods Goods that “go together”; a
decrease in the price of one results in an increase in demand for the other
and vice versa.
Classification of goods

Shift vs. Movement along a Demand Curve
Price rises
Income
rises
Quantity demanded falls Demand for substitutes shifts right
Demand for complements shifts left

Profit The difference between revenues and costs.
Firms build factories, hire workers, and buy raw materials because they believe they can sell
the products they make for more than it costs to produce them.
Supply of Product
Quantity supplied The amount of a particular product that a firm would be willing and
able to offer for sale at a particular price during a given time period.
Supply schedule A table showing how much of a product firms will sell at alternative
prices.
Law of supply The positive relationship between price and quantity of a good
supplied: An increase in market price will lead to an increase in quantity supplied, and
a decrease in market price will lead to a decrease in quantity supplied.

A producer will supply more when the price
of output is higher.
The slope of a supply curve is positive.
Supply is determined by choices made by
firms.
P – price of soya beans per bushel
Q – Bushels of soya beans produced per
year
Supply of Product

Assuming that its objective is to maximize profits, a firm’s decision
about what quantity of output, or product, to supply depends on:
1.The price of related products.
2.The cost of producing the product, which in turn depends on:
■ The price of required inputs (labor, capital, and land).
■ The technologies that can be used to produce the product.
Determinants of Supply

Shift of Supply Schedule for Soybeans
following Development of a New
Disease-Resistant Seed Strain
Schedule S0 Schedule S1
Price
(per Bushel)
Quantity Supplied
(Bushels per Year
Using Old Seed)
Quantity Supplied
(Bushels per Year
Using New Seed)
1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000
Shift of the Supply Curve for Soybeans following
Development of a New Seed Strain
When the price of a product changes, we move along the supply
curve for that product; the quantity supplied rises or falls.
When any other factor affecting supply changes, the supply
curve shifts.
Shift of Supply versus Movement Along a Supply Curve

When quantity demanded exceeds quantity supplied, price tends to rise.
When the price in a market rises, quantity demanded falls and quantity supplied rises until
an equilibrium is reached at which quantity demanded and quantity supplied are equal.
Market Equilibrium
Market equilibrium is achieved when consumers are willing to buy the same quantity of goods the
producers are willing to sell.

Point of Equilibrium
30/1/2016 MBA ZC416 MANAGERIAL
ECONOMICS Session 3
Price
Quantity demanded or supplied
L1
L2
P
Demand
Supply
Pe
Qe
Consumer and Producer surplus
A
B
Area of triangle APPe = Consumer Surplus
Area of triangle BPPe = Producer Surplus
Area of triangle APPe
= ½ PPe * APe (1/2 base* height)
Area of triangle BPPe =
½ PPe * Bpe = producer surplus
O
PA
Pb

Profit Motive Deadweight
Loss
153
(Price)
P
A
B
C
D
E
F
G
I
J
K
L
M
N
O
Overall economic surplus =
Consumer Surplus + Producer Surplus
Area of triangle ABP + Area of triangle CP
= Area of triangle ACP
MC = d(TC)/dQ
D(TC) = MCdQ
TC = ʃ(MC)dQ from 0 to L
Producer Surplus = CKMN
Consumer Surplus = ANM
Overall Economic Surplus
= Area of CKMN + Area of ANM
= Area of AMKC

ECONOMICS Session 3
Tax Regimes Deadweight Loss
P
Initial Supply Curve: p = a+bQ
Tax Imposed = T (payable by supplier)
Example: A manufacturer was selling his proudct at
Rs. 200 per kg. A flat tax of Rs. 10/ kg was imposed which
the suppliers chose to absorb and not pass on to the
Customer. (Had they passed on it would have affected the
Demand curve).
Part of the price retained by supplier = p-T
New Supply Curve p-T = a+bQ
p = a+T+bQ
The new supply curve would be pushed up by T as shown
in accompanying diagram.

Demand and Supply in Product Markets: A quick
recap
• A demand curve shows how much of a product a household would buy if it
could buy all it wanted at the given price. A supply curve shows how much of
a product a firm would supply if it could sell all it wanted at the given price.
• Quantity demanded and quantity supplied are always per time period—that
is, per day, per month, or per year.
• The demand for a good is determined by price, household income and
wealth, prices of other goods and services, tastes and preferences, and
expectations.

Demand and Supply in Product Markets: A quick
recap
• The supply of a good is determined by price, costs of production, and prices
of related products. Costs of production are determined by available
technologies of production and input prices.
• Be careful to distinguish between movements along supply and demand
curves and shifts of these curves. When the price of a good changes, the
quantity of that good demanded or supplied changes—that is, a movement
occurs along the curve. When any other factor changes, the curve shifts, or
changes position.
ECONOMICS Session 3

Demand and Supply in Product Markets: A quick recap
• Market equilibrium exists only when quantity supplied equals
quantity demanded at the current price.

Elasticity of Demand
• It allows us to analyze demand with greater precision.
• It is a measure of how much buyers and sellers respond
to changes in market conditions.

Elasticity of Demand
• Elasticity of Demand measures the degree of
responsiveness of the quantity demanded of a commodity
to a given change in any of the determinants of demand.
•

Types of Elasticity of Demand
• Price elasticity of demand
• Income elasticity of demand
• Cross elasticity of demand

PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY
FIGURE 1 Slope Is Not a Useful Measure of Responsiveness

price elasticity of demand The ratio of
the percentage of change in quantity
demanded to the percentage of change
in price; measures the responsiveness
of demand to changes in price.

Example
ECONOMICS Session 3
In a market, the demand for rice went up from 100 ton to 150 ton when the price fell from Rs. 50/kg to Rs. 40/kg.
Calculate the price elasticity of demand.
Price Elasticity of Demand = % change in demand / % change in price
% change in demand = (Final Demand – Initial Demand)/ initial Demand = (150-100)/100 = 50%
% change in price = (Final Price – Initial Price)/Initial price = (40-50)/50 = -10/50 = -20%
Price Elasticity of Demand = 50%/(-20%) = 50/(-20) = -2.5
Price Elasticity of Demand is expressed as a positive number. Price Elasticity = 2.5 (-2,5).
(-)2.5

Price Elasticity of Demand
• Elasticity of Demand
• Quantity demanded of a commodity in
response to a given change in price
• Always negative
• Relationship between the price and the
demand is inverse

FIGURE 2 Perfectly Elastic and Perfectly Inelastic Demand Curves

Degree of Price Elasticity of Demand
• Inelastic Demand (e<1): Quantity demanded does not
respond strongly to price changes.
• Elastic Demand (e>1): Quantity demanded responds
strongly to changes in price.

Degree of Price Elasticity of Demand
• Perfectly Inelastic: Quantity demanded does not
respond to price changes.
• Perfectly Elastic: Quantity demanded changes
infinitely with any change in price.
• Unitary Elastic (e=1): Quantity demanded changes by
the same percentage as the price.

Price Elasticity: Impact on Revenue
Elastic (e>1) Unitary
Elastic
Inelastic
(e<1)
Price rises TR falls No change in
TR
TR rises
Price falls TR rises No change in
TR
TR falls
TR = P*Q
d(TR)/dP = d(PQ)/dP = Q+PdQ/dP
e = [d(Q)/Q]/[d(P)/P] = -Pd(Q)/QdP
Pd(Q)/dP = -eQ
d(TR)/dP = Q-eQ = Q(1-e)
As you can see if e >1 (elastic), TR would fall with increase in P. If e=1 (Unitary elastic), TR is unchanged.
If e<1 (inelastic), TR would rise with increase in price.

Price elasticity of Demand
Urban India Short Run Long Run
Butter 1.478 2.78
Petrol 0.3 0.9
Tea 0.718 1.14
Coffee 0.292 0.685
Burger 1.49 2.79
Clothing 1.1 2.88

Goods/Services Price Elasticity
Brinjals 3.5
Cabbage 2.8
Health insurance 1.9
Public transport 1.0
Electricity for domestic
purpose
0.5
Price elasticity of Demand

CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES
To calculate percentage change in quantity demanded
using the initial value as the base, the following formula is
used:

We can calculate the percentage change in price in a similar way. Once again, let us use the
initial value of P—that is, P1—as the base for calculating the percentage. By using P1 as the
base, the formula for calculating the percentage of change in P is simply:

Once all the changes in quantity demanded and price have been converted into percentages,
calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:
ELASTICITY IS A RATIO OF PERCENTAGES

CALCULATING ELASTICITIES Arc Elasticity
THE MIDPOINT FORMULA
midpoint formula
A more precise way of calculating percentages using the value halfway between P1 and
P2 for the base in calculating the percentage change in price, and the value halfway
between Q1 and Q2 as the base for calculating the percentage change in quantity
demanded.

Using the point halfway between P1 and P2 as the base for
calculating the percentage change in price, we get

TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula
First, Calculate Percentage Change in Quantity Demanded (%DQD):
By substituting the numbers from Figure 1(slide 32): PRICE ELASTICITY COMPARES THE
PERCENTAGE CHANGE IN QUANTITY
DEMANDED AND THE PERCENTAGE
CHANGE IN PRICE:
DEMAND IS ELASTIC
Next, Calculate Percentage Change in Price (%DP):
By substituting the numbers from Figure 1(slide 32):

Problem
• You are given market data that says when the price of pizza is
Rs. 4, the quantity demanded of pizza is 60 slices and the
quantity demanded of cheese bread is 100 pieces. When the
price of pizza is Rs. 2, the quantity demanded of pizza is 80
slices and the quantity demanded of cheese bread is 70 pieces.
a.Can the PED be calculated for either good? Why?
b.If so, what is the PED?

Solution
• In order to calculate PED we need two (quantity, price)
pairs for one good (two points along a certain good’s
demand curve). We are given this information for pizza.
We are not given this information for cheese bread.
• We have two (quantity, price) pairs for pizza. Specifically,
(QD1 , P1 ) = (60, $4) and (QD2 , P2 ) = (80, $2) .
• PEDpizza = [Q2 – Q1]/Q1*P1/[P1 – P2] = [80-60]/60*4/[4-2] =
0.67

ELASTICITY AND TOTAL REVENUE
TR = P x Q
total revenue = price x quantity
In any market, P x Q is total revenue (TR) received by producers:
When price (P) declines, quantity demanded (QD) increases.
The two factors, P and QD, move in opposite directions:
Effects of price changes
on quantity demanded:

Determinants of Price Elasticity of Demand
• Nature of Commodity
• Availability and proximity of Substitutes
• Proportion of Income spent on the Commodity
• Time frame
• Durability of the Commodity

Income elasticity of Demand
• Income elasticity measures the responsiveness of
quantity demanded to changes in income, holding the
price of the good & all other demand determinants
constant.

• Positive for a normal good
• Negative for an inferior good
• Zero for a neutral good

• Luxury goods: Income elasticity is greater than 1
• Normal goods: Income elasticity is between 0 and 1
• Inferior goods: Income elasticity is negative

Cross elasticity of Demand
• Cross-price elasticity of demand (EXY) measures the
responsiveness of quantity demanded of good X to changes in the
price of related good Y, holding the price of good X & all other
demand determinants for good X constant

Cross-price elasticity of demand in the real world
Commodity X Commodity Y Cross-price elasticity
Tea (India) Coffee (India) 0.0385
Tea (India) Coffee (India) 0.3457 (long run)
Entertainment (US) Food (US) -0.72
Margarine (US) Butter (US) 1.53
Positive : Two goods are substitutes
Negative: Two goods are complements

Consumer Choice
ECONOMICS Session 3
A consumer is one who takes decisions about what to buy for satisfaction of wants, both as an individual and as a
Member of household, is called a consumer.
A consumer is considered to be rational which means he is someone who seeks to maximise his/her satisfaction
(utility) in spending his/her income.
Equilibrium is a state of rest when the entity concerned (for example the consumer or the producer) achieve their
objective and stop further action.

The Study of Choices
• We shall see how a consumer with a limited budget
chooses between two goods X and Y to maximize his/her
satisfaction (utility).

HOUSEHOLD CHOICE IN OUTPUT MARKETS
Every household must make three basic decisions:
1. How much of each product, or output, to
demand
2. How much labor to supply
3. How much to spend today and how much
to save for the future

THE BUDGET CONSTRAINT
Information on household income and wealth,
together with information on product prices, makes
it possible to distinguish those combinations of
goods and services that are affordable from those
that are not.
budget constraint The limits imposed on
household choices by income, wealth,
and product prices.

choice set or opportunity set The set of options that is
defined and limited by a budget constraint.
TABLE Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes
OPTION
MONTHLY
RENT FOOD
OTHER
EXPENSES TOTAL AVAILABLE?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No

THE EQUATION OF THE BUDGET CONSTRAINT
In general, the budget constraint can be
written:
PXX + PYY = I,
where PX = the price of X, X = the
quantity of X consumed, PY = the price of
Y, Y = the quantity of Y consumed, and I
= household income.

Budget Line
Example
ECONOMICS Session 3
A consumer has gone to the market to buy apples and oranges.Oranges are selling at Rs. 100 per kg and apples for Rs.
200 per kg. His budget is Rs.1000. Draw the budget line and graphically represent it. How would the graph change if
the price of apple increased to Rs. 250 per kg.
X and Y stand for consumption of apples and oranges respectively.
PX = Price of Apple = Rs. 200 per kg
PY = Price of Orange = Rs.100 per kg
Budget Line Equation is PX X+ Py Y = B
200X+100Y = 1000
X=0, 100Y = 1000, Y=10. The consumer can invest his/her full budget in
buying oranges alone. S/he would get 10 kg of oranges.
Y=0, 200X = 1000, X=5. The consumer uses the full budget to buy
apples and gets 5 kg of apples.
New Budge Line 250X+100Y=1000
1 2 3 4 5
APPLES
2
4
6
8
10
ORANGES
7 9
PXX + PYY = I,
Budget Line
Choice set
P (2 g of apples, 5 kg of oranges)
5
A
B

FIGURE Budget Constraint and Opportunity Set for Ann and Tom
The Budget Constraint More Formally

Explanation
ECONOMICS Session 3
B = Budget
Px = Price of item X
Py = Price of item Y
X = Consumption of X
Y = Consumption of Y
Money spent on X = XPx
Money remaining = B – XPx = Money spent on Y = YPy
Hence XPx + YPy = B

FIGURE The Effect of a Decrease in
Price on Ann and Tom’s
Budget Constraint
Budget Constraints Change When Prices Rise or
Fall
The budget constraint is defined by income, wealth, and prices. Within those limits, households are
free to choose, and the household’s ultimate choice depends on its own likes and dislikes.

THE BASIS OF CHOICE: UTILITY
utility The satisfaction, or reward, a product yields
relative to its alternatives. The basis of choice.

marginal utility (MU) The additional satisfaction gained by
the consumption or use of one more unit of something.
DIMINISHING MARGINAL UTILITY
total utility The total amount of satisfaction obtained from
consumption
of a good or service.
law of diminishing marginal utility The more of any one
good consumed in a given period, the less satisfaction
(utility)
generated by consuming each additional (marginal) unit of
the same good.
MC = d(TC)/dQ
MU = d(TU)/dQ

TABLE Total Utility and Marginal
Utility of Trips to the Club
Per Week
TRIPS
TO CLUB
TOTAL
UTILITY
MARGINAL
UTILITY
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0
FIGURE Graphs of Frank’s Total
and Marginal Utility

Trade off Example
ECONOMICS Session 3
Chocolates Balloons
Change in
chocolates
Change in
Balloons
10 0
9 1 1 1
8 3 1 2
7 6 1 3
law of diminishing marginal utility The more of any one good consumed in a
given period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the same good.

DIMINISHING MARGINAL UTILITY AND DOWNWARD-SLOPING DEMAND
FIGURE Diminishing Marginal Utility and
Downward-Sloping Demand

INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT
When the price of something
we buy falls, we are better
off. When the price of
something we buy rises, we
are worse off.

THE SUBSTITUTION EFFECT
Both the income and the substitution effects imply a negative relationship
between price and quantity demanded—in other words, downward-sloping
demand. When the price of something falls, ceteris paribus, we are better off,
and we are likely to buy more of that good and other goods (income effect).
Because lower price also means “less expensive relative to substitutes,” we are
likely to buy more of the good (substitution effect). When the price of something
rises, we are worse off, and we will buy less of it (income effect). Higher price
also means “more expensive relative to substitutes,” and we are likely to buy less
of it and more of other goods (substitution effect).
INCOME AND SUBSTITUTION EFFECTS

1. We assume that consumers have the ability to choose among the combinations of
goods and services available.
2. We assume that consumer choices are consistent with a simple assumption of
rationality (to maximize his satisfaction).
Customer Satisfaction (Indifference) Curves -
Assumptions
Chocolates Balloons
Change in
chocolates
Change in
Balloons
10 0
9 1 1 1
8 3 1 2
7 6 1 3

Deriving Customer Satisfaction (Indifference)
Curve
FIGURE An Indifference Curve
An indifference curve is a
set of points, each point
representing a combination
of goods X and Y, all of
which yield the same total
satisfaction (utility).
Chocolate
s Balloons
Change in
chocolates
Change
in
Balloons
10 0
9 1 1 1
8 3 1 2
7 6 1 3
chocolates
Balloons
1,9
3,8
6,7

Consumer Satisfaction Curve
• I went to the market to buy apples and oranges. I was
fourth in the queue. The seller asked me how many of
each I wanted and I replied “ 1 kg apples and 5 kg
oranges.” (1,5)
• There was a shortage of oranges. After the first customer,
the seller told me over the queue that he probably be able
to give only 4 kg oranges (as the previous buyer has
presumably bought 1 kg oranges). “Sir” he shouts “I shall
give you one extra kg of apples.” I say “Yes.” (2,4)
ECONOMICS Session 3

Consumer satisfaction Curve
• After the second customer he says “ Sorry, Can give you
only 3 kg oranges. May I add one extra kilo apple?”
• What do I do with so many apples? I came here for only 1
kg apples?
• “Sir, please take 1.5 kg apples instead.” I accept. (3.5,3)
• Finally when I am at his counter, he says “Sir, I can only
give you 2 kg oranges. To compensate for this 1 kg (of
oranges), I shall give you 2 kg apples extra apples
instead. (5.5,2)

Customer Satisfaction (Indifference) Curve
• (1,5), (2,4), (3.5, 3) and (5.5, 2) represent four points of
equal satisfaction for the consumer. A curve connecting
the four points is the consumer satisfaction curve or the
indifference curve. The customer is indifferent to the four
options before him.

Consumer Satisfaction (Indifference) Curves -
Properties
1. It slopes downwards from left to right
2. It is convex to the origin
3. It cannot intersect with another indifference curve

Indifference Curves
ECONOMICS Session 3
Indifference Curves are convex to origin (that is they bulge towards the origin.)

Indifference Curves
ECONOMICS Session 3
They occur in a series with higher curves representing higher levels of consumer satisfaction.
apple
orange
P
P1
P3

Indifference Curves
ECONOMICS Session 3
They curves DO NOT intersect each other.
E
apples
oranges

Indifference Curves
ECONOMICS Session 3
Indifference Curves DO NOT touch the axes.

Consumer Equilibrium
FIGURE: Consumer Utility-Maximizing
Equilibrium
CONSUMER CHOICE
As long as indifference curves are convex to the origin, utility maximization will take place at the
point at which the indifference curve is just tangent to the budget constraint.
I/Px’
I/Py’ D

THE UTILITY-MAXIMIZING RULE
In general, utility-maximizing consumers spread out their
expenditures until the following condition holds:

Law of Equi-marginal utility
• Let us say Mux / Px > Muy / Py
• This means Mux > Px * Muy / Py
• If the consumer buys 1 unit of X he gets additional utility
Mux and pays a price of Px. With Py he could have got one
unit of Y and enjoyed a utility of Muy; a utility per rupee of
Muy / Py.
• After spending Px with X he forgoes the utility of Px *Muy /
Py.
• If Mux > Px*Muy / Py he is better off buying 1 unit of X.

Consumer Choice
• I am choosing between rice and wheat.
• Price of rice = Rs. 40/kg, Price of wheat = Rs. 50/ kg
• Marginal utility for rice = Murice ( utility of 1 kg of rice)
• Marginal utility for wheat = Muwheat (utility of 1 kg of wheat)
With Rs. 40, I buy 1 kg of rice = Murice
With same Rs. 40, 40/50 kg of wheat = 0.8 kg of wheat =
0.8Muwheat
If Murice > (40/50) Muwheat Murice / 40= Price > Muwheat / 50 =
Pwheat

Law of Equi-Marginal Utility
• Indifference Curve equation : TUx + TUy = constant
• d(TUx)/dx+ d(TUy)/dx = 0
• Mux + Muy (dy/dx) =0 d(Tuy)/dx = d(Tuy)/dy*dy/dx =
Muy*dy/dx
• Mux/Muy = - dy/dx = Px/Py
• Mux/Px = Muy/Py d(Tuy)/dx =
d(Tuy)/dy*dy/dx = Muy*dy/dx
PXX + PYY = I,

Practice Question -1
ECONOMICS Session 3
Use consumer theory to explain the law of demand.
Law of demand states increase in price leads to decrease in demand.
Law of Equimarginal utility, Mux / Px = Muy / Py for equilibrium of consumption in a situation of choice.
Px increases. Equilibrium is disturbed.
Left hand side (LHS) is lower in value. As a consequence, the customer consumer more of item y, ignoring
Item X.
The demand for X goes down with its increase in price.

Practice Question-2
ECONOMICS Session 3
The customer challenged the fruit-seller. “Man, you just cheated the previous customer. You charged him higher for
apples. The standard rate of apples is Rs. 200 per kg. You charged him Rs. 250. This is unfair business practice.”
The fruit-seller angrily retorted “Gentleman, you might have put on expensive clothes. But you seem to know nothing
economics. You probably did not notice that I sold him oranges at a lower price. The market is running short of apples.
By altering the prices, I changed his Budget line and delivered his intended total satisfaction. His position might have
changed, but he still stayed on the same Indifference curve. Go figure.”
Apples
Oranges
P1
P2
Original Budget Line
Papple *Qapple + Porange * Qorange = B
B/Papple
B/Porange

BITS Pilani
Pilani Campus
MBAZC416
Sidharth Mishra, BE,PGDM
Associate Professor, Management - Finance
Email: sidharth.mishra@pilani.bits-pilani.ac.in

BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Demand Estimation and Forecasting

Agenda
• Estimation Methods
• Data
• Regression Analysis
• Correlation
• Time Series Analysis
• Trend Projection

Demand Forecasting –
Estimation Methods
224

Estimation Methods
225

Data
226

Regression analysis
• In the next few slides we will attempt to understand the assumptions and principles
behind regression analysis and how it may be leveraged in demand forecasting and other
types of business decision making
• Applications include projections of demand, sales, earnings, risk, etc.
• Regression analysis is a way to find the relationship between a dependent variable and
one or more independent variables based on the historical trend or relationship
– Dependent variable is the one whose value is being forecasted or predicted
– Independent variables are the underlying drivers which cause the dependent variable to change
• Scatter plot
– Shows the strength of the relation between two variables in a graphical manner
– If the points on the scatter plot cluster together in a straight line then the two variables can be said
to have strong linear relationship
Y
X

Regression analysis
• Steps for regression analysis:
– Specify the dependent variable (Y) and identify the independent variable (X)
– Obtain historical values of the independent variables and respective dependent variables
– Draw a scatter plot for visual evaluation
– Identify or fit a mathematical relationship based on the visual observation
• Linear: Y = b(0) + b(1).x1 + b(2).x2
• Logarthmic: Y = a* b^x
• Polynomial: Y = a + bX + cX^2+……
– Typically the method chosen to fit the data to the chosen model is the least squares principle
• Fits the data to the model such that the sum of the squared deviations of the historical data from the
theoretical model values are minimized
• Simple bi-variate linear regression model
– Y = b(0) + b(1)X + e
– Here b(0) = y intercept; the value of Y when X = 0
– X = independent variable
– Y = dependent variable
– b(1) is the regression co-efficient
• Measures how much the dependent variable changes per unit of change in the independent variable
• b(1) = delta(y)/delta(x); also known as the slope

Optimizing Business Decisions: Managerial Economics Insights

Optimizing Business Decisions: Managerial Economics Insights

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