PGP Course Material: Itrimester (PGDM, 1B, Bif, MM, HRM)

PGP COURSE MATERIAL
ITRIMESTER{PGDM, 1B, BIF, MM, HRM)

2020-21
Economics for Managers
institute of Public Enterprise

Shameerpet Campus
Hyderabad - 500101
Telangana
Economics for Managers
Trimester: 1"t Term- 202 Credits 3
Course Code: 103
Faculty: Sessions: 20
| Dr. Ch. Lakshmi Kumari, Dr. SaiSailaja, Modules: 3

Dr. Rajesh G, Dr. UshaNori&
Dr. Sandeep Kumar Kujur
Courses PGDM, PGDM-BIF,

PGDM-IB, PGDM-RM,
PGDM-HRM
S
ECONOMICS FOR MANAGERS
Code: 103 Credits: 3
Course Objective(s):The major objective of this course is to introduce to the students the
economic way of thinking about business decision and strategy. This course tries to develop
critical thinking skills and provides students with a logical way of analysis.
Course Outcome(s): The students are expected to develop and apply the most useful micre
economic concepts for business decision
making and strategic planning in the organization.
Unit I Introduction to basic concepts and their uses in business decision making
Opportunity Cost -Theory of individual behavior; Theory of Demand, Demand
Function, Elasticity of Demand - Types of Elasticities- Price, Income, Cross &
Promotional - Measurement of elasticity. Demand Forecasting and its use in
business planning- Cases and Exercises
Unit II Theory of Production - Total, Marginal and Average product, Law of Variable
Proportions Returns to scale, Isoproducts; Theory of cost and Revenue- cost

concepts; Isoquants - Least cost combination, economies of scale and scope-
Cases and Exercises.
)
Unit III Markets-Perfect and Imperfect- price output determination, Perfect Competition,
Monopoly; Price Discrimination, Monopolistic Competition; Oligopoly- Price
leadership, Market sharing collusions -Cartels - Cases and Exercises
Suggested Readings
1. S Charles Maurice, Christopher R Thomas, Managerial Economics, 12h Ed, 2015
2. Salvatore, Dominick adapted by SrivastavaRavikesh, Managerial Economics: Principles and
Worldwide Applications, 7th Ed, 2012
3. Michael R Baye, Managerial Economics and Business Strategy, 7th Ed, McGraw Hills Irwin,
2010
4. Peterson H C and Lewis W C, Sudhir K Jain Managerial Economics, Fourth Edition, Pearson
Education Asia, 2005 .
5. Keat Paul G, Young, Philip K.Y., and Banerjee, Sreejata, Managerial Economics: Economic
Tools for today's Decision Makers, Sixth Edition, Pearson India, 2012
6. Robert Pindyck and Daniel Rubinfeld, Microeconomics , Eight edition, Pearson Education
Asia, 2017
7. Sloman, John & Sutcliffe, Mark, Economices for Business, Pearson Education, Third edition,
Handout & Reading Material
Trimester:1" Term-2018 Credits 3
Course Code: 103
Faculty: Dr. Ch. Lakshmi Kumari, Dr. Sai Sessions:20

Modules: 3
Sailaja, Dr. Rajesh G, Dr. Usha Nori, Dr.
Sandeep
PGDM- IB, PGDM-

CoursesS PGDM, PGDM-BIF,
RM, PGDM-HRM
OVERVIEW
introduces managers to the essence of business econonics the theories, conceptsS

This course
the microeconomic environment. It is

and ideas that form the economist's tool kit encompassing
within
understanding of the economic climate
important for managers to have comprehensive
a
an understanding of the economic

factors involved in
which their business operates along with
course is essential for managers
to visualize the
internal decision making. Hence forth, this
economist's lens, enabling them to
better understand the economy and
economy through
improve their decision making.
wherein the students would be

The course is designed basically with a two pronged approach
and
The theory serves to sharpen analytical skills,
fully equipped with both theory and practices.
to real-world
of the principles and techniques
the practice will give experience in the application
business problems.
choice, production, cost,

topics include demand and supply, elasticity,
consumer
Microeconomic
market structure.
profit maximization and
Course Objectives
basic understanding of the economic
The purpose of this course is to provide students with a
problems. Students who

be used in decision-making
and analytical tools that
can
theory
Successfully complete the course will have a good understanding of economic concepts and tools
that have direct
managerial applications. The main course objectives are:
T o apply economic theoryand analytical toolsto help managers make betterdecisions.
To demonstrate the relation of Economics to the other courses in business education
he
overTiding objective of the course is to equip you with skills that will make you better
g e r and entrepreneurs. Some of the skills that you attain in this course will be useful
immediately. You will be able to better decipher the information you come across in the
business press. Other skills attain will prove
you to be useful in later courses in the program.
nere 1s more and more cross-over between economic, finance, strategy and marketing. In all of
tnese courses
your knowledge of economics will pay dividends.
inally, this cOurse assumes you have had no formal training in economics to this point. If you
have had economics courses in the past you may find that this economics course is much
diiferent. Past experience has showed that by the end of the trimester there is no significant
difference in the performance of students who have had economics training in the past and those
who have not.

Session Plan
Session Theme Portion of Textbook Case/Article/Activity
Module l1
The problem of what, how and Chapter-l of Introduction to the Challenge of

for whom to produce Textbook Conventional Economics Concepts
Case: Xerox Vs Canon
2 Basic Concepts and their uses in | Chapter-1 from Opportunity cost, NPV,
business decision making- Thomas & Maurice Discounting Principle etc.
Opportunity cost, Incremental
Principle, Discounting
Principle, NPV, Equi-Marginal
Principle
3 &4 Theory of Demand & Supply Chapter-2 Case Discussion: Understanding
the Post recession Customer-
Demand Function Thomas &Maurice HBR
Elasticity of Demand & Supply

Video: Determination of Demand
curve
Types - Price, Income, Cross
and Promotional Assignment Submission
Theory of Individual/ Consumer | Chapter 5 Income and Substitution Effects

Behaviour
Thomas & Maurice
5 Measuring Elasticity of Demane Chapter-5,6 of Price Elasticity Estimation

and Supply, Demand Thomas & Maurice|
Forecasting Its uses in Business Exercises with Data Estimating
-
the Demand for Chekkers Pizza.

Planning
Videos:
1. Types of elasticity
4
2. Demand forecasting
techniques
Test: 1 Article Study and assignment on Elasticity estimation
Module-2
Theory of Production: Chapter Table 8.1 Discussion

Introduction TP, MP, AP Short 8Thomas &
Run: Law of Variable Maurice Video:
Proportions Law of variable proportions
Long Run: Returns to scale, Chapter-9 Case Discussion: Mittal Steel in

Isoquant approach, Least Cost Thomas& 2006-Changing the Global Steel
Combination Maurice Game -HBR case (with all the
latest additions till 2015)
Video: Returns to scale in

Manufacturing Isoquant approach
Cost: Concepts of cost fixed, Chapter-8,9, 10 1.Case Discussion: Sunk, fixed &
variable & other economic Integrated variable costs: Computers, Software
costs Thomas& and Pizzas (Pindyck & Rubinfied
Maurice pp-20)
Video: Fixed vs. Variable costs
Continuation of Mittal steel case
Short run Cost Curves: U Chapter- 8,9, 10 1. Case: Short-run cost curve for a
Shaped Integrated printing firm (Author: Perlotf, 189)
Thomas &
Maurice Video: U-Shaped cost curves
Continuation of Mittal steel case
10 Long run cost curves Chapter-8,9, 10 Cases: Continuation of Mittal steel

Integrated case
Thomas &
Maurice Case 2: Economies of scale in the
Electronics Industry (Author:
Lipsey and Chrystal, pp:121)
2.Case: Breakeven Analysis for
Tata Motors' Nano Car (Author:
Dominic Salvatore pp-320)
Video: Break-even analysis
st 2 Mid semesterExannaion
odue
Perfect Competition Chapter-11Thomas Cases: 1.Competition in the

& Maurice Indian Mutual Fund Market
(Dominic Salvatore, pp-351)
2.Cocoa: the food of the gods
(Lipsey and Chrystal)p: 149
3.Copper, pp- 150-151
Video: Types ofmarkets: Perfect

Competition
12 Monopoly: Causes, Price Chapter-12ThomasCase: Case on Monopoly in the

Output Determination & Maurice Mumbai City Taxi Industry
(Dominic Salvatore pp-369)
De Beers- The Diamond

Monopoly (Suma Damodaran)p:
278
Video: Monopoly market
13 Price Discrimination- causes, Chapter-12 Cases: 1.Disneyland Pricing

degrees, dumping
Thomas & Maurice (Author: Perloff pp-387)
2. Price discrimination in the

Airlines Industry (Suma
Damodaran) p: 362
Video: Price discrimination
6
14&15 Monopolistic Competition & Chapter-13 Cases: 1.The Monopolistically
Competitive Medical Private
Oligopoly
Thomas & Maurice Practice Market in India
(Dominic Salvatore.pp37)
2.Case Presentation by students
on Evolution of Indian Telecom
Industry
3.Take Home assignment: Case
on Pricing in the Airlines
Industry
(Besanko pp-217)
Video: Imperfect markets
Sectoral assignments on HHI

and Firm Concentration Ratios
Test-3 Presentations on Sectoral assigrnments Nature of the Firm and Industry and estimaton ot i i l
and Firm Concentration Ratios
Cases: 1.The OPEC Cariei

16 Oligopoly-Price leadership, Chapter-9 of
Market Sharing Collusions Textbook (Dominic Salvatore pp 399)
2. Presentation by students on
the Role of Competition

Commission of India -Casc of
Cement Cartels
Video: Colusive oligopoly
End Semester Fxammauon

'
Evaluation Components
SNo Component
Class Participation* Date Weightage
At the end of 10 sessions| 5%
2 Class Participation* At the end of the course 5%
Assignment Seesession plan above 10%
Mid Term Examination
Seesession plan above 10%
Team Project Presentation & Write UP
-
See session plan above_ 10%

End Term
Exam 30%
*Class participation marks are
subject to attendance of the student.
.
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Chapter
Managers, Profits,
and Markets
After reading this chapter, you will be able to:
1.1 Understand why managerial economics relies on microeconomics and industrial
organization to analyze business practices and design business strategies.
1.2 Explain the difference between economic and accounting profit and relate
ecoromic profit to the value of the firm.
1.3 Describe how separation of ownership and management can lead to a
principal-agent problem when goals of owners and managers are not aligned
and monitoring managers is costly or impossible for owners.
1.4 Explain the difference between price-taking and price-setting firms and discuss
the characteristics of the four market structures.
1.5 Discuss the primary opportunities and threats presented by the giobalization of
markets in business.
Student of managerial economics: Will I ever use this ?

Professor: Only if your career is successful.
I uccess in the business world, no matter how you slice it, means
winning in the marketplace. From CEOs of large corporations to man-
agers of small, privately held companies-and even nonprofit institu-
tions such as hospitals and universities-managers of any of these kindsof
organizations cannot expect to make successful business decisions without á clear
understanding of how market forces create both opportunities and constraints
for business enterprises. Business publications such as The Wall Street journal,
2 CHAPTER 1 Managers, Profits, and Markets
Bloomberg Businessweek, The Economist, Harvard Business Revieu, Forbes, and For-
tune regularly cover the many stories of brilliant and disastrous business de
cisions and strategies made by executive managers. Although luck often
plays a role in the outcome of these stories, the manager's understandingor
lack of understanding-of fundamental economic relations usually accounts for the
difference between success and failure in business decisions. While economicanaly
sis is not the only tool used by successful managers, it is a powerful and essential
tool. Our primary in this text is to show you how business managers
goal can use
economic concepts and ànalysis to make decisions and design strategies that will
achieve the firm's primary goal, which is usually the maximization ofprofit.
Publishers roll out dozens of new books and articles each year touting the lat
est strategy du jour from one of the year's most "insightful" business gurus. The
never-ending parade of new business "strategies," buzzwords, and anecdotes
might lead you to believe that successful managers must constantly replace out
dated analytical methods with the latest fad in business decision making. While
it is certainly true that managers must constantly be aware of new developments
in the marketplace, a clear understanding of the economic way of thinking about
business decision making is a valuable and timeless tool for analyzing business
practices and strategies. Managerial economics addresses the larger economic and
market forces that shape both day-to-day business practices, as well as strategies
for sustaining the long-run profitability of firms. Instead of presenting cookbook
formulas, the economic way of thinking develops a systematic, logical approach to
understanding business decisions and strategies-both today's and tomorrow's.
While this text focuses on making the most profitable business decisions, the prin-
ciples and techniques set forth also offer valuable advice for managers of nonprofit
organizations such as charitable foundations, universities, hospitals, and government
agencies. The manager of a hospital's indigent-care facility, for example, may wish
to minimize the cost oftreatingacommurnity's indigent patients while maintaining a
satisfactory level of care. A university president, facing a strict budget set by the state
board of regents, may want to enroll and teach as many students as possible subject
to meeting the state-imposed budget constraint. Although profit maximization is the
primary objective addressed in this text, the economic way of thinking about business
decisions and strategies provides all managers with a powerful and indispensible set
of tools and insights for furthering the goals of their firms or organizations.
1.1 THE ECONOMI WAY OFTHINKING ABOUT BUSINESS

PRACTICES AND STRATEGY
Because this text relies primarily on economic theory to explain how to make more
profitable business decisions, we want to explain briefly how and why economic
theory is valuable in learning how to run a business. Managerial economics applies
the most useful concepts and theories from two closely related areas of economics-
microeconomics and industrial organization-to create a systematic, logical way of
analyzing business practices and tactics designed to get the most profit, as well as
formulating strategies for sustaining or protecting these profits in the long run.
CHAPTER 1 Managers,Profits,and Markets 3
Economic Theory Simplifies Complexity

No doubt you have heard statements such as "That's OK in theory, but what
about the real world?" or "I don't want ivory-tower theorizing; I want a practical
solution." Practical solutions to challenging real-world problems are seldom
found in cookbook formulas, superficial rules of thumb, or simple guidelines and
anecdotes. Profitable solutions generally require that people understand how
the real world functions, which is often far too complex to comprehend without
making the simplifying assumptions used in theories. Theory allows people to
gain insighta into complicated problems using simplifying assumptions to make
sense out of confusion, to turn complexity into relative simplicity. By abstracting
away from the irrelevant, managers can use the economic way of thirnking about
business problems to make predictions and explanations that are valid in the real
world, even though the theory may ignore many of the actual characteristics of
the real world. And, as we like to remind students, if it doesn't work in theory or
concept, it is highly unlikely to work in practice.
Using economic theory is in many ways like using a road map. A road map ab-
stracts away from nonessential items and concentrates on what is relevant for the
task at hand. Suppose you want to drive from Dallas to Memphis. Having never
made this trip, you need to have a map. So, you log on to the Internet and go to
Google maps, where you get to choose either a satellite view of the region be-
fween Dallas and Memphis or a simple street view. The satellite view is an' exact
representation of the real world; it shows every road, tree, building, coW, and river
between Dallas and Memphis. While the satellite view is certainly fascinating to look
at, its inclusion of every geographic detail makes it inferior to the much simpler street
view in its ability to guide you to Memphis. The simpler street view is better suited
to guide you because it abstracts from reality by eliminating irrelevant information
and showing only the important roads between Dallas and Memphis. As such, the
(abstract) street view gives a much clearer picture of how to get to Memphis than
the (real-world) satellite view. Likewise, the economic approach to understanding
business reduces business problems to their most essential components.
The Roles of Microeconomics and Industrial Organization

As we mentioned previously, managerial economics draws on two closely related
areas of economic theory: microeconomics and industrial organization. If you
microeconomics have taken a basic course in economics, you will recall that microeconomics is
The study of indi- the study and analysis of the behavior of individual segments of the economy:
vidual behavior of
individual consumers, workers and owners of resources, individual firms, indus-
consumers, business
firms, and markets, tries, and markets for goods and services. As a necessary means for addressing
and it contributes to the behavior of rational individuals (both consumers and producers), microeco-
Our understanding of nomics develops a number of foundation concepts and optimization techniques
business practices and that explain the everyday business decisions managers must routinely make in
tactics.
running a business. These decisions involve such things as choosing the profit
maximizing production level, deciding how much of the various productive in-
puts to purchase in order to produce the chosen output level at lowest total cost,
w w w . d o w n l o a d s l i d e . c o m
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and Markets
4 CHAPTER 1 Managers, Profits,
ILLUSTRATION 1.1
services. She
interest in advertising their
any to begin
be wise for her
Managerial Economics it would not
decided
runningradio ads.
The Right for Doctors
Several physicians.used
de Linear trend forecasting:
to forecast patient
load. An
offer MBA programs
A number of universities lineartrend analysis emergency room
for medical doctors. The majorily administiator of a'
hospital's
signed specifically these specialized programis using
day-of-weekdümmy
of the doctorsenrolled in
business-decision-making
services found that otfer hospital administra
develop the variables,he could
are seeking to private and public medical evidence instead of his casual to
skills they need to manage tors statistical certain days
of the week tend
clinics and hospitals. observation that
most interested in be (statistically)significantly
busier than others
Doctors are understandably practical business doctorin NewOrleans
Strategic entry deterrence A
quickly teach them
Courses that will
cinics in Baton Rouge and
many
economics, they have found decided to open new
skills. In nmanagerial
business.decision making and have clinics likehisarecurto
valuable tools for Morgan City No.other
principles and tools of mana- two cities.In order
been quick to apply the in rently operating inthese opening similar
economics to variety
a of business problems discourage other doctors from
gerial interesting of these appli- his services just slightly
medicine Some of the more will learn about in clinics, heplans to price significantly below
topics you but
cations, al of which are above average total costmaximize profit
under
thistext are discussed here: the price that would
making Nearly
Irrelevance offixed costsindecision some monopoly revenue maXimizatio1 A
to making
all the physicians admitted Profit maximization vs. ownership interest in
A director of
decisions based on fixed costs. complained doctor with a 25 percent realized during
oncology department apharmaceutical supply firm
a radiation administrative costs manager is probably;selling
that many of herhospital'sthe incremental costs of class that his sales
the manager's compernsa
areincluded as part of hospital too many units because he
While the on commissions.
treating additional patients Fionis basedsubstantially raising drug prices
a marginal cost
prided itself in moving toward accounting doctor plans to recommend
services the to sell fewer units and to
begin paying the sales
pricinig structure for marginalcostwas
department's calculation of profit
manager a percentageof Hospitalmanagers
administrative costs
inflated by fixed in Economies of scaleana scope:
doctor specializing toward managed
Price discrimination: A increase revenue by perceive the current trend
vasectomies wanted to care to:be forcing hospitals to reducecosts
discrimination. After
a lengthy
Economies of scale and
engaging in price of charging differ without reducing quality. economies exist
SCope, to the extent that such
about the legality
discussion decided to need for cost
for medical services, he solution to the
ent price placing a $40-off offer anattractive the class
clinic by administrators in
promotehis vasectomy He reduction Hospital
localnewspaper's TV guide empiricalmethods
coupon in the patients will clip were especialy interested inscale in order to plan
believes that only lowerincome of
ofmeasuring economiescontraction
price
thecoupon and pay lower discussion on
the future expansion or
for
Advertising dilemma:After a
class Onedoctor
oligopoly maTkets,
Cost tinimizing input combination:
a of walkincinic
the advertising dilemmainLASIK eye surgery who owns andmanages chain
specializes in reducethe.employment of MDs and
a doctor who decided to
expressed herrelief thaf none
of the other three increasetheemployment of
RNs on thebasis of
town had shown
ASIK surgeons in her small
2
CHAPTER 1 Managers, Profits, and Markets 5
classroom discussiorn of cost minimization. Appar- medical profession as hospitals, health raintenance
ently, for many of the procedures performed at the organizations, and other types of health care clinics
clinic, experienced nurses can perform the medical hire them to manage the business aspect of health care.
Some doctors, as well as the American Medical Asso
tasks approximately as well as the physicians, as to blending business and medical
long as the nurses are supervised by MDs. The ciation, are opposed
values. Given the nature of the applications of mana-
dortor-manager reasoned that even though MDs
nave higher marginal products than RNs, the mar- gerial economics cited here, it appears that a coursein
managerial economics offers doctors insights into the
ginalproduct per dollar spent on RNs exceeded business of medicine that they would not usually get
the marginal product per dollar spent on MDs.
in medical school. Many doctors think this knowledge
Business publications repori that doctors with MBA is good medicine.
degrees are becoming increasingly powerful in the
between two
choosing how much to spend on advertising, allocating production
or more manufacturing plants located in different places, and setting the profit
maximizing price(s) for the good(s) the firm sells.

These routine busincss decisions, made under the prevailing market condi
them
tions, are sometimes referred to as business practices or tactics to distinguish
inter1tionally to
from strategic decisions, which involve business moves designed
team
influence the behavior of rival firms. In other words, the firm's management
business practices or makes many decisions about business practices or tactics to create the greatest
the firm. Because
possible profit for the specific business environment faced by
tactics
Routine business
decisions managers
business practices typically involve maximizing or minimizing something, the
field of microeconomics can be extremely helpful in understanding how to make
must make to earn the
greatest profit under these operating decisions. As we will stress throughout this book, microeconom
maximizing and minimizing processes, provides kind
the prevailing market ä
Cs, with its emphasis on
conditions facing of all-purpose, Swiss army knife for explaining how to make the most profitable
e firm.
business decisions. Once you get the hang of this approach, you will see that
mana-
method
gerial economics is really just a series of repeated applications of a general illus-
of reasoning known as "marginal analysis." In Chapter 3, we will explain and
trate the powerful logic of marginal analysis. Economists like to say that marginal
the central
analysis provides "the key to the kingdom of microeconomics." Given
role of microeconomics in managerial economics, we can safely tell you that mar-
"the to the kingdom of managerial economics."
ginal analysisalso provides key
While microeconomics serves as our "Swiss army knife" for explaining most
business practices, a specialized branch of microeconomics, known as industrial
organization, gives us an additional, complementary tool for business analysis.
industrial organization Industrial organization, which focuses specifically on the behavior and structure
Branch of microeconomics of firms and industries, supplies considerable insight into the nature,motivation
focusing on the behavior and consequences of strategic actions firms may wish to undertake. Many of the
and structure of firms most important developments in business analysis and strategic thinking over the
and industries.
past 30 years flow directly from advances in the theory of industrial organiza-
tion. Most of the discussion in this text about strategic decision making can be
attributed to these advances in the field of industrial organization.
3
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FIGURE 1.1
Economic Forces That Fow close subslitules
Promote Long-Run
Profitability
Strong entry barriers
Weak rivalry within market
Low.market power,of Long run

input suppliers profitability
Low market power of
COnsumers
Abundant complementary
Products
Limited harm.ul. government
intervention
strategic decisions Strategic decisions differ from routine business practices and tactics be-
Business actions taken to
alter market conditions
cause
strategic decisions do not accept the existing conditions of competition
as fixed, but rather
and behavior of rivals in atternpt to shape or alter the circumstances under whic a
ways that increase and/ firm competes with its rivals. In so
or protect the strategic
doing, strategic decisions can create greater
profits and, in some cases, protect and sustain the profits into the future. While
firm's profit. common business practices and tactical decisions are
necessary for keeping
organizations moving toward their goalsusually profit-maximization-strategic
decisions are, in a sense, "optional" actions
managers might be able to undertake
should circumstances arise making a strategy suitable and likely to succeed. In
Chapter 13, we will show you how to apply a variety of concepts from game
theory and industrial organization to design strategic moves to make more profit.
With its emphasis on noncooperative
game theory and the behavior of firms
when rivals are few in number, industrial
role in every modern course in business
organization concepts now play a central
strategy. Business strategists rely heavily
on the field of industrial
that influence the long-run
organization to identify and examine the economic forces
profitability of businesses. Figure 1.1 shows a list of
economic forces that determine the level of
profit a firm can expect to earn in the
long run and the durability of long-run profits.' As a business or economics major,
you may wish to take an entire course in industrial organization to learn about
these forces. In this book, we will cover most of these factors in
of detail. We are confident that when varying degrees
you finish this course, you will agree that
'Michael Porter, in his book Competitive Strategy, New York: Free

Press, 1980, examines the first
five forces in Figure 1.1. His pioneering work, called "Five Forces
ied framework in business
Analysis," remains a widely stud-
strategy courses. More recently, Adam Brandenburger and Barry Nalebuff
have added complementarity of products and
inputs to the list of economic forces affecting long-run
profitability. See their book, Co-Opetition, New York: Doubleday, 1996.
managerial economics covers a wide range of important business decisions and

offers a powerful, indispensable view of the business world.
1.2 MEAStIRING AND MAXIMIZING ECONOMIC PROFIT

As mentioned previously, the primary purpose of this text is to show managers
how to make decisions that will generate the most profit for their businesses. Profit
serves as the score in the "game" of business. It's the amount by which revenues
exceed costs. And when costs exceed revenues, the resulting negative profits, or
losses, signal owners in no uncertain terms that they are reducing their wealth by
owning and running unprofitable businesses. The sucess of managers' decisions is
judged according to a single overriding concern: Are managers' decisions creating
higher or lower profits? Managers who can make the largest possible profits not
only enrich the owners of firms-and managers are often part or full owners of
firms they manage-but they also create for themselves a reputation for profitable
decision making that can be worth millions of dollars in executive compensation.
Thus, it is crucial for managers to understand how the "score" is calculated and
how to achieve the highest possible score without getting sidetracked by issues
that don't affeet the score. It is essential that managers never forget that the goal
of the firm is to maximize economic profits. Nothing else matters in the world of
business as much as profit does because the value of a business and the wealti of
its owners are determined solely by the amount of profits the firm can earn.
After hearing so much news about scandals over financial reporting errors, as
well as several spectacular cases of management and accounting fraud-think
Enron, WorldCom, and MF Global-you probably won't be surprised when we
explain in this section why "profits" reported in corporate financial statements
generally overstate the profitability of firms. The tendency for overstating profits
examined in this section, however, has nothing to do with accounting mistakes or
fraud. Indeed, the reason accounting reports of profit (which accountants may call
net income, net earnings, or net profit, depending on the circumstances) p0orly re-
flect the actual profitability of firms can be explained by examining the generally
accepted accounting practices set forth by professional accounting associations
subject to approval from government agencies. Before we can explain why finan-
cial accounting procedures overstate business profitability, we must first show
you how to measure the economic costs businesses incur when using resources to
produce goods or services.
Economic Cost of Using Resources
As you know, businesses produce the goods or services they sell using a variety
of resources or productive inputs. Many kinds of labor services and capital equip-
ment inputs may be employed along with land, buildings, raw materials, energy,
opportunity cost
financial resources, and managerial talent. The economic cost of using resources
What a firm's owners
give up to use resources to produce a good or service is the opportunity cost to the owners of the firm using
to produce goods or those resources. The opportunity cost of using any kind of resource is what the
services. owners of a business must give up to use the resource.
5
8 CHAPTER 1 Managers, Profits,and Markets
The method of measuring opportunity costs differs for various kinds of inputs
used by businesses. Businesses utilize two kinds of inputs or resources. One Or
market-supplied these categories is market-supplied resowrces, which are resources owned by
resources others and hired, rented, or leased by the fim. Examples of resources purchasea
Resources owned by
ofrom others include labor services ofskilled and unskilled workers, raw materials
others and hired, rented, or
leased in resource markets. Purchased in resource markets from commercial suppliers, and capital equipment
rented or leased from equipment suppliers. The other category of resources i5
owner-supplied Owner-supplied resources. The three most important types of owner-supplied
resources resources are money provided to the business by its owners, time and labor
Resources owned and services provided by the firm's owners, and any land, buildings, or capital
used by a firm.
equipment owned and used by the firm.
resources used.
Businesses incur opportunity costs for both categories of
total economic cost Thus, the total economic cost of resources used in production is the sum of the
Sum of opportunity opportunity costs of market-supplied resources and the opportunity costs of
costs of market-supplied
owner-supplied resources. Total economic cost, then, represents the opportunity
resources plus
opportunity costs cost of all resources used by a firm to produce goods or services.
of owner-supplied The opportunitycosts of
using market-supplied
resources are
the out-of-pocket
resources. monetary payments made to the owners of resources. The monetary payments
explicit costs made for market-supplied inputs are also known as explicit costs. For example,
Monetary opportunity one of the resources Apple Inc. needs to manufacture its iMac computer is an
costs of using
Intel Core 17 microprocessor chip. This chip is manufactured by Intel Corp,
market-supplied and Apple can purchase one for $310. Thus, Apple's opportunity cost to obtain
resources.
the computer chip is $310, the monetary payment to the owner of the input.
We want to emphasize here that explicit costs are indeed opportunity costs;
specifically, it's the amount of money sacrificed by firm owners to get market-
supplied resources.
In contrast to explicit costs of using market-supplied resources, there are no
out-of-pocket monetary or cash payments made for using owner-supplied re
sources. The opportunity cost of using an owner-supplied resource is the best return
the owners of the firm could have received had they taken their own resource
to market instead of using it themselves. These nonmonetary opportunity costs
implicit costs of using a firm's own resources are called implicit costs because the firm makes
Nonmonetary no monetary payment to use its own resources. Even though firms do not make
opportunity costs of
explicit monetary payments for using owner-supplied inputs, the opportunity
using owner-supplied
resources.
costs of using such inputs are not zero. The opportunity cost is only equal to zero
if the market value of the resource is zero, that is, if no other firm would be willing
to pay anything for the use of the resource.
Even though businesses incur numerous kinds of implicit costs, we will fo-
cus our attention here on the three most important types of implicit costs men-
tioned earlier: (1) the opportunity cost of cash provided to a firm by its owners,
equity capital which accountants refer to as equity capital; (2) the opPportunity cost of using
Money provided to land or capital owned by the firm; and (3) the opportunity cost of the owner's
businesses by the
time spent managing the firm or working for the firm in some other capacity.
owners.
For more than 70 years, these implicit costs have been the center of controversy
6
)

over how accountants should measure the costs of using owner-supplied re-
sources. We will have more to say about this issue in our later discussion of
meas:ring business profit, as well as in Ilustration 1.2. Let's first look at ex
amples of each of these implicit costs.
ILLUSTRATION 1.2
The Sarbanes-Oxley Act principles. But economists have long recognized thatprofit
wilit Close the GAAP between Economic and i s b ynomeans the same thingasaccounting profit.
Accounting Profit? This same concern is amplified by G. Bennett Stewart
in his commentary on the Sarbanes-Oxley Act:
When Congress passed the Sarbanes-Oxley Act
(2002), it gave the federal government substantial The realproblem [causing therecentaccourting
new authority to regulate the auditing of corporate scandals) is that earnings andearnings per share(EPS)
financial statements with'the aim of reducing fraudu- asmeasured according to GAAP, are unreliable measures
lent repoôrts of accounting profits Although sarbanes of corporate performance and stock-market value.
Oxley primarily focuses on detecting and preventing Accountants simbly are not counting what counts o
fraud via improved auditing, the act also rekindled measuring what matters.
interest in a long-standing conceptual disagreement We have discussed in this chapter how to measure
between economists and accountarntsconcerning how the implicit costs ofseveral kinds of owner supplied
AAP
to properly measure profits As we haveemphasized resources not presently treated as costs under GAAP:
inthis chapter, accountants follow reporting rules the owners financial capital (.e, equity capital)
known as generally accepted accounting principles, physical capital, and land, as wellas time Spent by
or GAAP which do not allow most kinds of implicit owners managing their firms. While all of these types
Costs of owner-supplied resources to be deducted from of implicit costs must be treated as costs to bring ac
revenues. Failure to deductthese implicit costs causes counting earnings in line with economic profits, it
accountin8 measures of profit referred to on finan the opportunity cost of equity capital, according to
cial statements variously as net earnings, earnings af Stewart that generatestne greatestsingle distortion inD
ter tax,net income,operating profit, and net profitto computing accounting profit:
Overstate economic profit, because economicprofit
subtracts allcosts ofresources used by businesses he most noteworthy flaw in GAAPis that no charge is
A number of authoritiesin thefields of finance deductedfrom [revenues)for the costof providing
and accounting belieye Sarbanes-Oxley roctuses too shareholaerswitha return on theirinvestment
The most significant proposed adjustment ot AA15
much attention and regulatory effort on reducing to deduct the cost of equity capitalfrom net income 1.e
fraud They believethemost important shortcoming accounting profitj Failure to deduct it is a stupendous
forfinancial statementsstems from accounting rules earnings distortion.

that poorly measure the profitability of businesses.
Robert Bartley, one of several experts who have As an example of the magnitude of this distortion,
contributedtheiropinions onthe subject,offeredthe in 2002 the 500 fimsthatcomprisethe Standardand
following observation Poor's (SP)stock index employed about $3 trillion
For whilethere has beeinsomecheatinig and comer
of equitycapital, which, at a 10 percent annualop-
cutting, the realproblemwithcorporate reportingis con- Portunity cost of equity capital representsa resource
EPs, the familiar earning per share [accounting
ceptualdivided COstto businesses of S300 billion (0.10 x $3 trillion).
Profit by the number of outstanding shares of 0put this cost which GAAP completely ignores,into
COmmon stockliS Supposed to measure corporate profit, perspecive, stewart notes thatthe sum total of all ac
as
detemined by GAAP orgenerally accepted accounting counting profitfor the S&P 500 firms in2002 was just
Continiued)
7
10 CHAPTER 1 Managers,Profits,and Markets
S118 bilion. After subtracting this opportunity cost of Robert L Bartley, "Thinking Things Over: bconomc
equity capital from aggregate accounting profit, the Vs. Accounting Profit," The Wall Street Journa
Jones&
Tesulting measure of economic profit reveals that these June 2, 2003,p. A23. Copyright 2003 Dow
500 businesses experienced a loss of $182 billion in 2002 Company, nc
G. Bennet Stewart II, "Commentary: Why Smart
As you
can now more fully appreciate, the GAAP be- Managers Do Dumb Things," The Wall Street Journal,
Lweenecornomicand accounting profit creates a sizable June 2, 2003,p. Al8. Copyright 2003 DowJones
distortion
able
that,if corrected, canturna seeminglyprofit Company
business, along with its CEO, into a big loser! SIbid.
Initially, and then later as firms grow and mature, owners of businesses -single
proprietorships, partnerships, and corporations alike-usually provide some
amount of money or cash to get their businesses going and to keep them running.
This equity capital is an owner-supplied resource and entails an opportunity cost
equal to the best return this money could earn for its owner in some otherinvest
ment of comparable risk. Suppose, for example, investors use $20 million of their
Ownmoney to starta firm of their own. Further suppose this group could take the
$20 millicn to the venture capital market and earn a return of 12 percent annually
at approximately the same level of risk incurred by using the money in its own
business. Thus, the owners sacrifice $2.4 million (= 0.12 x $20 miliion) annually
by providing equity capital to the firm they own. If you don't think this is a real
Cost, then be sure to read Illustration 1.2.
Now let's illustrate the implicit cost of using land or capital owned by the
firm. Consider Alpha Corporation and Beta Corporation, two manufacturing
firms that produce a particular good. They are in every way identical, with one
exception: The owner of Alpha Corp. rents the building in which the good is pro-
duced; the owner of Beta Corp. inherited the building the firm uses and there-
fore pays no rent. Which firm has the higher costs of production? The costs are
the same, even though Beta makes no explicit payment for rent. The reason the
costs are the same is that using the building to produce goods costs the owner of
Beta the amount of income that could have been earned had the building been
leased at the prevailing rent. Because these two buildings are the same, presum-
ably the market rentals would be the same. In other words, Alpha incurred an
explicit cost for the use of its building, whereas Beta incurred an implicit cost for
the use of its building Regardless of whether the payment is explicit or implicit,
the opportunity cost of using the building resource is the same for both firms.
We should note that the opportunity cost of using
owner-supplied inputs
may not bear any relation to the amount the firm paid to acquire the input.
The opportunity cost reflects the current market value of the resource. If the firm
Altermatively, Beta's sacrificed return can be measured as the amount the owner could earn if
the resource (the building) were sold and the payment invested at the market rate of interest. The
sacrificed interest is he implicit cost when a resource is sold and the procee invested. This measure
of implicit cost is frequently the same as the forgone rental or lease income, but if
the true opportunity cost is the best alternative return.
they
are not equal,
paid $1 million for a plot of land two years ago but the market value of the land
has since fallen to $500,000, the implicit cost now is the best return that could be
earned land is
ifthe for $500,000, not $1 million (which would be impossible
scld
under the circumstances), and the proceeds are invested. If the $500,000 could
be invested at 6 percent annually, the implicit cost is $30,000 (= O.06 X $500,000)
per year. You should be careful to note that the implicit cost is not what the re-
source could be sold for ($500,000) bui rather it is the best return sacrificed each
year ($30,000).
Finally, consider the value of firm owners' time spent managing their own
businesses. Presumably, if firm owners aren't managing their businesses or
working for their firms in other capacities, they could obtain jobs with some
other firms, possibly as managers. The salary that could be earned in an alterna-
tive occupation is an implicit cost ihat should be considered as part of the total
cost of production because it is an opportunity cost to these owners. The implicit
cost of an owner's time spent managing a firm or working for the firm in some
cther capacity is frequently, though not always, the same as the payment that
would be necessary to hire an equivalent manager or worker if the owner does
not work for the firm.
We wish to stress again that, even though no explicit monetary payment is
made for the use of owner-supplied resources, $1 worth of implicit costs is no less
(and no more) of an opportunity cost of using resources than $1 worth of xplicit
costs. Consequently, both kinds of opportunity costs, explicit and implicit oppor-
tunity costs, are added together to get the total economic cost of re:souree We ist
now summarize this important discussion on measuring the econonic costs of

using resources in a principle:
Principle Ihe opportunity cost of using resources. is the amount the firm gives up by using these
resources. 0pportunity costs can be either explicit costs or implicit costs. Explicit costs are the costs of
USIng ma:ket-supplied resources. which are the monetary paymentsto hire, rent, or lease resources owned
by others. Implicitcosts are thecosts oftusingownersupplied resources, which are the greatest earnings
forgonefrom usingresources ownedby the fim inthefirm's own production process, Total econsnic coSt
Isthesumof explicit and implicitcosts
Figure 1.2 illustrates the relations set forth in this principle. Now that we have
shown you how to measure the cost of using resources, we can explain the
difference between economic profit and accounting profit.
Now try Technical Notice to students: The notebooks in the left margin throughout this text are di
Problem 1. recting you to work the enumerated Technical Problems at the end of the chapter.
Be
sure to the answers provided for you at the end of the book before
check
ceeding to the next section of a chapter. We have carefully designed the Technical
pro-
Problems to guide your learning in a step-by-step process.
economic profit Economic Profit versus Accounting Profit

The difference between
total revenue and total Economie profit is the difference between total revenue and total economic
economic cost. cOst. Recall from our previous discussion that total economic cost measures the
19
FIGURE 1.2
Economic Cost of Using
Explicit Costs
of
Resources
Market-Supplied Resources
he monelary payments to
resource owners
Implicit Costs
Owner-Supplied Resources
Thereturns forgone by not taking
fhe owners resources tomarket
Total Economic Cost

Thetotal opportunity costs of
bothkinds ofresources
opportunity costs of all the resources used by the business, both market-supplied
and owner-supplied resources, and thus:
Economic profit = Total revenue - Total economic cost
Total revenue Explicit costs Implicitcosts

Economic profit, when it arises, belongs to the owners of the firm and will increase
the wealth of the owners. When revenues fail to cover total economic cost, economic
profit is negative, and the loss must be paid for out of the wealth of the owners.
When accountants calculate business profitability for financial reports, they fol-
low a
If you
set ofrules known
as "generally accepted accounting principles" or GAAP.
have taken courses in accounting, you know that GAAP
provides
tants with detailed measurement rules for developing accounting information
accoun
presented in financial statements, such as balance sheets, cash flow statements,
and income statements. The Securities and Exchange Comnission (SEC) along
with the Financial Accounting Standards Board (FASB), a
professional accounting
organization, work together to construct the detailed rules of GAAP. To under
stand the importance of GAAP for our
present discussion, you only need to know
that GAAP rules do not allow accountants to deduct most
types of implicit costs
for the purposes of calculating taxable
accounting profit.
Accounting profit, then, differs from economic profit because accounting
accounting profit profit does not subtract from total revenue the implicit costs of using resources.
total revenue and explicit
Accounting profit is the difference between total revenue and explicit costs:
costs. Accounting profit = Total revenue - Explicit costs
20
Depending on the type of financial statement and where it appears in a statement

accounting profit goes by a variety of names such as income, net income, operat
ing income, net profit, earnings, or net ez nings.
As you can see, when firms employ
wner-supplied resources, the resulting
implicit costs are not subtracted from total revenue and the accounting profits
reported in financial statements overstate business profitability. All three types
of implicit costs discussed earlier are ignored by accountants. We want to stress,
lowever, that when financial accountants omit these implicit costs from financial
reports, they are following generally accepted rules set forth by the FASB and
SEC. The practice of omitting most kinds of implicit costs, which can be quite large
for many firms, is widely recognized by managers, shareholders, government of-
ficials, and financial analysts, who make lucrative careers converting the infor-
mation in financial accounting statements into measures more closely resembling
economic profit (see Ilustration 1.2).
Business owners, of course, must bear all costs of using resources, both explicit
and implicit, regardless of which costs may be deducted for accounting purposes.
ecause all costs matter to owners of a firm, you should now clearly understand
why maximizing economic profit, rather than accounting profit, is the objective of
the firm's owners. And, as we explain in the following section, the value of a firm
1s determined by the amount of economic
profit, rather than accounting profit
the firm is expected to earn in the current period and all future periods. As you
now see, it is economic profit that matters in business decision making, so in the
rest of this chapter
and in later chapters
whenever we refer to we
"profit," wil
mean economic profit. We will now summarize the relation between economic and
accounting profits in a principle:
Principle Econoicprofitisthe diferencebetween total revenue and total economic cost:
tconomicprofit lotal revenue lotal economic cost

Total revenue Explicitcosts Implicitcosts
ACCOuDting protit ditters trom economic profit because accounting profit does not subtract from total
revenue
theimplicitcosts of using resources
Accounting profitota revenue Explicitcosts
Now try Technical
Problem 2. Sincethe owners of firms must coverthe costs ot al resources.used.by the firm, maximizing economic profit,
ratherthan accounting.profit,isthe objective of the fitms owners
One of the implicit costs that accountants do deduct when computing accounting profit is
the cost of depreciation of capital assets, which is the reduction in the value of capital equipment
from the ordinary wear and tear of usage. As you may know from taking accounting courses,
businesses have several methods to choose from when computing depreciation costs, and some of
these
methods tend to overstate the actual value of depreciation in the early years of equipment
Ownership.
2
Maximizing the Value of the Firm

As we stressed in the precedirng discussion and principle, owners of a firm,
whether the shareholders of a corporation or the owner of a single proprietor

best served by management decisions that seek to maximize the profit
ship, are
of the firm. In general, when managers maximize economic profit, they are also
maximizing the value of the firm, which is the price someone will pay for the
a
HoW much will someone pay for a firm? Suppose you are going to buy
irm.
business on January 1 and sell it on December 31. f thefirm is going to make an
economic profit of $50,000 during the year, you are willing
to pay no more
$50,000 (in monthly payments matching the flow of profit) to own the firm tor
than
that year. Because other potential buyers are also willing to pay up to
the firm likely sells for very nearly or exactly the amount of the economic profit
$50,000,
earned in a year.
When a firm earns a stream of economic profit for a number of years in the fu-
value of a firm ture, the value of a firm-the price for which it can be sold-is the present value
The price for which the of the future economic profits expected to be generated by the firm:
firm can be sold, which
equals the present value
of future profits.
Valueof afirm ta+t *T+ 2a+
where ,is the economic profit expected in period t, ris the risk-adjusted discount
risk premium
rate, and T is the number of years in the life of a firm Inasmuch as future profit
An increase in the
is not known with certainty, the value of a firm is calculated using the profit
discount rate to
compensate investors for expected to be earned in future periods. The greater the variation in possible future
uncertainty about future
profits.
profits, the less buyer
a is
willing to pay for those risky future The risk profits.
associated with not knowing future profits of a firm is accounted for by adding
a risk premium to the (riskless) discount rate. A risk premium increases the dis-
count rate, thereby decreasing the present value of profit received in the future, in
order to compensate investors for the risk of not knowing with certainty the future
value of profits. The more uncertain the future profits, the higher the risk-adjusted
Now try Technical discount rate used by investors in valuing a firm, and the more heavily future
Problem 3. profits will be discounted.
Principle The value of a fim is the price for which it can be sold, and that price is equal to the present
value of the expected future profits of the firm The larger (smaller the risk associated with future profits,
the higher (lower) the fisk-adjusted discount rate used to compute the value of the firm, and the 1lower
higher) will be the value of the firm
Because a dollar of profit received in the future is worth less than a dollar
received now,
multiperiod decision making employs the concept of present value. Present value is the value at the
present time of a payment or stream of payments to be received (or paid) some time in the future.
The appendix at the end of this
chapter reviews the mathematics of present value computations,
a
topic usually covered in an introductory course in finance or accounting.
22
. .

ILLUSTRATION 1.3
How Do You Value a Golf Course? 10 percent." Thus, a commercia real estate investor
Estimating the Market Price of a Business who wishes to earn 10 percent annually by owning
this golf course would be willing to pay about $4.8 mil-
ecently 8olf courses have ben raising their member- lion to buy it. Amore "greedy investor who requires
Sp and green fees, making golf courses more profit- a return of, say, 16 percent will only be willing to pay
ot surprisingly, Golf Digest reports that prices $3 million(6480,000/0.16) for thesame golf course.
Aosare paying for golf courses are nowrising.
x l a i n in this chapter, thevalue of any busi-
Whilethe valuation analysisin Golf Digest is math-
ematically corect and economically sound, it can be:
is theprice for which thefirm can be sold, misleading if thespecific golf course has additional f-
and this price will reflect the buyer's calculation of the nancial features that cause a buyer to offer a price either
e n t value of the future profits expected to be gen- higher or lower than the value of the golf course "enter-
erated by the
firm. prise itself. Suppose the golf course has accumulated
you wanted to invest in a golf course, how a cash account of $100,000. Because the buyer of the
Snould you expectto pay to buy one? Because 8olf course gets the $100,.000 of cash along with the goif
Oud be competing with many other investors, course, thebuyer wouldbe willing to pay a pricefor
Ouwould not expect to pay less thanthe precent the course that is $100,000 morethan the present value
aue otthegolfcourses future stream of profits. To of the expected stream of profit Alternatively sup
help answer this question, Golf Digest interviewed POse thegolf course hasborrowed nmoney in the past
eith Cubba,who is the national director of the for whatever reason and has $100,000 of debt owed to
80lt course group at alarge commercial real estate abank. At the time of purchase, the buyer of the golf
brokeragefirm. Based on this interview, Golf Digest course must pay offthedebtto the bank which reduces
worked up a valuation of a golf course using a com-the price the buyer of the golf course is willing to pay
Putational technique that is essentially equivalent toby $100,000. As you can now see, the actual price paid
thevalueofa firm equation we present on page 14 for the golf course may notbe equal to the present value
of this textbook. of the expected stream of profit if the golf course comes
GoDigest begins its computation with aspecific with some amount of cash ordebt. Finarcialeconomists
annual profitfigure,which we will say is $480,000for Sometimes referto the value ofthe stream of expected
thislustration. Golf Digest simplifies itscomputation profitas the "enterprise value (EV) of the business. We
intwo ways: (1) profit is assumed to be $480,000 in just callit "the valueof the firm" in this textbook.
every year,and (2)the profit streamcontinues forever
thatis, 1T in our textbook equation is infinity. Then, You might be wondering about Golf Digest's assumption
Go Digest explains that in today's commercial real that a golf course generates a perpetual stream of profit (ie
estate market,investors require a risk-adjusted rate of years
return equal to about 10 percent annually. The value of
. nour Forthe golfcourseinthisexample if we let T50
textbook equation, the value will be $4,759,111,
whichofis just
this golf course is then calculated by dividing the an- value asmallstream
a perpetual deviation from the
of profit. In $48
othermillion
words,present
even
nualprofitby the risk-adjusted rate ofreturn: if the investor believes the golf course will only generate
Value of golf course $480,000 54,800,000 profit for 50years, shecan stilluse GolfDigest's perpetuity
formula for the sake ofconvenience without much worry
0.10 thatshe willbe overvaluing the present value stream of
As it tums out, $48 millionis extremely.closeto the discLissed
Profitheinnature ofthis matheniatical approximationis also
the Mathematical Appendix at the end of this
numerical value you would get it you appled the chapter, Review of Present Value Calculations."
equation we present on page14 using $480,000 in the Source: Peter Finch, "Investors Are Taking a Fresh Look at
numerator for the profitevery year overa very long GolfandLiking WhatTheySeeGolf
Digest, December
period of time and a risk adjusted discount rate of 2014 P62
23
Find more at www.downloadslide.comn
16 CHAPT Managers, IProfits, and Markets
The Equivalence of Value Maximization and Profit Maximization
Owners of a firm want the managers to make business decisions that will maximize
the value of the firm, which, as we discussed in the previous subsection, is the sum
of the discounted expected profits in current and future a
periods. As general rule,
then, a manager maximizes the value of the firm by making decisions that maxi
mize expected profit in each period. That is, single-period profit maximization and
means to the same end:
maximizing the value of the firm are usually equivalent
Maximizing profit in each period will result in the maximum value of the firm, and
maximizing the value of the firm requires maximizing profit in each period.
Principle If cost and revenue conditions in any period are independent of decisions made in other time
periods, a manager will maximize the value of a firm (the presentvalue ofthe fim) by making decisions that
maximize profit in.every singletimeperiod.
the value
The equivalence of single-period profit maximization and maximizing
of the firm holds only when the revenue and cost conditions in one time period are
independent of revenue and costs in future time periods. When today's decisions
attect profits in future time periods, price or output decisions that maximize profit
in each (single) time period will not maximize the value of the firm. Two examples
of these kinds of situations occur when (1) a firm's employees become
more
case
productive in future periods by producing more output in earlier periods-a
current production has the effect of increasing
cost
of learning by doing-and (2)
in the future-as in extractive industries such as mining and oil production.
Thus,
if increasing current output has a positive effect on future
revenue and profit, a
that is than the level
value-maximizing manager selects an output
level greater
that maximizes profit in a single time period. Alternatively, if current production
the value of the firm
has the effect of increasing cost in the future, maximizing
requires a output than maximizing single-period profit. maximiza-
lower current
between the two types of
Despite these examples of inconsistencies between the conclusions
generally the case that there is little difference of this
tion, it is
of single-period profit maximization (the topic
of most text) and present
hnical
Now try
Problen value maximization. Thus, single-period profit
maximization is generally the rule
maximize the value of a firm.
for managers to follow when trying to
Some Common Mistakes Managers Make

in managerial economics is certainly notrequirement for mak-
a
Taking a course
can name some extraordinarily astute
ing successful bus ness decisions. Everyone
business managers who succeeded in creating

and running very profitable firms
or economics. Taking this
course
business
with little or no formal education in MBA degrees
either. Plenty of managers with
will not guarantee your success and
in economics but nonetheless failed sensationally
took courses managerial
in hostile takeovers by more profitably
man-
ended uP getting fired or replaced economics
however, that a course in managerial
aged firms. We firmly believe, mistakes that have led other managers
avoid some of the more c o m m o n
helps you
24
to fail. Asyou progress through this book, we will draw your attention at various
the
points along way a number of common pitfalls, misconceptions, and even
to
mistakes that real-world managers would do well to avoid.
Although it is too soon for us to demonstrate or prove that certain practices can
reduce profit and possibly create losses in some cases-this is only Chapter 1
we can nonetheless give you a preview of several of the more common mistakes
that you will learn to avoid in later chapters. Some of the terms in this brief pre-
view might be unclear to you now, but you be that will
can sure we carefully
explain things later in the text.
Never increase output simply to reduce average costs Sometimes

managers
get confused about the role of average or unit cost in decision making. For example,
a firm incurs total costs of $100 to produce 20 units. The average or unit cost is $5
for each of the 20 units. Managers may believe, incorrectly, if they can increase
output and cause average cost to fall, then profit must rise by expanding produc-
tion. Profit might rise, fall, or stay the same,
nothing to do with falling average costs.
and the actual change in profit has
As you will learn in Chapter 8, producing and selling more units in the short
run can indeed cause unit or average costs to fall as fixed costs of production are
spread over a greater number of units. As you will learn in Chapter 9, increas-
ing output in the lorng run causes average cost to fall when economies of scale
are present. However, profit-maximizing firms should never increase prodüction
levels simply because average costs can be reduced. As we will show you, it is
the marginal cost of productionthe increment to total cost of producing an extra
unit-that matters in decision making. Consequently, a manager who increases or
decreases production to reduce unit costs will usually miss the profit-maximizing
output level. Quite simply, output or sales expansion decisions should never be
made on the basis of what hapPpens to average costs.
Pursuit of market share usually reduces profit Many managers misunderstand

the role market share in
plays determining profitability. Simply gaining market
share does not create higher profits. In many situations, if managers add mar-
ket share by cutting price, the firm's profit actually falls. Ilustration 1.4 examines
some empirical studies of
managers who pursued market share while ignoring
proft. Youwill leam in Chapters 11 and 12 that the best general advice is to ignore
market share in business decision making.
We should mention here an important, although rather rare, exception to this
rule that will be examined more carefully in Chapter 12: the value of market share
when "network effects" are present. Network effects arise when the value each
consumer places on your product depends on the number of other consumers whoo
also buy your product. Suppose consumers highly value your good because a
large number of other consumers also buy your good. UInder these circumstances,
grabbing market share faster than your rivals could give you a dominant position
in the market, as consumers switch to your product away from sellers with smal1
market shares. Failing to capture substantial market share might even threaten
25
ILLUSTRATION 1.4
Managerial Strategy Five Years
Maximize Profit or Maximize Market Share? Net Present Value of Expected Profit over
Although sports and war metaphors are common inbusi Low-price strategy High-price strategy
ness conversation and management seminars, managers
Base treatment
may be reducing the value of their fims by placing too $ 80 million
Yourfim $40million
much emphasis on beating their competitors out of mar- Beat treatment
ket share rather than focusing on making the most profit 80 million
for their shareholders. In a provocative study of manage- Yourffirm 40million
Rival firm 20 million 160 million
rial strategy. Professors J.Scott Armstrong atthe University
of Pennsylvania's Wharton School and Fred Collopy
at Case Western Reserve University advise CEOs to They discovered that exposing manag
focus on profits instead of market share Armstrong pertormance. share
to techniques that focus on gaining market
andColoPy discovered that, instead of maximizingprofit ers proportion of subjects who abandoned
increased the
nany managers make decisions with an eye toward per profit maximization. When executives take
strategic
forming well relative to their competitors adecision management courses, they become more likely to
making pointof view they refer toas competitor-oriented results are
experie make profit-reducing decisions These
n their nine-year study ofmore than1000 that impressive because they have been repeated in more
Cnced managers, Armstrong and Collopy found
managers are more likely to abandor. the goal of profit
than 40experiments with morethan 1,000 subjects share
To see if firnms that seek to maximize market
maximization when they have greater amounts of
in- profitable
competitor-oriented firms tend to be less
tormationaboutthe performance of their rivals.In the o0er the long run than firms that pursue profit with-
two
study, managers were asked to choose betweenhigh-Out concern for market share,Armstrong and Gollopy
Pricing Plans for a new product alow price and a
groups of firns overa
present value tracked the performance.of two
price strategy andwere told the five-yearstrategy. The 54-year period The group of firms that made pricing
of expected profits associated with each competitor-oriented goals,suchas
"treatments deCisions based on
tablein thenextcolumn presentstwo ofthe increasing market share, were consistently less profit
that were administered to different groups of subjects. period than the group that made
able over the 54-year
hebase treatment gives the manager no infor- two pricing decisions to increase profit without regard to
mation abouthow a rival firm will fare under the pursuing nmarket
the beat treatment allows the manager marketshare, Furthermore, companies
plans, while
sharewere foundto be less ikely to survive Fourof
how a decision will affect a rival. In the base share
toknow chose the the Sx Companies thatfocused strictly on
market
almostal managers, as expected, Steel) did not
treatment
strategy (high price) When given in-Gult American Can, Swift,and National (DuPont,
most profitable survive All four profit-oriented companies
formation about the rival firm's profit subjects could and General Electric ion Carbide, and Alcoa) did.
their decision on their rival,
see the impact of ATmstrong and ColloPY conclude that the use.of
maximization. In
many managers abandoned profit maximize competitor-oriented objectives is
detrimental to profit
thebeat treatment, 60 percent chose not to their focus on
that the ability 1oencourage managers keep
profit (low price). To address the possibility Arm- Proitand notonmarket share,they offerthe following
to
Subjects were considering longer-term profits,
strong and Collopy changed the payoffs to
20-yea specific advice
Present values The results were the same Do not usemarketshareas an objective
and Collopy believe the abandonment
Armstrong
of
Avoid using sportsandmilitaryanalogies
ofprofit as the firm's objective is a consequence
competitor s
becausetheyfostera competitor orientation
managers having information about a
26
CHAPTER1 Managers, Profits, and Markets 19
Do not use management science technigques that apency may fail to be the most profitable airline or
are oriented to maxinmizing market share, such as auto rental agency. As mentioned in our discussion
porttolio planning matrices and experience curve of common management errors, the presence of net-
analysis work effects can make the pursuit of market share a

Design information systems to focus attention on Profitable strategy, as we will explain more fully in
the firm's Chapter 12. In his recent book on market share
performance, as measured by profits.
Beware that improvement in the ability Richard Miniter offers this warning on the exceptional
sure market
to mea- case of network effects
sharcspecifically tlurough scatn
ner data collected at checkouts-may lead to a
Every rule has an exception (network effects)-and
stronger focus on market share and less focus on are it. Their busi-
everyonewants to believe that they
profitability. ness is special and unique and therefore profits are
na book about the business not primaryfor them, but market share is. Too many
strategies Southwest
of managers believe that the myth of market share is not
Airlines, the authors examine the decisions made by the
myth -for them. In a handful of cases, they're right
airline's CEO, Herb Kelleher. In a section titled "Say
Nuts to Market Share,"Kelleher explains the rolethat Market shareiswhat matters. (In) the majority of
cases Profitalone should sit on the throne.
market share plays at Southwest Airlines. Kelleher says: We will show you in Chapter 12 how to identify
Market share has nothing to do with profitability thosespecial few industries when market share mat
Market share says we just want to be big, we don't care if ters. As this llustration stresses, most managers should
we make money doing it That is really incongruousil
profitability is your purpose.
ignore market share. Between advances n shareholders
willingness and ability to fire CEOs and the active mar
The book goes on to say that Kelleherbelievescon ket
fusing the two concepts(increasing profit and increas
for corporatecontrol (mergers, acgquisitions.and
takeovers),a manager who fails to puursue primarily the
ing market share) has derailed many ims that were maxnization ofprofitmay have ashort career
otherwise on track in fulfilling theirfundamental pur
pose (maximizing profit and firm value) Perhaps it Sources: J ScottEffects
tor Orientation Armstrong and Fredand
of Objectives Collopy, "Competi-
Information on
was only a coincidence, but we should mention that Managerial Decisionsand Profitability Journal of Market
the value of Southwest Airlines tripled during the ng Research, May 1996.pp.188-9; The Profitability of
early to mid-1990s Winning Chief Executive June 1,1994, P.60; Kevin Freiberg
As we andJackie Freiberg, Nuts!SouthwestAirlines'Crazy Recipefor
emphasize in this chapter, shareholderswISnBiusiness and Personal Success The Myth
to see the value of their firms maximized A manager 1995), p. 49, Richard Miniter,(New York:ofBroadway Books,
Market Share (New
bent on being the biggest airline or big8estauto rental York: Crown Business, 2002), p. 139.
your long-run survival in the market. As we will expiain fully in Chapter 12, your
best move when network effects exist may be to charge a low initial price so that
you can dominate the inarket and charge higher prices in later periods. Again,
we must stress that pursuing market share is consistent with profit-maximization
only when network effects are present.
Focusing on profit margin won't maximize total profit Profit margin is the
difference between the price you charge for each unit and the average cost of
producing the units. Suppose you charge $15 per unit, and average or unit cost
is
$9per unit. profit
Your margin,
or average profit per unit, is $9) per
unit. As we will demonstrate later in Chapters 11 and 12, managers should not
$6 ($15
27
20 CHAPTER Managers, Profits, and Markets
make decisions with the primary objective of increasing profit margin because
or
d
the output and price level where profit margin
is not maximized at
unit
profit
to ignore profit margin wnen
profit is 8reatest. In later chapters youAswill learn
will profit margin is handy for
making pricing and output decisions. you see,
no
makes, but profit margin plays roie
compuing the amount of profit a business subtle distinction in the proper use
or
in making profit-maximizing decisions. This
community.
profit margin is not well understood in the business
an
profit You might think managers have
if
Maximizing total revenue reduces
total revenue, they
in a way that increases
oPportunity to change price or quantity revenue does not necessarily
Will always wish to do so. As it turns out, increasing
that the demand curve
increase profit and may even lower profit.
You will see
maximum price a firm can charge to sell various
tacing a firm tells a manager the total revenue is computed
chosen point on demand,
quantities of its product. At any different points on a
multiplying price times the quantity demanded. Choosing
by revenue the firm generates,
as well as
firm's demand curve will alter the amount of show
costs and the amount of profit left over for the
owners. We will you
production
in Chapters 11 and 12 that the point on a firm's demand curve that maximizes profit
will not be the price and quantity that maximizes total revenues General managers
units
are tied to the number of
have learned that, when the salaries of sales managers
to persuade
dollar amount of revenue generated, sales managers may try
sold or the sell too much product. The result: Revenue goes
and
general managers to produce
up,but goes down!
profit
pricing
Cost-plusare formulas don't produce profit-maximizing prices Pricing
decisions probably. the most difficult and risky of all the business decisions
for the same product must
make. To make matters worse, prices
managers must month after
as market conditions change
routinely be set over and over again some firms thou-
month and year after year. Of course,
produce hundreds, even
blame managers for trying to find simple pric-
a
sands, of products. So, it's hard to data. One
formula requiring nothing more than readily available spreadsheet
ing pricing formula, cost-plus pricing, is still widely used even though everyone
such
than unit
trained in economics and marketing knows that setting prices higher never works.
determined portion of unit cost almost
cost by some fixed, arbitrarily
does not deliver profit-maximizing
The unfortunate truth is that cost-plus pricing to set the most
12, we will show you how
prices, except by sheer luck.° In Chapter
for the same good-a method
the same price
profitable prices when everyone pays
in practice. When a price-
this rule exists, but it arises very rarely
In theory, o n e exception to maximize profit by maximizing total
revenue.
costs that are zero, it will
setting firm faces marginal 12.
We will explain this exception in Chapter
constant costs can a formula
for choosing a profit-maximizing
Only when businesses face formula is so complicated to apPply that
it offers
contrived. But, this pricing
markup on unit cost be cost" approach to optimal pric-
no practical advantage over
the "marginal revenue equals marginal
consider this contrived formula to be worthless and do not
learn in Chapter 12. We
ing that you will
cover it anywhere in this
text.
28
Fintf more at
21
CHAPTER 1 Managers, Profits,and Markets
will show you several advanced

known as pricing. In Chapter 14, we
uniform
different buyers different prices and generate
pricing techniques, which charge
even more revenue than with uniform prices.
to avoid. Don't
These are few of the many mistakes we will teach you how
just a
understand these mistakes-we
be concerned at this point if you're not sure you
guarantee you will by the end of the text!
1.3 SEPARATION OF OWNERSHIP AND CONTROL OFTHE FIRM

choose to delegate control of their businesses to a pro-
Business owners frequentlh
fessional executive or senior manager who will typically be
assisted by additional
team that relieves
subordinate managers, which creates an executive management
the owners of management duties. Only in the smallest business organizations
and family
typically sole proprietorships, smaller general partnerships, businesses. The
businesses-are likely to see owners managing their own
you
between business
decision to hire professional managers creates a separation
ownership and its management. This separation forms a special relationship be-
tween business owners and managers known as a principal-agent relationship.
priucipal-agent In this particular type of principle-agent relationship, a business owner (the
relationship
Relationship formed principal) enters an agreement with an executive manager (the agent)
whose job is
when a business owner
to formulate and implement strategic business decisions that will fur-
tactical and
(the principal) enters ther the objectives of the business owner (the principal). The agency "agreement"
arn agreement with an some degree of
executive manager (the can, and
usually does, take the form of a legal contract to confer
as an informnal agrec-
agent) whose job is to legal enforceability, but it can also be something as simple
formulate and implement ment settled by a handshake between the owner andmanager
Separating ownership and control of a firm holds the potential significantly
tactical and strategic to
business decisions that increase a firm's value, especially when it replaces "amateur" owner-managers
will further the objectives decision makers. In
of the business owner with more experienced and talented professional business
from hiring e x
practice, however, some or all of the potential gain to the
owners
(the principal).
pert managers can be lost when owners cannot managers from behaving
prevent
to the own-
opportunistically by taking self-interested actions that are harmful
ers. We will now discuss this fundamental problem arising from the separation of
examine some ways to solve or at least control
ownership and management and
the severity of these problems.
The Principal-Agent Problem

A fundamental problem that frequently, but not always, afflicts the principal-
agent relationship between business and managers occurs
owners a
when
manager takes an action or makes a decision that advances the interests of the
We are employing here a rather specific definition of the principal-agent relationship to focus
on the agency relationship between a firm's owners and the firm's executive managers. Business
organizations typically form a variely principa-agent relationship in addition to the one between
owners and executive managers that we are discussing in this textbook. Several other examples of
principal-agent relationships include CBOs and other executive officers (CFO, CIO, and COO), the
boards of directors and CEOs, and CEOs and middle managers.
29
manager but is harmful to the owners because the manager's action reduces the
value of the firm. This celebrated problem, which has generated considerable in
terest and concern among business consultants, economists, and management
principal-agent scholars, is known as the principal-agent problem. A principal-agent problem
problem
requires the presence of two conditions: (1) the manager's objectives must be dir
A manager takes an must find it to0 costly or even
ferent from those of the owner, and (2) the owner
action or makes a decisions or behavior
decision that advances impossible to monitor the manager's decisions to block any
the interests of the that would reduce the firm's value.
manager but reduces the
owners and managers In the
natural state of
value of the firm. Conflicting objectives between
aftairs between owners and managers, the goals of owners are almost certainly
different from the goals of managers, and thus we say that owner and manager
goals are not aligned that managers and owners possess conjlicting objectives.
or
A self-interested owner naturally wants her business run in a way

that maximizes
the value of her business. A self-interested executive manager-if the penalty is

to make
zero or small-will naturally wish to take advantage of opportunities
when these deci-
decisions or take actions that will promote his well-being even
sions also harm the owner of the business.
lavish
For example, managers may choose to consume excessive, even
indeed who would not
perquisites (or perks). It would be an unusual manager
like to have the company (i.e., the owners) pay for a lavish office, memberships
insurance, a
in exclusive country clubs, extraordinary levels of life and health
and, if at all possible,
nanny to look after their children, a chauffeured limousine,
a corporate jet. Although the decision to consume lavish perks
is good for the
and value of the firm and thus
manager, these perks reduce the profitability
harm the owners.
Another important example of conflicting goals involves managers who get
such as the
sidetracked by goals that are inconsistent with value-maximization, show that
or the pursuit of higher market share. Studies
pursuit of larger firm size reasons for this behavior. First, executive managers are
there may be a coup
notorious for their enormous egos and intense desire to engage in empire build-
the process. Second,
ing, which they find satisfying even if profit is sacrificed in at their
some executives believe that their future salary and compensation, either
present job or at their next job, will be richer if the

firm they now manage experi-
ences rapid growth in assets, number of employees, or
level of sales and revenues
relative to their rival firms. As you will learn later in this book, pricing and produc-
tion decisions focused on creating the biggest, fastest-growing, or relatively largest
or the value of the firm. You
Companies do not, as a general rule, maximize profit
recall that American Airlines was the largest airline in the United States for
may
Southwest Airlines was the most profitable airline during
many years, but smaller
the same time period. Similarly, the largest car rental agency is usually not the most
profitable rental car company, and Samsung's Galaxy S is the market share leader
in smartphones but Apple's iPhone 6 has created far more profit for Apple share-
holders. Ilustration 1.4 examines some of the causes and consequences of managers
focusing on maximizing market share instead of economic profit.
30
Problems with monitoring managers Business owners, recognizing that their

interests may diverge from the interests of their managers, can try to bind man-
agers through some form of incentive agreement-typically a legal contract
for employment-that is carefully designed using incentives and penalties to
force executives to make only decisions that will increase the value of the firm.
complete contract Let's suppose that a complete contract-one that protects owners from every
An employment contract
that protects owners
possible deviation by managers from value-maximizing decisions-could in
from every possible fact be designed by the owners' lawyers. Once this complete contract is signed
deviation by managers by the owners and excecutive manager, the owners then face the costly task
from value-maximizing of monitoring and enforcing the contract to make sure managers do not shirk
decisions. renege, or otherwise underperform when carrying out their contractual resporn
sibilities to maximize the value of the firm.
If monitoring the manager could be accomplished perfectly and at a low cost,
then no principle-agent problem would arise because the (hypothetical) complete
contract forms an exact alignment of the owners' and manager's objectives, and
low-cost monitoring ensures that the contractual alignment of goals is enforced.
As you probably guessed, this ideal plan for the
principal-agent prob-
eliminating
lem fails in practice-even if complete contracts could be written-because moni
toringmanagers is usualiy a costly activity for owners, and thus owners of the
firm will not find it in their best interest to perfectly monitor the executive man-
ager. When monitoring costs are significant, as they usually are, managers.wil
be able to undertake some opportunistic actions that further their interests at the
expense of the owners.
In more extreme situations, monitoring becomes practically impossible be-
hidden actions cause the manager is able to take hidden actions or make hidden decisions that
Actions or decisions cannot be observed by owners for any economically and legally feasible amount
taken by managers that of monitoring effort. Hidden actions can be either good or bad actions from. the
cannot be observed by
decrease the
ownersfor any feasible owners point of view; that is, a hidden action can either increase or
value of the firm. Because owners do not know whether a hidden action has been
amount of monitoring
effort. taken-either bad one-it is impossible for monitoring efforts
a
good one or a
hidden actions. In
by owners to block or prevent managers from taking "bad"
this situation, owners' efforts to monitor managers cannot protect owners from
a principa-agent problem caused by hidden actions. This particular form of the
moral hazard principal-agent problem is called moral hazard. As you can see, moral hazard
A situation in which
managers take hidden
is both a problem of nonaligned objectives and problem of harmful hidden
a
actions. If either one of these two aspects is missing then there is no moral hazard
actions that harm the
owners of the firm but
problem. After all, in the absence of conflicting objectives, managers would make
further the interests of value-maximizing decisions and any hidden actions that might be undertaken
the managers. would be "good" hidden actions that increase profit rather than "bad" hidden
actions that reduce profit.
Principle Aprincipal-agentproblem arises berweenafrms owerand manager when twocondiions

aremet(1)theobjectivesofthe ownerand managerarenotaligned. and 12theowner finds iteithertoo
COStlyorimpossibleinthecaseofmoralhazard toperectly monitorthemanagerto blockallmanagement
decisions that might be harmtul to the owner of.the business.
Corporate Control Mechanisms

meant to imply that the
The discussion of the principle-agent problem is not face or
or shareholders df corporations are completely
helpless in the
owners
to do. Rules of corporate
aren't doing what owners expect them
managers who them to control managers
shareholders rights that allow
8overnance give
control measures and indirectly through
directly through specific corporate whose responsibility
it is to monitor
the corporation's board of directors, with the board of
Shareholders themselves, and
in partnership
management.
of 1nechanisms for controlling agency prob
directors, may choose from a variety forces outside the firm
methods,
lems. In addition to these internal governance value. We will
maximization of the firm's
can also motivate managers
to pursue
for intensi-
most important types
of these mechanisms
now review a few of the
to maximize profit.
tying a manager's desire reduce the intensity of conflicting
Stockholders to resolve or at least
often try compensation
between owners and managers by tying managers' have a greater
bjectives Managers
to fuliling the of the owner/shareholders.
goals when managers
incentive to make decisions
that further the owners goals
of the most
has proven to be one
themselves are owners. Equity ownership so much so
that
effective mechanisms for taming the principal-agent problem, institutional

and large
number of professional money managers stake
a growing hold little
or no equity
managers
investors refuse to invest in firms whose
in the firms they manage. shareholders charged
directors are agents of the
Ihe members of the board of as managers
are
the decisions of executive managers. Just can

with monitoring too are directors, and thus
principal-agent problems
agents for owners, so shareholders. Many experts
in corporate gover-
arise between directors and services is enhanced by
nance believe that the
value of the board's monitoring team-
on the firm's management
o u t s i d e r s - d i r e c t o r s not serving
appointing firm. Although
to the value of the
and by linking directors' compensation member compensation to
board
outsiders on the board and linking
having to mitigate principal-agent
problems, other
firm value are both effective ways the effectiveness of a board
remain troublesome. Specifically,
problems can
business decision is so complex
undermined when a particular
of directors is decision furthers shareholder
whether the
the board cannot reliably judge
that
another problem arises
when CEOs play an important
interests or not. And yet will
of the individual board members. Just how objective
role in the selection to be
to the person they are supposed
board members be who owe their jobs
monitoring? make value-

incentives for managers to
Another method of creating A policy
on debt financing.
decisions involves corporate policy rather than
maximizing investments with debt
that emphasizes financing corporate further
raise financial capital-can
of c o m m o n stock to
equity-selling shares First, debt financing makes
shareholders in several ways.
the interests of if have no debt.
they
in that firms cannot go bankrupt
bankruptcy possible,
32
Find more al
CHAPTER 1
Managers, Profits, and Markets 25
value their employment have additional incentive to

an
Thus, managers who
increase profitability to lower the probability bankruptcy. Second, manag-
of
ers face less pressure to generate revenues
to cover the cost of investments if
the payments are dividends to shareholders, which they can choose to defer or
are installments on
neglect altogether, rather than if the investment payments incentive to monitor
a loan. Finally, lending institutions themselves have an
from them. Banks and other lenders are

managers of firms that borrow money
make
likely to make it difficult for managers to consume
excessive perks or
unprofitable investments.
should add to
Lookingbeyond the internal control mechanisms discussed, we ini-
our discussion of corporate control mechanisms an important external force
tiated by parties outside the firm itself-a corporate takeover-that can impose
and
an effective solution to the principal-agent problem between shareholders
its is less than
managers. When the value of a firm under present management
arises
what it would be with a different management team, a profit opportunity
for outside investors to acquire stock and take control the underperforming
firm and then replace the existing management team with a new and presumably
more profitable set of managers. If the new owners are indeed able
to increase
and raiders will be rewarded by
profit, the firm will become more valuable the
higher stock prices.
Even though Hollywood movies have portrayed corporate takeovers as greedy
maneuvers aimed only at making corporate raiders rich, most economists believe
that takeovers check on the power of opportunistic managers who
can serve as a
a market for corporate control
exploit principal-agent problems. Takeovers create
of publicly traded businesses that can help resolve the conflict between managers
and shareholders caused by separation of ownership and management: managers
know they must maximize the value of their firms or else face a takeover and 1ose
their jobs to new management.
1.4 MARKET STRUCTURE AND MANAGERIAL DECISION MAKING
As we have mentioned, managers expect to succeed without understand-

cannot
ing how market forces shape the firm's ability to earn profit. A particularly impor
tant aspect of managerial decision making is the pricing decision. The structure of
the market in which the firm operates can limit the ability of a manager to raise
the price of the firm's product without losing a substantial amount, possibly even
all, of its sales.
Not all managers have the power to set the price of the firm's product. In some
industries, each firm in the industry makes up a relatively small portion of to
tal sales and produces a product that is identical to the output produced by all
the rest of the firms in the industry. The price of the good in such a situation
is not determined by any one firm or manager but, rather, by the impersonal
forces of the marketplace-the intersection of market demand and supply, as you
will see in the next chapter. If a manager attempts to raise the price above the
33
26 CHAPTER 1 Managers, Profits,and Markets

in the indus:
the other firms
market-determined price, the firm loses all its sales to
this identical product, and
After all, buyers do not care from whom they buy
try. be unwilling to pay mnore than th: going
market price for
the product.
they would price-taker and cannot set the price of the prod uct
price-taker In such a situation, the firm is a and you Will
detail in Chapter 11,
A firm that cannot set it sells. We will discuss price-taking firms in
is horizontal at the price
price-taking firm
the price of the product see that the demand curve facing a
it sells, since price is
determined by market forces price-setting
determined strictly by firms, the manager of a
the market forces of In contrast to managers of price-taking
A price-setting firm
has the ability to raise
demand and supply. firm does set price of the product.
the
is somehow differentiated
its price losing all sales because the product
without
area in which
price-setting firm from rivals' products or perhaps because
the geographic market
sellers of the product. At higher
the product is sold has only one, or just a few,
A firm that can raise its
firm sells more
price without losing all of and at lower prices the
prices the firm sells less of its product, called market
its sales.
without losing all sales is
of its product. The ability to raise price
13 and 14.
examine more thoroughly in Chapters
market power power, a subject we will in later
structures to be analyzed
A firm's ability to raise Before we discuss some of the differing market and
nature
consider the fundamental
price without losing all
sales.
chapters of this text, we first want you to
purpose of a market.
What Is a Market?
final
and sellers exchange
market A market is any arrangement through which buyers
in general, anything or
Any arrangement goods services, resources used for production, or,
or
such as a commercial bank
through which buyers value. The arrangement may be a location and time,
market
and sellers exchange an agricultural produce
from 9 a.m. until 6 p.m. on.weekdays only,
anything of value. at a commodity exchange
every first Tuesday of the month, trading "pit" stadium an hour before
a
the parking lot of a
during trading hours, or even
sometimes show up to sell tickets to sporting
game time when ticket scalpers location
events. An may.also be something other than a physical
arrangement
a website on the Internet.
and time, such as a classified ad in a newspaper or
because
You should view the concept of a market quite broadly, particularly
and sellers
advances in technology create new ways of bringing buyers
together.
Markets are arrangements that reduce the cost of making transactions.
valuable time and other
Buyers wishing to purchase something must spend
resources finding sellers, gathering information about prices and qualities, and
must
ultimately making purchase itself. Sellers wishing to sell something
the
fee to sales agents to do so),
spend valuable resources locating buyers (or pay a
creditworthiness
gathering information about potential buyers (e.g, verifying
or legal entitlement to buy), and finally closing the deal. These costs of mak-
a transaction happen, which are additional costs of doing
business over
transaction costs
ing
and above the price paid, are known as transaction costs. Buyers and sellers
Costs of making a use markets to facilitate exchange because markets lower the transaction costs
transaction happen, for both parties. To understand the meaning of this seemingly abstract point,
other than the price of
the good or service itself. consider two alternative ways of selling a used car that you own. One way to
34
)
on doors
find a buyer for your car is to canvass your neighborhood, knocking
This will
until you find a person willing to pay a price you are willing to accept.
likel require a lot of your time and perhaps even involve buying a new pair
of she es. Alternatively, you could run an advertisement in the local newspaper
are willing to accept for it. This
describing your car and stating the price you
method of selling the car involves a market-the newspaper ad. Even though
to use this market because the
you must pay a fee to run the ad, you choose
transaction costs will be lower by advertising in the newspaper than by search
ing door to door.
Different Market Structures

market structure Market structure is a set of market characteristics that determines the economic
Market characteristics environment in which a firm operates. As we now explain, the structure of a
that determine the
economic environment market governs the degree of pricing power possessed by a manager, both in
he short run and in the long run. The list of economic characteristics needed to
in which a firm
operates.
describe a market is actually rather short:
The number and size of the firms operating in the market: A manager's ability to
raise the price of the firm's product without losing most, if not all, of its buy-
ers depends in part on the number and size of sellers in a market. If there are
a large number of sellers with each producing justa small fraction of the total
salesin a market, no single firm can influence market price by changing its pro-
duction level. Alternatively, when the total output of a market is produced by
one or a few firms with relatively large market
shares, single firm can cause
a
the price to rise by restricting its output and to fall by increasing its output, as
long as no other firm in the market decides to prevent the price from changing
by suitably adjusting its own output level.
The degree of product differentiation among competing producers: If sellers all pro-
duce products that consumers perceive to be identical, then buyers will never
even a penny more for a particular firm's the
need to pay product than price
charged by the rest of the firms. By differentiating a product either through real
differences in product design or through advertised image, a firm may be able
to raise its price above its rivals' prices if consumers find the product
differ
ences sufficiently desirable to pay the higher price.
The likelihood ofnewfirms entering a market when incumbent firms are earning economic
profits: When firms in amarket earn economic profits, other firms will learn of this
return in excess of opportunity costs and will try to enter the market. Once enough
firms entera market, price will be bid down sufficiently to eliminate any economic
profit. Even firms with some degree of market power cannot keep prices higher
than opportunity costs for long periods when entry is relatively easy.
Microeconomists have analyzed firms operating in a number of different mar-
ket structures. Not surprisingly, economists have names for these market struc-
tures: perfect competition, monopoly, monopolistic eompetition, and oligopoly.
Although each of these market structures is examined in detail later in this text,
25
we briefly discuss each one now to show you how market structure shapes a
manager's pricing decisions

In perfect competition, a large number of relatively small firms,sell an undifferen
tiated product in a market with no barriers to the entry of new 1.rms. Managers or
firms operating in perfectly competitive markets are price-takers with no market
power. At the price determined entirely by the market forces of demand and sup
ply, they decide how much to produce in order to maximize profit. In the absence
of entry barriers, any economic profit earned at the market-determined price will
vanish as new firms enter and drive the price down to the average cost of produc
tion. Many of the markets for agricultural goods and other commodities traded on
national and international exchanges closely match the characteristics of perfect
competition. kind of barrier to entry,

In a monopoly market, a single firm, protected by some available. A
monopoly
produces a product for which no close substitutes are
1s a price-setting firm. The degree of market power enjoyed by the monopoly
substitutes for the
is determined by the ability of consumers to find imperfectthe
monopolist, thee
monopolist's product. The higher the price charged by a barier
other products. The existence of
more
willing are c o n s u m e r s to buy that economiC
without concern
to entry allows a monopolist to raise its price of true
profit will attract new firms.
As you will see in Chapter 12, examples
monopolies are rare. firms
In markets characterized by monopolistic competition,
a large number of
differentiaied
of the market produce
that are small relative to the total size difference between
of barriers to entry. The only
products without the protection is the product differentiation
competition and monopolistic competition
perfect s o m e degree of
market power; they
are
that gives monopolistic comnpetitors markets, the

rather than price-takers. As
in perfectly competitive
price-setters will eventually be bid
barriers that any economic profit
ensures
absence of entry market provides one example
of monopo-
entrants. The toothpaste but not
awayby new brands and kinds of toothpaste
are close,
The many
listic competition.
manufacturers differentiate
their toothpastes by
perfect, substitutes. Toothpaste whiteners, fluoride levels,
and other ingre-
different flavorings, abrasives, to create brand
using amount of advertising designed
with a substantial
dients, along
not need
loyalty. market structures discussed
here, managers do
In each of the three A monopolist has
no
to a price change.
the reaction of rival firms total market
to consider relative to the
rivals; competitor is small enough
monopolistic with price
a
cause rival firms to retaliate
that its price changes
will not usually firm is a price-
and, of course, a perfectly competitive
changes of their own;
from the
market-determined price. In
not change its price most or
taker and would a few firms produce
c a s e of a n oligopoly
market, just
contrast, in the will have a signifi-
firm's pricing policy
market output, so any o n e of
all of the This interdependence
sales of other firms in the market. have an
will
cant effect on the firm in the market
actions by any one
firms m e a n s that As you will see in Chapter 13,
oligopoly of the other firms.
effect on the sales and profits
36
CHAPTER 1
Managers, Profits, and Markets 29
the strategic decision making in oligopoly markets is the most complex of all
decision-making situations.
Globalization of Markes
globalization of For the past quarter century, businesses around the world have experienced a
markuts surge in the globalization of markets, a phrase that generally refers to increasing
Economic integration
of markets located in economic integration of markets located in nations throughout the world. Market
when goods, services, and resources (particularly people and
nations around the
World.
integration takes place
money) flow freely across national borders. Despite excitement in the business press
Over the present wave of globalization, the process of integrating markets is not a
but rather it is an ongoing process that may advance for some
new phenonmenon,
period of time and then suffer setbacks. The last significant wave of globalization
lasted from the late 1800s to the start of World War I. During that period, expan-
sion of railroads and the emergence of steamships enabled both a great migration
of labor resources from Europe to the United States as well as a surge in the flow
of goods and international markets. Even
between regional though some govern-
ments and some citizens oppose international economic integration, as evidenced
by a number of antiglobalization protests, most economists believe the freer flow of
resources and products can raise standards of living in rich and poor nations aiike.
The movement toward global markets over the last 25 years can be traced
to several developments. During this period North American, European, and
Latin American nations successfully negotiated numerous bilateral and multi-
lateral trade agreements, eliminating many restrictions to trade flows among
those nations. And, during this time, 11 European nations agreed to adopt a
single currency-the euro-to stimulate trade on the continent by eliminat
ing the use of assorted currencies that tends to impede cross-border flows of
resources, goods, and services. Adding to the momentum for globalization,
the Information Age rapidly revolutionized electronic communication,
mak
ing it possible to buy and sell goods and services over a worldwide Internet.
As noted in llustration 1.5, Microsoft Office software has become something
of an international language for businesses, as companies around the world
communicate using Excel spreadsheets and documents created in Word and
PowerPoint. All of these developments contributed to reducing the transaction
of bringing buyers and sellers in different nations together for the pur-
costs
pose of doing business.
As
you can see from this discussion, globalization of markets provides manag-
with an opportunity to sell more goods and services to foreign buyers and to
ers
find new
sources of labor, capital, and raw material inputs in
and cheaper other
countries, but along with these benefits comes the threat of intensified competi-
tion by foreign businesses. This trend toward economic integration of markets
changes the way managers must view the structure of the markets in which they
sell their products or services, as well as the ways they choose to organize
produc-
tion. Throughout the text, we will point out some of the opportunities and chal-
lenges of globalization of markets.
37
Find more at
Markels
CHAPTER 1 Managers, Profits,and
30
ILLUSTRATION 1.5
workers in
services to
in outsourcing Jamaica,
lead the way the Philippines,
of ServicesS countries,such as India, Republic.
Internet Spurs Globalization other the Czech
Ghana, Hungary, and in his article, the
Internet
Washington,
protestors in Seattle, As Lavin emphasizes
vast improvements in tele
Antiglobalization
criticized multina-
coupled with sector
have the xplosion the service
Quebec, and Genoa technologyenabled
D.C corporations-as well as their governments, communications Because many
globalization.
tional lnternational Monetary to the process' of infrastructure in
World Trade Organization,
the join the
for moving manufactur- nationscan afford when
Fund, and the World Bank While theThird World toaccess the I n t e r n e t e v e n
to countries with low wages. poorervestments
required be too
costly-Lavin
ing operations workers in bridges may

deep concern that better roads and service sector could cre
protestors express
multinational corpora- globalization of the standards in
by predicts
improvement in living
countries will be "exploited sweatshops for unfair significant multina
tions and be forced to work in ate a by providing
protestors seems to
be
among nations. Furthermore, buyinexpensive
wages, the more basic

fear with the ability to
jobsPoorer
lose their
an understandable
concern that they will tionalcorporations tendsto increaseproductivity
moves to other countries services, globalization home countries
as manufacturing Street Jotumal, explains to push wages up in the
DouglasLavinin The Wall overlooked a which tends protestors may argue
protestors have corporations. Although us that
o these Lavin reminds
s e r v i c e s T h a n k s largely poor
antiglobalization
that harms the accoun
more significant
shift in Microsoft Office,
globalization
now working as
decent education, thousands of people as
to the fact that.a Manila as in Min- the
Arthur Andersen in
the Philippines and
areall as useful in tantsfor thrilled to trade their
and the Internet (global)." Fhe are
sector has gone services engineers
for asco in India Internet, and they are no
neapolis, the service possible for skills on the
now makes education and
worldwide Internet possiblefor
steamships made poor two
what railroads and produced any 1onger recognized that when
Services can be Economists.have long parties
manufactured goods via engage in trade, both
parties vOluntarily services made possible by the
anddelivereddigitally
where in the world fiber-optic cables, or high Globalization of

terrestrial, broadband, geosynchronous orbits to
end gain. provides an opportunity for such trades
capacity satelites in imaginablenternet
costs, and hundreds of
anywhere in the world Every usinesses can reducetheir can earn
users most experiencing
globalization
thousands of workers
indow-incomenations
now
kind of serviceis claims processing, credit
from accounting services, customer seTvice questions hi8her wages
evaluation, and answering entry,software Goes Upscale"in The
1-800telephone numbers to data Source: Lavin, Globalization
Douglas
on i ntheUnited February1,2002,p. A21
gambling Businesses Wall Stret Journal,
coding,and even and France currently
States Britain, Spain, Hong Kong,
1.5 SUMMARY business decisions

for understanding
everyday
the
con- a business.
mostthe usefu make in running
applies
Managerial economics m i c r o e c o n o m i c s and indus- managers routinely
referred to as busi-
and theories from Such decisions are frequently
cepts decisions differ
to create a systematic,
logical way ness practices
or tactics. Strategic
trial organization because
tactics designed
and or tactics
of analyzing business practices from routine business practices
strate-
decisions seek to alter
the conditions un-
as well as formulating
to maximize profit, strategic
these profits in the with its rivals in ways
gies for sustaining
or protecting
foundation
der which a firm competes
provides the
long run. Marginal analysis
38
16 Chapter
BREAK-EVEN ANALYSIS
AND COST CONTROL
LEARNING OBJECTIVES
After
completing this
chapter, the student should be able to
1. Explain the concept of Break-Even Analysis.
(BEA)
2.
Draw the Break-Even Chart.
3. Understand the practical use of
BEA
4.
Comprehend the concept and techniques of cost control.
Structure
16.1 The
Meaning of Break-Even Analysis (BEA)
16.2 The Break-Even Chart
16.3 Formula Method for
Determining BEP
16.4 Assumptions of Break-Even
Analysis
16.5 Limitations of BEA
16.6 Usefulness of BEA
16.7 Practical Problem
16.8 Cost Control
16.9 Techniques of Cost Control

16.10 Areas of Cost Control
i6.1he Meaning of Break Even Analysis (BEA)

Break-Even
Chart The break-even analysis (BEA) has considerable significance for economic research, busine
decision making, company management, investment analysis and public
The chart sho- policy.
wing the point of The BEA is an important technique to trace the relationship between
zero profit level at the varying levels of output or sales.
costs, revenue and prof
AsJoel Dean (1976) puts it, the BEA presents. flexible projections of the impact of the volun
of outpüt upon eost,
ievenue and profits. As such, it
provides an important bridge between busine
behaviour and economic theory of the
fim
31
373
BREAK EVEN ANALYSIS AND COST CONTROL
In BEA, the break-even point is located at that level of output or sales at which the net income
or profit is zeto. At this point, total cost is cqual to total revenue, Hencc, the break-even point
Is the no-profit-no-1oss zonc.
However, the object of the BEA is not just to determinc the break-cven point (BEP), but
to understand the functional relationship among cost, revenue and the rate of output.
16.2 The Break-Even'Chart

In recent years, the break-even charts
YA
havc been widely used by business cconomists,
company executives, investment analysts,
government agencies and cven trade unions.
A break-cven chart (BEC) is a group of
the short un relation of total cost and of total
revenue to the rate of output and sales.
BREAK-EVEN
The BEC graphically shows cost and POINT
revenue relation to the volume of output. It
C
thus depicts profit output relationship. Hence,
the BEC is also called profit group.
W VARIABLE COST
Figure 16.1 illustrates a typical break TVC
even chart.
In Figure 16.1, the volume of output is FIXED COSST

measured along the X-axis; cost and revenue
are measured along the Y-axis.
For the sake of simplicity, assuming OUTPUT(SALES)
constant factors, a linear revenue function is
drawn. Similarly, a linear total cost function
he Break-even Chard
is assumed. It is composed of the fixed cost
which is represented by the horizontal curve (TFC) on the chart. The variable cost function is
also assumed to change linerly in a constant proportion to the change in output rate.
In the chart, the break-even point (B) is the point

at which total revenue equals total cost, so net profit is
zero at OQ level of output.
The area between the TR curve and TC curve depicts
the profit function. It follows that the firm incurs loss,
when it produces output below 0Q level. 0Q level of
BREAK-EVEN
Output is at break-even point of no profit, no loss. When POINT
it expands further output, it makes profit.
The break-even chart is an excellent înstrument pånel
for guidance of the business manager or businessman
FiXED TVC
in determining the profitable output and controlling the KLOS
COST
business.
VARIABLE COST
16.2.1 An Alternative Form of the Break-Even Chart
OUTPUT(SALES)
Sometimes, an alternative form of the break-even
chart is drawn by starting with the variable cost function The Breakeven ChartAitemative irorm)
from the horizontal axis and then adding total fixed cost
to determine the 1otal cost function or curve, as shown in Figure 16.2,
MANAGERIAL ECONOMICS
|374
We get similar information in Figure 16.2, as in the traditional Figure 16.1. However, t
alternative form of BEC is better for providing a ready reference to the contribution to fixed (overhe
cost and profits.
16.3 Formula Method for Determinig BEP means of a ormula.

There are two ways of determining the break-cven point (BEP) by
can be determined either in terms of physical units of output or in terms of sales vlne of t|
output, i.c., in money terms.
BREAK-EVEN ANALYSIS OF THE PC-BUILD, INC.

irmi
a case study prepared by Remey and T!mmons, the break-even chart of the PC-Build, Inc. (a manufacturing
n
the personal computer kit industry) is reported, as follows:
The fim intended to offer three main products, viz:

B2000 Basic it, SX3000 Super Kit, and SXA000 Deluxe kit priced al $699, $899 and $150, respeclively
800,000 TOTAL REVENUES

700,000 TOTAL COSTS
600,000
500,000-H
400,000
300,000
200,000 FIXED COSTS
100,000-
O
100 200 300 400D 500 600 700 800
UNITS PRODUCED
Fig. 16.3 BEA of the PC-Build
suggests that the firm reaches the

break-even point at 521 units of product-sales mx.
Ine BEA Chart (Fig. 16.3)
16.3.1 BEP in Terms of Physical Units
the break-even point (BEP) is located at t
Viewing in terms of per unit cost and revenue,
to the average cost (AC). Th
level of output at which the price or average revenue (AR) is equal
in full as well as a part of the fi
the selling price should cover the average variable cost (AVC)
cost.The price of the excess other (AVC) is regarded as contribution margin per unit, which contribu
towards the fixed cost. Thus, the BEP is spotted at a point where a sufficient number of ur
total contribution margin becomes equal to the total fixed co
of output are produced so th¡t its
Hence, we may give the formula as under:
BEP
TFC
P-AVC
where,
BEP the break-even point
TFC the total fixed cost
P the selling price
AVC = the average variable cost
Obviously, P-AVC measures the contribution margin per unit

375
BREAK-EVEN
ANALYSIS AND COST cONTROL
of the formula:
illustrate the application
examples determine the break-
The following total r e v e n u e functions,
following total cost and
Given the
Example 1.
Cven point:
TC 48 + 1002
TR 50Q
sold).
(Here, is the units of output have
we
cost functions,
Solution. From these linear
Total Fixed Cost (7FC)

=
48
Variable Cost (AVC)
=
10 per unit
Average
Since TR = P.Q
TR= 50Q
as the selling price
(P)
implies Rs. 50
BEP is
The formula for
measuring
BEP p- AV
480 480 = 12 units.

BEP 50-10 40 sold. Because,
when
points are produced and

reached when 12 Rs. 600.
Answer.
Break-even point is and TR =
50 x 12
+ Rs. 120
=
Rs. 600
480
produced, TC point.
=
break-even
12 units are
is zero. Hence, the
no profit, no loss. Net profit
Thus, TR
=
TC, so
of Sales Value terms of sales value,

16.3.2 BEP in Terms
BEP is to be measured in
is a multi-product
firm, the
When the firm ratio sales. Thus,
contribution margin
as a to
by expressing the
Total Fixed Cost
BEP Contribution Ratio
ratio is measured as:

contribution
Here, the
TR-TVC
=
Contribution Ratio (CR) TR
of the formula:
illustrates the application its
The following example cost of Rs. 10,000 and
incurs fixed cost
of Rs. 4,000 and variable
firm
Example 2. A Determine the
break-even point.
are Rs. 15,000.

total sales receipts
**
Solution:
TR-TVC
CR =
TR
376 MANAGERIAL ECONOMICs
15,000-1,000
15,000 3
TFC4,000 4,000x3
BEP 12,000
CR
Answer. The break-cven point is reached when the fim's sales value is R:. 1,000. At
12,000 sales valuc, there is no profit, no loss, Because, variable cost at sales value o" Rs. 12,
S
8,000
TC Rs. 8,000 Rs. 4,000 Rs. 12,000 is

+ =
equal to TR =Rs. 12,000.
16.4 Assumptions of BreakEvenAnalysis

The validity of the BEA is conditioned by a number of assumptions as foliows:
1. The cost function and the revenue function are. linear.
2. The total cost is
divided into fixed and variabie costs.
3. The selling price is constant.
4. The volume of sales and the volume of production are identical.
5. Average and marginal productivity of factors are constant,
6. The product-mix is stable in the case of a multi-product firm,
7. Factor price is constant.
In practice, all these assumptions are unlikely to be fulfilled.
16.5 1umitation of BEA

The break-even analysis has certain major limitations as follows:
I t is static. In the BEA, everything is assumed to be constant. This implies a st
condition. It is not suited to a dynamic situation.
I t is unrealistic. It is based on many assumptions which do not hold good in practi
Linearity of cost and revenue function are true only for a limited range of output
I t has many shortcomings. The BEA regards profit as a function of output only
fails to consider the impact of technological change, better management, division of labc
improved productivity and such other factors influencing profits.
Its scope is limited to the short. run only. The SEA is not an effective tool fo
long run analysis.
I t assumes horizontal demand curve with the given price of the product. But t
is not so in the case of a monopoly firm.
I t is dificult to handle selling costs in the BEA. Selling costs do not vary with outf
They manipulate sales and affect the volume of output.
The traditional BEA is very simple. It makes no provision for corporate incomet
etc.
**** -***
43
377
BREAK-EVEN ANALYSIS AND COST CONTROL
BEA purpose
serves some useful in business decision
Despite these limitations, however, the
for the alternative possibilitics and arriving at a better
making. The BEA provides a rough guideline of and intuition
substitute for judgement commonscnse
decision. Of course, the BEA is not a perfect
and logical
can be a good supplement to the value judgement
possessed by the businessman. But, it
deductions made with commonsense.
16.6 Usefulness öf BEA

decision making in regard to pricing, cost control, producl-
The BEA is particularly useful for
mix, channels of distribution, etc
The BEA provides microscopic view of the profit structure of the firm.
control in business.
Empirical cost functions requircd
in BEA can beofgreat hclp for cost
and under expected
flexible set of projections ofcosts
revenue
T h e BEA when it provides a

becomes a tool for profit
and
conditions can serve the purposc of profit prediction
future
making. extent to which
be used for determining

the 'safety margin' regarding the
T h e BEA can
losses.
a declinein sales without causing
the firm can permit
Sales BB100
Safety Margin Sales sales volume.
the tàrget profit
T h e BEA can be useful in determining
TFC-Target Profit
Target Sales Volume Contribution Margin
decision.
I t is useful in arriving at make or buy to pricing policy,
decision making pertaining
significant in business cautiouslyY
In short, BEA is highly the technique
is to be used
etc. However,
capital budgeting,
sales projection,
T6.7PracticalProblem variable cost of

product
Rs. 12,000. Its and safety
amounting to
incurs fixed expenses break-even quantity (BEQ)
A small firm
price is Rs. 8. Determine its
unit. Its selling
X is Rs. 5 per
5000 units.
margin for the sales of
Solution:
TFC
(BEQ P-AVC
= 12,000=4,000
8-5
Sales-BE0 100
(i) Safety Margin Sales
5000-4000x 100 20%

5000
378
16.7.1 Interpretation of the Result

P:1 BEQ BEP 4000 units of product X in this case
or
any loss implies that the

profit of selling this level of output at Rs. 8. In other
or
firmn would not h
output level, becausc: words, this is a zero prc
T TR TC
Solution:
In this case,
TR=P.Q= 8 x
4,000 =32,000
TC TFC + TVC
12,000+5 4000 = 32,000
=
x
T
32,000 32,000 =0
Answer: Furthermore, the safety margin 20% in this case suggests that
to reduce its sales of the firm can atffo
product X upto 20 per cent of the present sales value of 5000 units (i.e
20% of Rs.
40,000) before incurring any loss.
P:2 A firm starts its business with
fixed expenses of Rs. 60,000 to
lts variable
cost is Rs. 2 per unit. produce commodity
should the firm
Prevailing market price of the product is Rs. 6. How muc
produce to earn profit of Rs. 20,000 at this price?
Solution:
In this case we have to
determine target profit sales volume (TPS) by using the formuli
TFC -Target Profit
TPS =
Contribution Margin
Contribution Margin = Price - AVC
6-2 = Rs. 4
TPS 60,000 20,00040,00 10,000

4 4
Answer: The firm should
produce 10,000 units of X to earn targeted profit of Rs. 20,00
per unit of time.
A HYPOTHETICAL CASE OF COST VOLUME PROFIT ANALYSIS (cVPA)

Break Even Analysis (BEA) is essentially cost volume
profit analysis (CVPA). It is an analytical technique for tracing
relationships among key business variables such as costs, revenues and profits at different output levels. Needless to
say that BEA chat is a basic CVPA chart.
CVPA is useful for analysing a decision
making
publisher for publishing a textbook on Business Economics. Following problem. are available.
a hypothetical case of a Let us assume
COST GROUP:
particulars
Amount
Fixed costs:
(Rs.)
Editing charges 10,000
Artist: Design/Diagram charges
15,000
Typesetting charges 25,000
Total Fixed Costs (TFC)
50,000
Variable cost items (per copy):
Paper costs 10
Printing charges 20 (Cont...)
45
BREAK-EVEN ANALYSIS AND CoST CONTROL 379
(Cont.)
Binding costs 2
Salesman commission 3
Administrative overhead 0
Whole-sellers' discount 15
Aulhor's royalties 10
Total Variable Cost (AVC): 70
List Price (P): 85
Price contribution in this case is: P - AVC = 85 - 70 = 15
Break Even quantity is estimated as:

QBE TFC/(P AVC) =50,000/(85 70) = 3333 copies.
The publisher should evaluate the size of the total market on the basis of number of sludents as potential buyers,
other books in competition and other determinants.
f it is observed that the book cannot reach this break-even point within a reasonable time limit (say one year).
business decision should be made for cuting down the costs of production by reducing the number of diagrams, num
of pages, author's royalties with convincing negotiations and so on. Suppose a 20% cut is effectuated, then
TFC 40,000, AVC = 56
Now price is also reduced to RM 80 to be more compettive. In this case
QBE = 40,000/(80 56) =1667 copies
If in one year the firm is expecting to sell at least 25000 copies and prints accordingly, its profit estimale is
Profit= TR TC
TR 2500 x 80 RM200,000
TC = TFC+ TVC = 50000 (56 2500) = RM190,000
Profit 200,000 190,000 10000

Author in this case may get total royalty, assuming Rs. 8 per copy: 500 x 8 = Rs. 20,000
P: 3 A manufacturer buys certain components for producing X at Rs. 20 per unit. If he

has to make these components it would require a fixed cost Rs. 15,000 and average variable cost
Rs. 5. His present requirement is .1000 units of these components.
Advise him. whether he should make or by them, if he intends to double the output.
Solution:
In this case we need to measure the BEP of the components
Thus:
TFC
BEP P- AVC
Here, for P we 'have to take the purchase price.
15,000 15,000 100

BEP
20-5 15
Answer: At 1000 units requirement it makes no difference whether the firm buys or makes
the components. But, when requirement increases, it is profitable to make the components.
************* ****T
46
380 MANAGERIAL ECONOMICS
Cost Control
lt refers to
16.8 Cost Control
the comparison Profit maximisation is the major objective of a business firm. Even if profit is not maxinised,
of actual and in the long run, the firm must be able to carn sustained profits.
) standard costs Profit depends on the positive difference between the selling price and unit cost of output.
and involving a
When the price is determined by the market forces, the firm at a given price of the product can
prograinme for a
enjoy profits by minimising its cost of production. Cost control is thus essential for the cost
continuous im-
provement in minimisation.
cost standards.
Cost control implies a search for carrying the production in economic ways. It entails a programme
of continuous improvement in cost standards. According to Prof. J. Batty, cost control refers
to "the comparison of actual and standard, costs and then taking action on any variations which
have arisen."
A planned programme of cost reduction is essential for the effective cost control. It should
be noted that cost control is not cost reduction. Cost control implies efforts to be made for achieving
a target or goal or cost minimisation. Cost reduction means the actual achievement in reducing
the cost. It is the real and permanent reduction in the unit costs of production achieved by reducing
the expenditure and/or by raising the productivity. In cost reductions, standards are always challenged
tor further improvement. In cost control, however, standards are accepted as they are fixed and
not challenged over a period of time. Thus, cost control, in practice, lacks dynamic approach.
For improving its profitability and competitiveness, however, the firm must resort to cost
control.
It helps it in actual cost reduction and the lowering of price. In a high cost economy of
India, therefore, cost control is very important for the industries.
In cost control activity, two important rules have great.significance: (i) Keeping costs down
1S always easier than bringing them down and (ii) when business conditions are good, lesser efforts
are involved in cost control than under bad business situation.
.
There should be a consortium approach, i.e., all concerned, such as executives, foremen,
Supervisors and workers, should join hands to achieve a common goal of cost minimisation.
For controlling costs, it is not sufficient to have actual cost information. Though it relates
to past performance, it does not show. whether this performance was satisfactory or not. As such,
the managenent has io lay down some cost standard norms for evaluation of the actual cost and
measure its deviation from the norms. The planning and control function should be integrated with
the estimated cost standards under given efficient working of the fim.
T69echnigues of ieOstcontro
There are two methods costcontrol, viz., (i) budgetary control, and (i) standard costing,
16.9.1 Budgetary Control

The budgetary control relates to the cost of running different production departments in the
factory.or company. To control factory overhead costs preparation of flexible budgets is of great
use. Flexible or variable budgets serve as a basis for determining anticipated costs at various levels
of production processes, viz., selling and distribution
costs, warehousing and transport costs,
administration costs, accounts department's costs, labour and factory overhead costs, etc.
Similarly, capital expenditure budget is to be prepared covering a detailed planned expenditure
on plant, machinery, tools, etc. Further, the company's cash budget must be prepared for the
entire business organisation.
7
381
BREAKEVEN ANALYSIS AND COsT CONTROL
Finally, a master bidget is to be prepared by aggregating departmental budgcts. The maste

shoula
budgei should reconcile the conflicts betwcen the departmental budgets. The master budget
also incorporate a planned profit and cost account and the annuai balance shect
When the period of budget commences, actual cost data should be collected and comparea
with the budgctary data for cffecting cost control in a proper way. '
16.9.2 Standard Costing

Standard costing is devised to form standards of performance for producing commodities
They
Standards serve as thc norms or which arc to bc attained in actual cost performance.
goas
set norms. Statistical
also serve for evaluating iost data and their deviation from the
the actual
technique of variance is useful in this regard.
'in the firm's
of setting standard costs is to induce cost consciousness
The major objective
operation.
cost reasoably, during
a future
Standardcosting implies estimate of what a product ought to
period, under the efficient working of the firm.
iike material costs, labour
Standard costing is formed by collecting all kinds of information
costs, overhead costs, selling costs, etc., from various sources.
After preparing the standard costs, actual cost data are collected on monthly basis and.compared.
be attributed to factors like:
Any deviation or variance of actual data from the standard costs may
(i) higher material prices; (ii) excess use of materiais; (ii) low productivity of labour, (iv) higher
overhead charges; etc:
wages; (v) less output than what is planned; (vi) high
for high cost
Standard costing can trace these causes and which department is responsible
can be easily located.
16.10Areas of GCost Control

In cost controlling efforts the following important areas may be carefully tackled:
be done with proper

materials. For minimising the material cost buying should
care. of
Cost A bulk purchase of materials at wholesale rates would imply a considerable savings
in this regard.
and
Use of materials can be economised and made more efficient through Research
Development (R&D).
rther. Packaging costs
material costs may be reduced
Through inventory controls,
of materials should be minimised by reusing the containers, etc.
Labour costs. Labour costs can be economised by improving the labour productivity
through training, automation devices, etc. Through proper co-ordination in different job
processes, wastage or labour-time can be minimised, which indirectly reduces the labour
be effective
cost per unit of output. A sound HRM policy (to be a good employer) can
in causing better industrial harmony and workers' dedication. Early retirement offers,
an effort of labour
such as Voluntary Retirement Schemes (VRS) are also regarded as
cost reduction approach in the corporate and public sector enterprises.
Overhead costs. Overhead expenses of the firm can be minimised by proper maintenance
of machinery, tools and equivalent, avoiding. wastage of electricity, fuel, etc., proper
checks costs can be saved:by reduction of clerical and accounting work. Checking the
misuse of telephones can save upon telephone bills. Saving in transport costs is possible
vehicles wagon loads. Out-sourcing is the
by taking advantage of full-load of bigger or
best method of cost minimisation in many areas of productive activity.

382
Selling costs. Selling costs can be minimised by

training of
in the sales
departmcnt, sclecting cheaper or better media salesmen, proper supervision
of effective advertisements,
To Decision Making
hobroak-evan analysls is a guide post 1o. firms economic
Break even point indicates zeroproit perlormance and expansion.
business vonturo. position which is the slarl marching point towards profitebility of the
reak-even point is detemined when total
revenue, however, 1the marginal revenue equates total c0st. At this point,
cost is
falling Marginal cost marginal
REVIEW QUESTIONS
Q: 16.1 (a) What is break-cven
analysis?
(6) What arc the assumptions underlying break-cven analysis?
c) What are the limitations of
break-even analysis?
Q: 16.2 Explain
and illustrate break-even
chart. Point out the usefulness
of break-evcn
Q: 16.3 (a) What is
the differençe between cost analysis.
control and cost reduction?
(6) What are the
techniques cost control?
of
Q16.4 Explain the concept of break-even
break-even points in terms of point. What are its assumptions? Using hypothetical figures, determine
physical units.
Q 10:5 Discuss
the importance
of cost control in relation
areas of cost
control and tools of such
to profit planning with specific reference to the
control. major
PROBLEMS
P:T6.1 Explain the term "Break-Even Analysis" and discuss
the following data: its usefulness. Calculate the break-even point from
Sales
:S50units
Sales Receipts
:Rs. 28,875
fotal Fixed Costs
:Rs. 16,000
Total Variable Costs :Rs. 11,000
P:16.2Explain the nature of break-even analysis. Given the following functions, find the break-even
Total Cost =
100 +
5X point:
Total Revenue = 10Y where X
is the quantity sold.
Htnts: The reader should note that here
for the quantity.] X is used, whereas in the text 'we have
used "2 as the notation
P: 16.3 A firm
purchases ball
ibearings at Rs. 12. Its monthly
its fixed cost
would/be Rs. 18,000 and variable requirement is 1000 units. If it decides to make,
cost Rs. 5 per unit.
P: 164 The Sardar What is your
Manmohan Singh (SMS) Pvt. Ltd. has advice?
its output is araund been
75% of its rated manufacturing
capacity of 20,000 units per year. Atal
track suits for athletes.
Currently
the sample
and has offepred to buy 5,000 Exports Pvt. Ltd., has approved
units at a special price of Rs. 1:500 per
normal price is Rs. suit, whereas the
2,100. The Company's cost function is company's
analysed as under:
***********"*" ******** ********** * *** ******* ****** ******** ****

BAEAK-EVEN ANALYSIS AND COST CcONTROL
Per unit Cosis Rs.

- Labour 250
- Matcrial 820
Administration variable cost 130

- Fixed cost 400
1,600
Decision Problems:
A. Should the SMS accept the offer?
B. As a consultant, what is your advice if the Atal Exporters offers to buy 10,000 units.
50
Chapter
Demand, Supply, and

Market Equilibriumn
After reading this chapter, you will be able to:
2.1 ldentify demand functions and distinguish between in demand and
a change a
change in quantity demanded.
2.2 ldentify supply functions and distinguish between a change in supply and a
change in quantity supplied.
2.3 Explain why market equilibrium occurs at the price for which quantity
demanded equals quantity supplied.
2.4 Measure gains from market exchange using consumer surplus, producer
surplus, and social surplus.
2.5 Predict the impact on equilibrium price and quantity of in demand
shifts or supply.
.2.6 Examine the impact of government-imposed price ceilings and price floors.
uccessful managers must be able to accurately predict the prices and

production levels of the goods and resources relevant to their businesses.
Executive managers at Intel, for example, must plan production of their
semiconductor chips many months ahead of
buyers' orders. Semiconductor profits
depend critically on understanding the market forces affecting both the demand
and supply conditions that will
ultimately determine the price of Intel's chips and
the number of chips
they must produce to meet demand. Intel's semiconductor
chips will end up in everything from Dell and Mac computers to automobiles, cell
phones, and jet aircraft control and navigation systems. Intel faces many compet-
ing chip manufacturers in these various markets, so the production planners at
Intel cannot make the best decisions without accurate estimates of
the prices their
chips will fetch in the market and the number of chips they will need to produce.
If Intel produces too many semiconductor
chips, it will lose money on excessive
38
5
Market Equilibrium
CHAPTER 2 Demand,Supply, and
Intel
unload the excess chips. I
nventory costs and on the price cuts necessary to to its
rs
too fewchips, it will miss out on sales as buyers turn compe

produces of
number Sen
fill their orders. And the likelihood ai producing the wrong
to forecast the prices of its cniP
ductor chips is high if Intel is unable to correctly
most powerful tools of econon
Supply and demand analysis is one of the levels in con
for the market forces determine prices and output
analyzing way
and demand analysis
markets. As you will see in this chapter, supply
petitive used by highly experienced-anu
reasonably simple to learn. And, it is widely
well-paid-market analysts and forecasters. markets for consumer goods and ser
on the way
This chapter focuses primarily markets for resources
the basic concepts apply also to
Vices function, although equipment. Supply
and
de
Such as labor, land, raw materials, energy, and capital
markets characterized by many buyers anu
mand analysis applies principally to nondifferentiated good or servit
sellers in which a homogeneous or relatively
such markets are called compeniv
Sold. As we stated in the previous chapter,
individual firms are
because
price-takers prices
markets. In competitive markets, and suppiy
are determined by the impersonal forces of
the marketplace-demand
the buyer sia
We begin the analysis of competitive markets by describing
of the market. Next we describe the seller
of the market-called the demand side
demand side with the suppiy
side-called the supply side. We then combine the
are determined in
a market. Finaly
Side to show how prices and quantities sold market can
we show how forces on the demand
side or the supply side of the
and thereby affect the price and quantity
sold in a market.
change
2.1 DEMAND
able
in market are wiling and
good or service that consumers a
The amount of a
week, a month) is called quantity
to purchase during a given period of time (e-g,
a
demanded. Although economists emphasize

the importance of price in purchasing
quantity demanded
that a multitude of factors
other than
The amount of a good decisions, as w e will do, they also recognize However, to
or service consumers or service people will purchase.
are willing and able to
price affect the amount of a good economists ignorethe many
purchase during a given simplify market analysis and make it manageable, and concentrate only on
period of time (week, factors that have an insignificant effect on purchases
are considered sufficiently
month, etc.). the most important factors. Indeed, only six factors
market demand.
important to be included in most studies of relations:
This section develops three types of demand (1) general demand functions,
and five other fac-
which show how quantity demanded is related to product price
which show the relation between
tors that affect demand, (2) direct demand functions,
when all other variables affecting
quantity demanded and the price of the product inverse demand which
demand are held constant at specific values, and (3) functions,
various amounts of
are willing to pay to obtain
give the maximum prices buyers from
direct demand functions are derived
product. As you will see in this chapter,demand curves are derived from direct de-
general demand functions, and inverse referred to direct demand functionss
mand curves. Traditionally, economists have
We shall follow this tradition.
simply as demand functions or demand.
52
40 CHAPTER 2 Demand, Supply, and Market Equilibrium
The General Demand Function: Q, = fP M, P I, P N)
The six principal variables that influence the quantity demanded of a good or
service are (1) the price of the good or service, (2) the incomes of consumers,
(3) the prices of related goods and services, (4) the tastes or preference patterns
of consumers, (5) the expected price of the product in future periods, and (6) the
number of consumersinthe market. The relation between quantity demanded and
general demand these six factors is referred to as the general demand function and is expressed
function
The relation between as follows:
quantity demanded and
the six factors that
affect
Q, fP, M, Pa T, P N)
uantuty demanded: Q,
fP, M, PI, Pe N.
where fmeans "is a function of" or "depends on, and
Q quantity demanded ofthe good or service
P price of the good or service
M = consumers' income (generally per capita)
Paprice ofrelated goods or services

taste patterns of consumers
Pexpected price of the good in some future period
N= number of consumers in the market
The general demand function shows how all six variables jointly determine the
of these
quantity demanded. In order to discuss the individual effect that any one
six variables
has on Q, we must explain how changing just that one variable by
itself influences Q, Isolating the individual effect of a single variable requires that
all other variables that affect Q, be held constant. Thus whenever we speak of
the effect that a particular variable has on quantity demanded, we mean the indi
vidual effect holding all other variables constant.
We now discuss each of the six variables to show how they related to the
are
the
amount of a good or service consumers buy. We
begin by discussing effect
of changing the price of a good while holding the other five variables constant
As you would expect, consumers are willing and able to buy more of a good the
lower the price of the good and will buy less of a good the higher the price of
the good. Price and quantity demanded are negatively (inversely) related because
when the price of a good riseß, consumers tend to shift from that good to other
() goods that are now relatively cheaper. Conversely, when the price of a good falls,
consumers tend to purchase more of that good and less of other goods that are
now relatively more expensive. Price and quantity demanded are inversely re-
lated when all other factors are held constant. This relation between price and
quantity demanded is so important that we discuss it in more detail later in this
chapter and again in Chapter 5.
Next, we consider changes in income, again holding constant the rest of the vari-
ables that influence consumers. An increase in income can cause the amount of a
commodity consumers purchase either to increase or to decrease. If an increase
in income causes consumers to demand more of a good, when all other variables
53
41
Equilibrium
CHAPTER 2 Demand,Supply,and Market
a commoaity
we refer to such
general demand function are held constant,
in the causes
a decrease in income
normal good as a normal good. A good is also a normal good if
A good or service for consumers to demand less of the good, all other things
There
(ield constant. consumer arc
income vould reduce
which an increase some goods and servi for which an increase in
referred to as
(decrease) in income
other variables held constant. This type
of commodity is
causes consumers to demand, income causes consume
an interior good. In the case of inferior goods, rising
demand more (less)
of the causes c o n s u m e r s
to demand iore
good, holding all other less of the good, and falling income inferior incluae
demand services that might be
variables in the general Some examples of goods and
of
the god. food products, and used cars.
demand function constant. mobile homes, shoe repair services, generic as substitutes
in either of two ways:
inferior good Commodities may be related in consumption can be used in
are substitutes
if one good
A good or service for general, goods
In
which an increase
or as complements. example might be Toyotas
and Chryslers. If
two gOOds
the placeof the other; an
will increase the demand ror
(decrease) in incomne
are substitutes, an increase
in the price of one good
causes consumers to rises while the price of Chryslers remains
demand less (more) the other good. If the price of Toyotas Chryslers-holding al
to purchase more
consumers
of the good, all other constant, we would expect causes consum
in the price of a related good
factors held constant. other factors constant. If an increase substitutes. Similarly, two
demand more of a good, then the two goods are consum-
ers to
substitutes decrease in the price of one
of the goods causes
are substitutes if a
Two goods are goods constant.
substitutes if an increase ers to demand less of
the other good, all other things with each otner
if are used in conjunction
(decrease) in the price of Goods are said to be complements they or baseball games
one of the goods causes be iPods and music, lettuce and salad dressing, will increase
Examples might the baseball game
consumers to demand the price of tickets to
and hot dogs. A decrease in for hot dogs at
more (less) of the other increase the demand
demanded, and thus
good, holding all other the quantity of tickets increases when
for one good
the price of
If the demand
factors constant. the game, all else constant. Similarly, two goods
decreases, the two goods are complements. consumers
complements a related good of one of the goods

causes
are complements
if an increase in the price
Two goods are
complements if an demand less of the other good, all other things constant.for a service.
to
can change
demand good or
increase (decrease) in tastes d emand.
A change in c o n s u m e r decrease c o n s u m e r
the price of one of the could either increase or
bviously, taste changes other variables in
measurable (as are the
tastes are not directly
consumers
goods causes
I as an index
of
While consumer
to demand less (more)
of wish to view. the variable
the general demand function), you
may a good becoming
the other good, all
other c o n s u m e r s perceive
c o n s u m e r tastes; I
takes o n larger values as
things held constant.
more healthful,
or more
desirable in any way.
more fashionable, from a good
higher in quality, to a change in
consumer tastes away
or
A decrease in corresponds appearance,
c o n s u m e r s perceive falling
quality, or displeasing in the general
or service as when all other variables
diminished healthfulness.
Consequently, tastes toward
a
a movement in consumer
demand function a r e
held constant, tastes awayy
movement in consumer
will increase demand and a tastes

good or service decrease demand for the A change in
consumer
good. Medicine
from good
a will
the New England Journal of
o r preferences
occurs when, for example,
Many commodities
either substitutes complements in consumption.
or
to significantly
commodities
the price of lettuce
are
Not all would not expect
For example, we and
commodities as independent
are essentially independent. w e can treat
these
influence the demand
for automobiles. Thus, automobiles.
the demand for
lettuce when evaluating
the price of
ignore
51

publishes research findings that show a higher incidence of brain cancer among
people who use cell

regularly This causes the demand for cell phones to
phones.
decrease (the taste index J declincs), all other factors remaining constant.
Expectations of consumers alsen influence consumers' decisions to purchase
80ods and services. More specifically, consumers' expectations about the future
price of a commodity can change their current purchasing decisions. If consumers
in the
expect the price to be higher in a future period, demand will probably rise
current period. On the other hand, expectations of a price decline in the future will
some purchases to be postponed-thus demand in the current period
will
cause
fall. An example of this can be seen in the automobile industry. Automakers often
announce price increases for the next year's models several months before the cars
are available in showrooms in order to stimulate demand for the current year's cars
in the market will increase the
Finally, an increase in the number of consumers
demand for a good, and a decrease in the number of consumers will decrease the
demand for a good, all other factors held constant. In markets that experience a
growth in the number of buyers-such as the health care industry as the population
matures or Florida during the tourist season-we would expect demand to increase.
The general demand function just set forth is expressed in the most general
mathematical form. Economists and market researchers often express the general
demand function in a more specific mathematical form in to show
order
more pre-
cisely the relation between quantity demanded and some of the more important
variables that affect demand. They frequently express theis general demand
example of a
function in a linear functional form. The following equation an
linear form of the general demand function:

Q a + bP + cM + dP + eT +fP, +gN
where QP, M, PR T, P, and N are as defined above, and a, b, c, d, e, f, and g are
parameters.
The intercept parameter a shows the value of Q, when the variables P, M, Pp
9, Pp, and N are all simultaneously equal to zero. The other parameters, b, C, a,
de-
slope parameters e,f, and g, are called slope parameters: They measure the effect on quantity
Parameters in a linear manded of changing one of the variables P, M, PR T, Pp, or N while holding the
function that measure the
rest of these variables constant. The slope parameter b, for example, measures
the effect on the
dependent variable (Q change in quantity demanded per unit change in price; that is, b AQ/AP2 As =
of changing one of the

stressed earlier, Q, and Pare inversely related, and b is negative because AQ, and
independent variables (P, APhave opposite algebraic signs.
M, P T, P and while The slope parameter c measures the effect on the amount purchased of a one-unit
holding the rest of these
variables constant. change in income (c AQ,/AM). For normal goods, sales increase when income
=
rises, so c is positive. If the good is inferior, sales decrease when income rises, so c
is negative. The parameter d measures the change in the amount consumers want
to buy per unit change in P, (d = AQ,/AP). If an increase in P, causes sales to
The symbol "4" means "change in." Thus, if quantity demanded rises (falls), then AQ, is
the the
positive (negative).
Similarly, if price rises AP is
(falls), positive (negative). In general, ratioof
change in Ydivided the
by in X (AY/Ax) measures the change in Y per unit change in X
change
55
43
Find more at and
Market
Equilibrium
Demand, Supply,
CHAPTER 2
Sign of
s l o p ep a r o m e t e r
Rolatlon to
quantity domondod
TABLE 2.1
Variablo b A0,/Pis negative
C A0,/AMis positive
Summary of the General Invorso
P
(Linear) D e m a n d Function
Diroct for normal goods C A0,/AMis negative
cM+ dP M
a,= a + bP + Inverse for inlerior goods
d A0,/AP,is
positive
+ e +P, + gN goods negative
Diroct for substituto d A0,/AP, is
PA Invorse for comploment goods A0,/AT is positive
fA0,/APis positive
Direct
Direct g A0,/ANis positive
N Direct
increase in P,
t causes
sales
and d is positive. If an and N are ead

goods are
substitutes Since I, P,
rise,
the
and d is negative. all posiuve are
and g
n e two goods
are complements
purchased,
the parameters e,f,
to the
related
amount
directly
in linear form:
fuunction is expressed
Relation When the general demand
a+DP+ cM+dP +e P+gN purchased orCne9

measure the effect on the amountofthe good constant. For exampie
parameters (b: c. d.e. fand g) holding the rest of the
variables
ne siope and N) while M
(P MPTP, per unit change inprice holding
ing one of variables
the quantiny
AG4P measures the
change: in quantity demandedvariable is positive (negative) in sign,
a specific
0
the slope parameter of

and N constant. Whon related to that variable.
demandedis directly [inversely) function.
Each
demand
this discussion of the general table shows
2.l summarizes and the
Table demanded is listed, varia ble
that affect quantity with each
of the six factors directly o r inversely
d e m a n d e d varies that these relations
whether the quantitythe parameters. Again let
u s stress
the price
o f the
the sign of slope An increase in
andgives c o n t e x t of all other things
being equal. a s the other
a r e in the
decrease in quantity
demanded a s long t a s t e s , Pprice
will lead to a consumer
commodity of related
commodities,
v a r i a b l e s - i n c o m e , the price constant.
customers-remain not
number of variable but may
expectations, and the i n c l u d e s price as a Market
A general d e m a n d
function always shown in Table
2.1.
other five variables since these
include every o n e of the
always s o m e t i m e s omit c o n s u m e r tastes and price expectations,
analysts n u m b e r of customers
s i t u a t i o n . The
in every when the
v a r i a b l e s may not be important demand equation
a general
be disregarded in formulating For example,
may also does not change.
c o n s u m e r s in a particular market since
number of n o t likely to depend
o n c o n s u m e r tastes,
d e m a n d for city w a t e r is and city water

the no role in determining
w a t e r usage,
fashion generally plays
wish to
the other variables, you may
consumer tastes are not directly measurable as a r e
think a product is
Since c o n s u m e r tastes that ranges
in value from 0, if coFsumers
as a n index of e showS
view
In this case, the parameter
the product is extremely desirable.
worthless, to 10 if theyofthink
a orne-unit change in
the taste index (9), and e is positive.
the effect o n quantity
44
CHAPTER 2
Demand, Supply, and Market Equilibrium
should be tasteless! Pricc expectations are also, unlikely to affect municipal
water demand. In January, people don't drink more or less water-or bathe
more or les frequently-because they expect the Pice of city water to be lower
or higher in February. Furthermore, in a small town that experiences only an
inconsequential change in the number of residents, N does not play an impor-
tant role in determining the variation in Q, and need not be included in the
general demand function. For these reasons, the general linear demand func-
tion can sometimes be
simplified to include just three variables from Table 2.1:
Q-a+bP + cM + dP
Although it is not always appropriate to use this simplified version of the gen-
Now try Technical eral demand function, the three-variable demand function does provide a reason-
Problem 1. able model of consumer demand in
many applications.
Direct Demand Functions: fP)
Q, =
The relation between price and quantity demanded per period of tirne, when all
direct demand
other factors that affect consumer demand are held constant, is called a direct
function
demand function or
A table, a
graph, or an simply demand. Demand gives, for various price of a good,
the
equation that shows
how quantity demanded
corresponding quantities that consumers are willing and able to purchase at
each of those
is related to prices, all other things held constant. The "other things" that are
product held constant for a
specific demand function are the five variables other than price
price, holding constant that can affect demand.
A demand function can be expressed. as an equation, a
the five other variables
schedule or table, or a .
that influence demand: graph. We begin with a demand equation.
a,= fP). A direct demand function can be
expressed in the most general form as the
equation
,fP)
which means that the quantity demanded is a function of (i.e, depends on) the
price of the good, holding all other variables constant. A direct demand function
is obtained by holding all the variables in the general demand function constant
except price. For example, using a three-variable demand function,
Q-P, M, P) =fP)
where the bar over the variables M and P, means that those variables are held
constant at some specified amount no matter what value the product price takes.
Relation Adirect.demand function (aiso called"demand") expresses.quantity demanded as functiona

of product price only 0 PI Demand fünctionswhether expressed as equations, tables, or graphs
give the quanity demanded ät various prices, hölding constant the effects.of income. price of relatëd goods,
consumer tastes, expected price, and the number of consumers. Demand functions are derived from general
demandfunctions by holding all the variables in the general demand function constant except price
To illustrate the derivation of direct demand function from the
a
demand function, suppose the

general
general demand function is
Q 3,200-10P +0.05M 24P
57
45
Equilibrium
Find more at Market
Demand,Supply,
and
CHAPTER 2
must
be as
orice o f a
variables M and P the price
the and a n d Pg
demand function, Q,
SP), =
i n c o m e is
$60,000
of M
To derive a
values. Suppose consumer the ffixed
ixed
values values
or
v
function,
specific (fixed) To find the
demand
related good is $200. demand

function
substituted into
the general
are 3,200 10P+0.05(60,000)24(200)
4,800
10P +3,000-
=
3,200 mand
= 1,40010P a
linear
u of theh
form of
in the
function is
expressed
1,400, is
the amou
demana .
demand parameter,
Thus the
direct of thisc a u s e s q u a n t i t y
The intercept slope
1,400 10P. z e r o . The
=
Q, is
cquation, d e m a n d if price i n c r e a s e in price
would
that a $1 f u n c t i o n s are
linea
consumers indicates demand
80Od is -10 and not all u s e d speciea
tion (= AQ/AP) Although
10 units. frequently
to d e c r e a s e by the linear form is a
aemanded text that the derin
later in the functions. forth in
will see demand conditions set
you and forecasting
s a t i s f i e s all
the
c o n s t a n t - n c o n e
for estimating are

held
the e q u a t o t
d e m a n d equation
than product price price, "
nis linear All v a r i a b l e s other at $200.

At each
For exampie
demand. related good that price.
1on of and the price
of a
would purchase
at
at $60,000 that
consumers
amount
8ives the
price is $60, = 800
(10 x $60)
1,400
Q
or if price is $40, 1,000

$40)
=
thne
and
1,400-(10x
several prices
of
showsa list again holalng
schedule (or table) each of the prices, c o r r e s p o n d i n 8
at
of time and their
demand
A
demand schedule
d e m a n d e d per
period Seven prices combinations
seven
of the
constant.
list of quantity exactiy
A table showing
a
other than price Table 2.2. Each function
possible product prices all

variables
shown in demand
demanded
are from the
derived
and the corresponding
quantities demanded is
quantities demanded. and quantity
price
o as s h o w n above.
Quantity
demanded
TABLE 2.2 Price

The Demand Schedule $140 200
the
Demand
Function 120 40D
for
D Q =1,400 10P 100 GDD
800
5D 1,000
1,200
20
52
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46
CHAPTER2 Demand, Supply, and Market Bquilibrium
FIGURE 2.1
A Domand Curvø:
a, 1,400 10P
40S140, 0
$120, 200
120
$100, 400
100
A
. $80, 600
80
$60, 800
Do
40
$40, 1,000
$20, 1,200
200 400 600 800 1,000 1,200 1,400 1,600

Quontily demanded (O
As noted, the final method of showing a demand function is a graph.

demand curve A
A graph showing graphical demand function is called a demand curve. The seven price and
demanded combinations in 2.2 are plotted in and
the relation between quantity Table Figure 2.1,
these points are connected with the straight line D, which is the demand curve
quantity demanded and
price when all other associated with the demand equation Q, = 1,400 10P. This demand curve meets
variables influencing the specifications of the definition of demand. All variables other than are price
quantity demanded are held constant. The demand curve D. gives the value of quantity demanded (on the
held constant.
horizontal axis) for every value of price (on the vertical axis).
You may recall from high school algebra that mathematical convention calls for
plotting the dependent variable (Q) on the vertical axis and the independent vari-
able (P) on the horizontal axis. More than a century ago, however, Alfred Marshall,
a famous economist and author of an influential economics textbook, decided to
counter this mathematical tradition by plotting all monetary variables-such as
prices, revenues, and costs-on the vertical axis. This switch is now an established
tradition among economists. We mention here the matter of reversing axes only to
make sure that you do not let this minor quirk distract you; it is the only meaning-
less matter we address here!
inverse demand
function
The demand function
Inverse Demand Functions: P flQ0
when price is expressed In some situations, it is quite useful to express price as a function of quantity
as a function of quantity demanded. This form of demand is called the inverse demand function because
demanded: P= fi0). it is the mathematical inverse of the direct demand function. For example, consider
59
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CHAPTER 2 Demand,Supply, and Market Equilibriurn
the direct demand

cquation for D, in Figure 2.1:0 = 1,400 10P. Solvingthisdirect
cdemand cquationfor Pgives the inversedemandequation: P = 140-1/
By Swilching the Q, and P axes as nmentioned above, the graph of a e a t
Tgure 41 1s, mathematically speaking, a graph of the inverse demand function.
SCe n the figure, the vertical intercept is 140, indicating that at a price of Di*
frequently called the "choke" price-consumers will demand zero units or t ood.
ne norz0ntal intercept is 1,400, which is the maximum amount of the gooa D
ers will take when the good is given away (P = 0). The slope of the graphed iv
must
demand is-1/10, indicating that if quantity demanded rises by one unit, price
fall 1/10 of a do!lar (or 10 cents). This inverse demand, as you can see in the ng
yields price-quantity combinations identical to those given by the direct dena
cquation, Q, =1,400 10P, In other words, the demand relation shown in 1abe
IS
identically depicted by either a direct or inverse form of the demand equati um
ATthough demand is generally interpreted as indicating the amount that co
know
ers will buy at each price, sometir researchers wish to
managers and market AS1 irns
the highest price that can be charged for any
given amount of the product.
Out, every point on a demand curve can be interpreted in either of two ways:
maximum amount of a good that will be purchased if a given price is charge
4 the maximum price that consumers will payfor a specific amount of a gooa. Con-
Sider, for example, point A ($100, 400) on the demand curve in Figure 2.1. If the pri
of the good is $100, the maximum amount consumers will purchase is 400 ut
Equivalently, $100 is the highest price that consumers can be charged in order to >e
total of 400 units. This price, $100, is called the "demand

demand price
a
price" for 400 units, ana
every price along a demand curve is called the demand price for the correspornan
The maximum price
quantity on the horizontal axis. Thus the inverse demand function gives the demand
consumerS will pay for
we
a
specific amount ofa price for any specific quantity of the product or service. Later, in section 2.4,
of
good or service. will explain why demand price can also be interpreted as the economic value any
specific unit of a product, because, as you now understand from this discussion
demand price is the maximum amount consumers are willing to pay for the good.
Movements along Demand

NoW try lechnical
Problems 2-3.
Before moving on to an analysis of changes in the variables that are hela coa
when deriving a demand function, we want to reemphasize the relation between
price and quantity demanded, which was discussed earlier in this chapter. In the
demand equation, the parameter on price is negative; in the demand schedule,
law of demand
Quantity demanded price and quantity demanded are inversely related; and in the graph, the demand
curve is
increases when price falls, negatively sloped. This inverse relation between price and quantity
and quantity demanded demanded is not simply a characteristic of the specific demand function discussed
decreases when price rises, here. This inverse relation is so pervasive that economists refer to it as the law
other things held constant. of demand. The law of demand states that
quantity demanded increases when
Recall from high school algebra that the "inverse" of a direct function Y is the function
=f(X)
X=f), which gives X as a function of Y, and the same pairs of Yand X values that satisfy the direct
function Y =f(Y) also satisfy the inverse function X = f(Y). For example, if the direct equation is Y =
10-2X, then the inverse function, X =
5- (1/2)Y, is found by solving algebraically for X in terms of Y.
60
a8
CHAPTER 2
Demand, Supply, and Market Equililbrium
falls and quantity demanded decreases when price rises, other things held
price
constant.
conomists refer to the inverse relation between price and quantity demanded as a
law, not because this relation has been proved mathematically but because examplesto
thecontrary have never been observed. If you have doubts about the validity of the law
of demand,tryto think of any goods or services that you would buy more of fthe price
were higher, otherthings being equal. Or can you imagine someone going to the grocery
store expecting to buy one six-pack of Pepsi for $2.59, then noticingthatthe price is $5,
and deciding to buy two or three six-packs? You don't see stores advertising higher
prices when they want to increase sales or get rid of unwanted inventory.
change in quantity Once direct demand
a function, Q, fP), is derived from a general demand
=
tunction, a change in quantity demanded can be caused only by a change in price

demanded
A movement The other five variables that influence demand in the general demand function
along a
given demand curve that M, P I, Py and N) are fixed in value for any particular demand equation.
ocCurs when the price A Chaiuge in price is represented on a graph by a movement along a fixed demand
of the good
changes, all
else constant.
Curve. In Figure 2.1, if price falls from $100 to $80 (and the other variables remain
constant), a change in quantity demanded from 400 to 600 units occurs and is
illustrated by a movement along D, from point A to point B.
elation For ademandfunction QfP) achangelnpricecauses achangeinquantitydemanded.The

other five variables thatinfluencedemand in thegeneral demandfunction(M PPandNlarefixedat
Speciticvalues for any particular demand equation Onagraph, achange in pricecauses amovement along
a demand curve from one price to another price
Shifts in Demand
When any one of the five variables held constant when deriving a direct demand
function from the general demand relation changes value, a new demarnd function
results, causing the entire demand curve to shift to a new location. To illustrate
this extremely important concept, we will show how a change in one of these five
variables, such as income, affects a demand schedule.
We begin with the demand schedule from Table 2.2, which is reproduced in
columns 1 and 2 of Table 2.3. Recall that the quantities demanded for various
product prices were obtained by holding all variables except price constant in the
TABLE 2.3
(1) (2) 3 (4)
Three Demand Schedules
D:Q 1,400 10P D,: Q- 1,600 10P DQ-1,000 10P
Quantity demanded Quantity demanded Quantity demanded
Price (M= $60,000) (M $64,000) M= $52,000)
$140 0 200
I20 200 400 0
00 00 600
30 600 800 200
50 300 1,000 400
40 1,000 1,200 600
Z0 1,200 1,400 800
Find more at www.downloadslide.com 49
Fquilibrur
Market
APTER2 emanl, SsuppBy,and
ILLUSTRATION 2.1
alburns were up neary
of vínyl old
ffects of Changes in Determinants of Demand old
artists alike. Sales in demand for
the
increase
in 2014. This of a growin
Much of the diecussion of demand in this chapter K0percent in the
tastes
a change
technolegy
caused by share of total dermai
focuses on understanding the effects of changes in the is still a small music ensures its
number of c o n s u m e r s
demand-shilting varinbles, and the consequent eflects
for music. The
convenience of digital m ald"
shifls o n prices and sales. Some actual until digital music
becomes an
e s dmand shoinld illustrate and reinforce
dominance, at least once again
tastes change
ecis technology and
consumer
this thet
this theoretical analysis, Expectations of
Consumers
(
Changes in Price can pos
Changes in Income (M) and
consumers
services that to
For those goods demand will be sensitive
As China's economy booms, personal incomes are hone purchasing, the current
rising sharply. US. and European corporations selling buyers perceptions

normal goods (e-g, carthmovers, cellular phones, soft markct is
oboutfuture
is a particularly
pricc ofte
example
particularly good exampie
market a
the importance
ol inporta
of current
of inereased the level ot curre
8nac)
are
taking advantage
of price expectations in determining of housing
consumers. Even demand for demand. n the early phase
of the collapse
hinese homes found it very dite
luxury goods (eg, French-style manors, in-home movie prices in Florida, sellers of néw were falling
theaters, Bentley automobiles, Louis Vuitton handbags ficult to sell new homes, even thougna i d l y falling
and jewelry by Carticr) is booming in China. With Potential buyers of new homes, seeing o n e d pur
if they postponea pu
prices, expected even lower prices of a large residential
12 percent of total world demand for all luxury goods,
soon pass the Unitcd States and lapan
ta Fess, sales manager
in this
Could
become the world's largest market for luxury goods. chasing. Jack s u m m a r i z e d the problem
home builder in Florida,
house is really tough these
Changes in the Price of Related Goods (P) a deal on a n e w
Wway: Closing the buyer, "You better Duy
days when you have to tell
ang prices of neu cars is knocking down demand wait the price is only going to
cars. for cars of all makes and mod- house today becauseif you will
for used Prices new As home prices
continue falling, a po
dowm."
CISnave been faling tor the past severalyears,
as deal-go
reached where buyers no lnge 11
incentives to eventually be
ers have been offering various kinds of will fall further, and falling price eXpecta
new-car buyers thata effectively lower new-car prices. prices leftward.
it quit pushing housing demand
Since used cars are
substitute good for new cars,
Buyers (
is no surprise that' falling new-car prices have cut the Changes in the Number of
demand for used cars, as car buyeis are attracted awayActhe.nronortion of older Americans rises, the nut
services is rising sharply
from used cars into lower priced new cars ofpeopleneeding health care ofhealth care service to
causing demand for every kind
,
Changesin Taste(7 this:curen
shift rightward. Demographers predicted
Teakthroughs in technology, especially in the consumer increase in elderly patients as the unavoidable conse
ctronicS sector cause consumers tastes
to change
demand for the "old' technologyquence of the post-World WarII baby boom
Tatherguickly, causing lea f the
800ds to dry.up and demand for the new technology to These illustrations should give you some-1aea.ou
foursh. Ina rare caseotconsumer tastes reversing to the way that changes in the determinants of demand acru
old technology, the demand for vinyl LPrecord albums ally shift the demand for goods and services.and.now
sharply increased in2014 Younger music consümerS insuch shifts affect the price and sales ot the POgp
theUnitedStatesarenowhip totheidea of'droppins hey,should also gveaninsight into how mana
aneedle into the groove to geta superior audioquality an forecast and reactto suchchangesan amanne
thatdigitalmusic cannotduplicate Thisphenomenonhas furthers thegoalsof theorganization
now spread wellbeyond audiophiles playing their oldpersonalconversationwittijackFess,July 12007
espedallyindie
Beatle albums Now youngermusicfans,
rOck fansare demanding moreviny albums by new.and RecordsThe WalStreetJoiurnal,December 11, 2014P 51
ind mo www downloadsirtecr
s HA ER
inad, Suyly, nnd Matket 1quilaiam
FIGURE 22
Shifts in Demand 160
140 D
120
Demand
Increase
P 100
80 D $80, 800
$80, 600
60
$60, 400 $60, 800
A0
Demand
20 decrease
-
200 400 600 800 1,000 1,200 1,400 1,600
increase in demand Quantily demanded (Qd
A change in the demand
function that causes an
increase in quantity
general demand function. If income increases from $60,000 to $64,000, quantity
demanded at every price
and is reflected by a demanded increases at each and every price, as shown in column 3. When the price
rightward shift in the is $60, for example, consumers will buy 800 units if their income is S60,000 but
demand curve. will if their income is $64,000. In Figure
buy 1,000 units 2.2, D, is the demand
decrease in damand the demand curve after
curve associated with an income level of S60,000, and D, is
income rises to $64,000. Since the increase in income caused quantity demanded
A change in the demand
to increase at every price, the demand curve shifts to the right from D, to D, in
function that causes a
decrease in quantity figure 2.2. Everywhere along D, quantity demanded is greater than along D, for
demanded at every price equal prices. This change in the demand function is called an increase in demand.
and is reflected by a A decrease in demand occurs when a change in one or more of the variables
leftward shift in the
demand curve. M, PR 9, P or N causes the quantity demanded to decrease at every price and
the demand curve shifts to the left. Column 4 in Table 2.3 illustrates a decrease in
determinants of demand caused by income falling to $52,000. At every price, quantity demanded
demand
Variables that change in column 4 is less than quantity demanded when income is oreither $60,000
the quantity demanded $64,000 (columns 2 and 3, respective in Table 2.3). The demand curve in
at each price and that Figure 2.2 when income is $52,000 is D, which lies to the left of D, and D
determine where the While we have illustrated shifts in demand caused by changes in income, a
demand curve is located:
M, Pp 3, P and N. change in any one of the five variables that are held constant when deriving a
demand function will cause a shift in demand. These five variables-M, P , Pp
change in demand and N-are called the determinants of demand because they determine where the
A shift in demand, either demand curve is located. A change in demand occurs when one or more of the
leftward or rightward, that
determinants of demand change. Think ofM, P T, P and Nas the five "demand
ocCurs only when one of
the five determinants of shifting" variables. The demand curve shifts to a new location only when one or
demand changes. more of these demand-shifting variables changes.
63
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.APTE Temanvt, Sroeplv,anut Market Euilibrium
Relation A i ih deroewt n a thar, at

eaxh price, more i4 deriande0,
nT , 81 tth prte, less is tertoardhed ter and tharnget, Or shifts, when one ofthedeterina
TrN r taste,
Chaes. ihiese deterrrinants of denarvi are incorne,
prices of relaterd ods, no
EKpetted fusture prnce, anvt the nntrer of conseners.
The
shifts in demand illhustrated in Figure 2.2 were derived mathematically t
the general demand function. Recall that the demand function D, ", *
10P) was derived fromn the general demand function
O, 3,200 10P+ 0.05M- 24P,

wnere income and the price of a related good were held constant at values or
M $60,000 and P, S200. When income increases from $60,000 to $64,000, the
hew demand cquation at this higher income is found by substituting M $64,D
1nto the
=
general demand function and solving for the new denand functio
D:,-3,200 10P + (0.05 x 64,000) - 4,800
1,600 - 10P
ln
Figure 2.2, this demand function is shown by the demand curve D. Atev
Price, quantity demanded increases by 200units(1,600 = 1,400 + 200). Each of the
guantitiesin column 3 of Table 2.2 was calculated from the new demand equation
O00 10P. As you can se, every quantity in column 3is 200 units larger
than the corresponding quantity in column 2. Thus the increase in income nas
caused an increase in demand.
When income falls from $60,000 to $52,000, demand shifts from D, to D We
eave the derivation of the demand function for D, as an exercise. The procedure
however, is identical to the process set forth above.
From the preceding discussion,
you may have noticed that the direction
in which demand shifts when one of the five demand determinants changes
depends on the
sigrn of the slope parameter on that variable in the general
demand function. The increase in income caused quantity demanded to rise
for all prices because AQ/AM (= +0.05) is positive, which indicates that a
$I increase in income causes a
0.05-unit increase in quantity demanded at every
price level. Since income increased
by $4,000 in this example, quantity de
manded increases
by 200 units (=4,000 x 0.05). Thus when the parameter slope
on M is
positive in the general
demand function, an increase in income causes
an increase in demand.
As explained earlier, when income and quantity
demanded are positively related in the
general demand function,
normal good. If the parameter on M is negative, an increase
the good 1s a
in income causes
Now try Technical
a decrease in demand, and the good is an inferior good.3 Table 2.4 summarizes
Problems 4-6. for all five determinants of demand the
relations between the of the signs slope
It is only correct to speak of a change in income affecting
the quantity
general demand function. Once income has been held constant
demanded when
referring to
to derive a direct demand functiorn,
a
change in income causes a change in demand (a shift in the demand
demanded. The same distinction holds for the curve), not a change in quantity
other determinants of denmand
Pg, 9, Pg and N.
Find more al
52 CHAPTER 2 Demand, Supply,and Market Equilibrium
TABLE 2.4 Demand Demand Sign of slope

parameter
Summary of Demand Determinants of demand increases decreases
Shifts
Income (M
Mfalls C>0
Normal good Mrises
M falls Mrises c<0
Inferior gootd
2. Price of related good IP
P falls d>0
Substituto good Prises d<0
Complement good P. falls Prises
Itises falls >0
Consumer tastes (9)
P talls f>0
4. Expected price (P) P rises
Number of consumers (N Nrises Nfalls g>0
Demand incteases when the domand cuve shifts rightward.

Demand decreases when the domand curve shifts leltward.
demand function.
h s column gives the sign of the corresponding slope purameter in tha general
shift when each one of

parameters and the directions in which demand
curves
the determinants changes.

AS you may also have noticed from the previous
discussion, as shown in
shifts
to one another. These parallel
Figure 2.2, our demand curves shift parallel decision to illustrate demand curves
in demand are
strictly the result of our
using linear general demand functions. In the next section,the you will also see linear
In real-world, demand
Supply curves, which result in parallel shifts supply.
in
are seldom parallel.
linear and shifts
and supply curves are seldom perfectly the easiest way to learn the
Nonetheless, linear curves and parallel shifts provide
real-world curves can
basics of demand and supply analysis. And, in many cases,
that if
be closely approximated by linear functions. We must warn you, however,
that are not parallel, the new demand
you draw demand shifts (or supply shifts)
curve (or supply curve) must not cross the original demand curve (or supply
constructed D, to
Curve). To see why, suppose in Figure 2.2 we had mistakenly
at prices above
cross
D from above at $100-this is not shown in the figure-then
demand would have
$100 demand would have increased and at prices below $100
demand or
decreased. Obviously, this would not represent either an increase in
a decrease in demand because quantity demanded must either be larger at every
price or smailer at every price, respectively.
2.2 SUPPLY
The amount of a good or service offered for sale in a market during a given
quantity supplied period of time (e-g, a week, a month) is called quantity supplied, which we
The amount of a good or will denote as Q. The amount of a good or service offered for sale depends
service offered for sale on an extremely large number of variables. As in the case of demand, econo-
during a given period of
mists ignore all the relatively unimportant variables in order to concentrate on
time (week, month, etc.). those variables that have the greatest effect on quantity supplied. In general,
65
Find more al
HAPTER 2 Demand,Stupply,and Market Equilibrium 53
Cconomists assume that the
major varinbles: quantity of a good offered for sale depends on six
The price of the
2. The
good itself.
prices of the inputs used to
prices of goods related in produce
3. The the good.
4. The level of available production.
The technology.
expectations of the producers concerning ihe future
One price of the goa
number of firms or the amount of productive capacitý in the industry:
general supply The General
function Supply Function: 0, =
flR P, P, T P,F
The relation between The general supply function shows how all six of these variables jointly deterrmine
quantity supplied and the
quantity supplied. The general supply function is
the six factors
that jointly
affect quantity supplied:
expressed mathemaieay as
a,- fP, P,P. T P. F). , SUP, P, P, T, P, F)
The quantity of a good or service offered for sale
the
price of the good or service (P) but also by the(Q.)prices
is determined not only
of the
oy
production (P), the prices of goods that are related in production inputs used nt
technology (T), the expectations of producers concerning (P),
available the level O
of the the future p
good (P), and the number of firms or amount of
industry (F). productive capacity t ud
Now we consider how

each of the six variables is related to the
a
good or service firms produce. We begin by quantity o
in the price of a good while discussing the effect of a cnarg
holding the other five variables constant.
the
higher the price of the product, the Typically
produce and sell, all other things being greater the quantity firms wiSh to
equal. Conversely, the lower the

quantity firms will wish to produce and sell. Producersprice
the smaller the
motivated by higher prices to produce and sell more, while lower prices are
to discourage production. Thus price and tend
directly related. quantity supplied are, in general,
An increase in the
price of one or more of the inputs used to produce
product will obviously increase the cost of tne
becomes less production. If the cost rises, the good
profitable and producers will want to
Conversely, decrease in the price of onesupply
substitutes in each price.
a
smaller quarntity at
a
production to or more of the

inputs usea
Goods for which an produce the product will decrease the cost of
increase in the price of good becomes more profitable and production. When cost falls, the
one good relative to the at each producers will want to
price. Therefore, an increase in the price of an supply larger
a amount
price of another good in
production, while decrease in the price of an
a
input causes a decrease
causes producers to
production. input causes an increase inn
increase production of the
now higher priced good Changes in the prices of goods that are related in
and decrease production
ers in either one of
two ways, production may affect produc-
of the other good. complements in production. Two
depending on whether the
goods are substitutes or "
if an increase in the goods, X and Y, are substitutes in production

price of good X relative to good Y causes
producers to increase
b4
CHAPTER 2 Demand, Supply, and Market Equilibrium
production of good X and decrease production of good Y. For example, if the price
of corn increases while the price of wheat remains the same, some farmers may
change from growing wheat to growing corn, less
and wheatwill be supplied.
In
the case of manufactured goods, firms can switch resources from the production
complements in
of one good to the production commodity when the
of a substitute (in production)
price of the substitute rises. Alternatively, two goods, X and Y, are complements
production in production if an increase in the price of good X causes producers to supply
Goods for which an
increase in the price of more of good Y. For example, crude oil and natural gas often occur in the same oil
one good, relative to the field, making natural gas a by-product of producing crude oil, or vice versa. If the
price of another good, price of crude oil rises, petroleum firms produce more oil, so the output of natural
causes producers to
increase production of gas also increases. Other examples of complements in production include nickel
both goods. and copper (which occur in the same deposit), beef and leather hides, and bacon
and pork chops.
technology Next, we consider changes in the level of available technology. Technology is
The state of
knowledge the state of knowledge concerning how to combine resources to produce
concerning the
and services. An improvement in technology generally results in one or more of
goods
Combination of resources
to produce goods and the inputs used in making the good to be more productive. As we will show you
services. in Chapters 8 and 9, increased productivity allows firms to make more of a good
or service with the same amount of inputs or the same output with fewer inputs.
In either case, the cost of producing a given level of output falls when firms use
better technology, which would lower the costs of production, increase profit, and
increase the supply of the good to the market, all other things remaining the same.
A firm's decision about its level of production depends not onlyon the current
of
about the
price of the good but also upon the firm's expectation future price
in the
the good. If firms expect theprice of a good they produce to
rise future
they may withhold some of the good, thereby reducing supply of the good in the
current period.
Finally, if the number of firms in the industry increases or if the productive
Capacity of existing firms increases, more of the good or service will be supplied
at each price. For example, the supply of air travel between New York and Hong
Kong increases when either more airlines begin servicing this route or when the
firms currently servicing the route increase their capacities to fily passengers by
adding more jets to service their New York-Hong Kong route. Conversely, a de-
crease in the number of firms in the industry or a decrease in the
productive capac-
ity of existing firms decreases the supply of the good, all other things remaining
constant. As another example, suppose a freeze in Florida decreases the number of
firms by destroying entirely some citrus growers. Alternatively, it might leave the
number of growers unchanged but decrease productive capacity by killing a por-
tion of each grower's trees. In either situation, the supply of fruit decreases. Thus
changes in the number of firms in the industry or changes in the amount of produc-
tive capacity in the industry are represented in the supply function by changes in F.
As in the case of demand, economists often find it useful to express the general
supply function in linear functional form
h + kP + IP, + mP, + nT + rP, + sF
67
Find more at
55
APTER2 Demand, Supply,and Market Equiibriurm
where 2, P, P, P, T, P, and F are as defined earlier, h is an ter,
n,,
intercp csion
n, r, and s are slope parameters. Table 2.5 summarizes this discusst
egeneral suppiy function. Each of the six factors that affect production
sTClong with the'elation to quantity supplied (direct or inverse). Let is o
stress that, just as in the case of demand, these relations are in
tne
other things being equal.
Direct Supply Functions: Q, =
f{P)
direct
Just as demand functions derived from the general demand functiony u
are
direct supply function
A table, a graph, or an
supply functions are derived from the general supply function. A direct suP
and
equation that shows funetion (also called simply "supply") shows the relation between ,a
how quantity supplied is holding the determinants of supply (P, P, T, P, and F) constant:
related to product price,
holding constant the five Q, P,P, P, T,P, F) =SP)
other variables that where the bar means the determinants of supply are held constant at so
influ
ence supply: 0, fP
=
Specified value. Once a direct supply function Q. = {(P) is derived from a geneta
supply furnction, a change in quantity supplied can be caused only by a cnarg
determinants of
supply in price.
Variables that cause a
change in supply (i.e., a Relation A direct suppiyfunction expresses quantity supplied as a function of productprieef n t
shift in the supply curve). the effects o inpue
SUpply functions give the quantity supplied for various prices, holding constant
change quantity
and the
prces, pricesofgoods related in production, the state of technology, expected price, all the number or
holding variables in
supplied ne inousty. Suppiy functions are derived from geheral supply functions by
A movement alonga general supply function constantexceptprice
AARRAAERE.SBH
given supply curve that
occurs when the price of 1o illustrate the derivation of a supply function from the general supply func
a good changes, all else tion, suppose the general supply function is
constant.
Q, 100 +20P 10P, +20F
or
Technology, the prices of goods related in production, and the expected price
the product in the future have been omitted to simplify this illustration. supPPOSe
25 firms in tne
the price of an important input is $100, and there are currently
TABLE 2.5 Relation to Sign of

of the General Variablequantity supplied slope parameter
Summary k= A0/AP is positive
(Linear) Supply Function P Direct
h + kP+ IP,+ Inverse = Q/AP is negative
mP,+ nT+ rP. + sF Inverse for substitutes in m A0/AP, is negative
production (wheat and corn)
Direct for complements in production m=A0/AP, is positive
(oil and gas)
Direct n= AQ/ATis positive
r AQ/AP, is negative
Inverse
Direct s= A0/AFis positive
56 CHAPTER 2
industry producing the product. To find the supply function, the fixed values ofP
and F are substituted into the general supply function
Q 100 + 20P- 10($100) + 20(25)
400 + 20P
Thelinear supply function gives the quantity supplied for various product prices,
holding constant the other variables that affect supply. For example, if the price of
the product is $40,
Q -400 + 20($40) =400
or if the price is $100,
Q , = 4 0 0 + 20($100) = 1,600
supply schedule A supply schedule (or table) shows a list of several prices and the quantity sup-
A table showing a list of
possible product prices plied at each of the prices, again holding all variables other than price constant.
of
and the corresponding Table 2.6 shows seven prices and their corresponding quantities supplied.
from
Each
seven price-quantity-supplied combinations is derived, as shown
quantities supplied. the
the supply equation Q. = -400 +20P, which was derived from the general sup-
earlier,
supply curve ply function by setting P, = $100 and F 25. Figure 2.3 graphs the supply curve
A graph showing the
relation between quantity associated with this supply equation and supply schedule.
supplied and price,
when all other variables Inverse Supply Functions: P fla)
influencing quantity
supplied are held constant. Notice in Figure 2.3 that price is shown on the vertical axis and quantity on the
horizontal axis as with demand curves. Thus the equation plotted in the figure is the
supply function: P 20 +
=
inverse supply inverse of the
supply equation and is called the inverse
function 1/200. The slope of this inverse supply equation graphed in Figure 2.3 is APA
The supply function which equals 1/20 and is the reciprocal of the slope parameter k (= AQ/AP = 20).
when price is expressed

as a function of quantity
As your intuition tells you, producers usually quit producing price falIs if
below some minimum level. You can think of $20 in Figure 2.3 as the lowest
supplied: P= f{Q).
price for which production will occur. Mathematically speaking, w e might say
the supply equation describes supply only over the range of prices $20 or greater
(P $20). We will show in later chapters how to find the price level below
which
production ceases.
TABLE, 2.6 Price Quantity supplied

The Supply Schedule for $140 2,400
the Supply Function S 120 2,000

Q, = -400 + 20P
I00 1,600
80 1,200
50 800
4U 400
20 0
69
7
Equil1brium
Demand,Supply,and
Market
CHAPTE R 2
140, 2,4O 9
FIGURE 2.3
A Supply Curve 140
a,-400 4 20P
$120, 2,000
120
$100, 1,60o
100
$80, 1,200
80
$60, 800
60
$40, 400z
40
20$20,0
2,000 2,400
400 800 1,200 1,600
Quantily supplied (0
on a supplIy cur
and quantity supplied
Any particular combination of price the supPPY si
ways. A point
on
can be interpreted in either of two equivalent
De
service that will
a m o u n t of a good
or
indicates either (1) the maximum to

inauce
ule or (2) the
minimum price necessary
offered for sale at a specific price minimum price is s o metimes
for sale. This
producers to offer a given quantity
referred to as the supply price for that
level of output.
supply price
once a direct supply
equation, 2, =JE),
The minimum pricee in the case of a demand function, can De
AS a change
in quantity supplied
necessary to induce general supply function,
supplied represents a
1s d e r i v e d from a
producers to offer a given
caused only by a change
in price. A change in quantity in Figure Z..3.
quantity for sale. curve. Consider
the supply curve S, to
a given supply rom 400
movement along increases
rises from $40 to $60, the quantity supplied
t product price
the supply curve o
800 units, a movement from point R to point S along
ihe
a change in quantity supplied.
AP change in price causes
Relation For a supply function Q = fixed in value 1or any
a
affect supply jin the general-supply function PP T.P Aare

Other five variables that causes.a movement along a supply curvetrem one
a change in price
partucular SUpply function Ona graph,
price to anotner prces
Now try Technical
Problems 7-8. Shifts in Supply
demanded because ofa change
As differentiate between a change in quantity determinants
one of the
we
demand because of a change in
in price and a shift in A shift in sup-
distinction with supply.
make the same )
of demand, w e must of supply (P, P, T, P
occurs only when one of
the five determinants
ply
70
58
CHAPTER2 Demand, Supply, and Market Pquilbrium
changes value. An increasc in the nunber of firms in the industry, for exam-
increaso in supply ple, causes the quantity supplied to increase at every price so that the supply
curve shifts to t
A
change in the supply right, and this circumstance is called an increase in supply.
function that couses A decrease in the number of firms in the
an increase in
industry causes a decrease in
quantity supply, and the supply curve shifts to the left. We can illustrate shifts in supply
supplied al every price, by examining the effect on the supply function of changes in the values of the de-
and is reflected by a terminants of supply.
rightward shift in the
supply curve. Tablefalls2.6to is$60,reproduced
input the
in columns 1 and 2 of Table 2.7. If the price of the
decrease in supply
new
supply function is Q, and the
=
20P, quantity supplied
A dhange in the inreases at cach and every price, as shown in column 3. This new supply curve
supply price of the falls to $60 is shown as S, in Figure 2.4 and lies to the
function that causesa
decrease in quantity
when the input
right of S, at every price. Thus the decrease in P, causes the supply curve to shift
supplied at every price, rightward, illustrating an inciease in supply. To illustrate a decrease in supply,
and is reflected by a Suppose the price of the input remains at $100 but the number of firms in the
leftward shift in the supply industry decreases to 10 firms. The supply function is now Q, = -700 + 20P, and
curve.
quantity supplied decreases at every price, as shown in column 4. The new supply
TABLE 2.7 (1)

****
Three Supply Schedules 2) (3) 4S: Q,=-700 + 20P

S: 0,= -400 + 20P S: Q 20P
Price
Quantity supplied Quantity supplied Quantity supplied
P= $100, F= 25) (P= $60, F= 25) P $100, F= 10)
$140 2,400 2,800 ,100
120 2,000 2,400 1,700
100 1600 2,000 1,300
80 1,200 1,600 900
60 800 1,200 500
40 400 800 100
20 0 400
FIGURE 2.4
Supply
Shifts in Supply 120 decrease
100
$80, 900
80 $80, 1,200
*****
60
wwwwaaew
40
40, 400. $40, 800
20 * *
-Supply
increase
200 400 600 800 1,000 1,200
Quantity supplied (Q)
Find more at 59
Market
FEeuiibrium
CHAPTER2 Domand, upply,and
Sign of siope
supply Supply parameter
TABLE 2.8 decreases"

inrease
Determinhnts of supply
Summary of Supply
Shifts 1.Prn of inputs(P)
m
7. Prite of goxuds related in prexha.titm t) Pfalis Prise m9

Susstinuto gfd
Prises PMalls n>0
Comyplement qond talls
Trises
3.Stnte of tothnology (7) 0
falls Prise 0
4.Lxpetted prite (P) Ffalls
5. Number ol firms or prothuttive capatity in industry{) Frises
"Supply incr0ases when the supply turve shifts rightvward

curve shifts leftward.
'Supply decreases when the supply function.
parameter in the general supply
his colurnn gives the sign of the corresponding slope
u
Thus the decrease in

2.4, lies to the left of S, at every price.
S,, a lettwar
curve igure c a u s e s a decrcase in supply, which is represented by
in
number
firms
of F the five "supply
think of P, P, T, P, and
as
in the supply curve. You can shifts in suppiy
shift variables. Table 2.8 summarizes
this discussion of
shifting"
more of the good is supplied;
decrease a
increase in
supply means that, at cach price,
of the dereni
Kelation An less is supplied. Supply changes (or
shifts) when one
Supply means that, at each price, the price of go0ds

related inpu
of supply are the price of inputs,
changes. These determinants the amount
OT SUppiy state technology, the expected price in the future, and the number of firns or
Ouction,the of
Now try Technical productive capacity in the industry
Problems 9-11.
ILLUSTRATION 2.2
Changesin Input Prices (P

Effects of Changes in Determinants of SuPply
U.S. candy makers are cutting productiorn eyels
Inthis llustration, we present more examples their domestic plants, causing adecrease or leftwara
that are
of changes in supply-shifting variablesreal-world shift in the supply of candy manufactured in tn
taken'trom a number of recent events in The cause of the decrease in the U.s
States.
markets. These examples further reinforce our United federal gov-
theoretical discussion about how shifts in the sup- candy supply can be directly attributed to designed to
ply curve are caused by changes in the five suPply rnment pricesupports for sugar:that are
determinan ts: input prices, technolog8Y Prices of keep sugar prices artificially
high inthe United tates
to protect American sugar growers proits. Eongre
800ds related in supply, producers expectations cane'sugar growers reP
about future prices, and the number of firms or pro sional protection of beet and example of an interest
ductive capacity in the industry. Always remember resents a particularly egregious
toshift the supply curve horizontally (not vertically)group receiving valuable.benefits from goveinment
general public. By
either leftward for a decrease in supply or rightward regulation atthe expense of theUnited
Propping up sugar prices in the States about
foranincrease in supply unregulated price of sugar
14percent higher than the
*****
(Continued)
72
Find more at www.downloacdslide.com
anthe world markets-fcderal government policy sig don't eat more soybeans when the price of corn goes
c a n y increases the price of a key input for candy up, as they would if soybeans and corn were indeed
makers. AS predicted by economic theory, the higher substit: tes in consumption.
sugar (injput) price is reducing the amount of candy
in (T)
plants located in the Changes Technology
United States A octuring
surprisingly, U.S. companies Improvements in available technology make
t at
nroaolaa
b 7 i n g their candy manufacturing by open- least one of the inputs more productive, and this
ingnew produclion plants worldwide, specifhcally in boost in productivity increases supply by shifting
h e r e sugar can be purchased at the lower supply rightward. One of the most promising new
R the unregulated global sugar market. As we technologies for the 21st century is additive manufac:
o u r Chapter 1 discussion of globalizntion, turing (AM) if you're an engineer, or3D printing if
ePrimary advantages that globalization of you're not an engincer. Additive manufacturing starts
CTS Dtters to managers is the opportunity to rewith a computer-aidcddesign (CAD) file that contains
duce production costs
by purchasing raw materi three-dimensional engineering design information
o t h e r countries. In this case, managers of for a dosired component.Using the CAD ile, an AM
Caray irms must move their entire production fa machineconstructsaPhysicalreplicaof the component
clity, into a foreign country toget the lower sugar by depositing and bonding successive layers of raw
prices available outside the regulatory authority of materialypically sand, plastic, metal, or glasso
Congress. According to Erick Atkinson, the president create a fully functional and durable component. AM
of Jelly Bean Candy Co, "it's a damn shame"because technology has many thousands of applications in
thereare now 60 jobs in Thailand that had previously manufacturing and offers tremendous producvity
been located in Lufkin, 8ains in producing parts for everything from
aero-
Texas.
space aircraft, automobiles, to industrial eguipment,
Changes in the Price of Goods Related in
Production (P) medical devices, and toy manufacturing. VWe expect
thatsupply.curvesfor many goods will shift rightward
When two goods are related in production the two as thisnew AM technology becomeswidely applied
goods are produced using some of the same important
EXPectationsofProducers-(P
srces decrease in the price of one good canChanges in Price
Cause the supply of the other good to shifteither right-For any particular price, the amount of output
ward or leftward, depending on whetherthe two goods producers are willing to supply today depends not only
are related in production as substitutes (rightward on the current price of the g0od, but Current supPY
shift or complements (leftward shift). A recent ex also depends on the price producers expect in the
ample otsubstitutes in production follows from the in- future For example, when events occurring in the
creasein soybean siupply caused by the falling price of current time period cause an increase in what sellers
corn. When the demand for the gasoline additive.calledbelieve will be the future price of their good, then
ethanol.dropped.sharply(ethanol is made from com), sellers will have an incentive to move some of their
the price of con fell sharply as less corn was needed supply from the current time period to the future time
tor ethanol production. Facing lower corn prices, Mid-period Turkey, which supplies more than 70 percent
west farmers planted less comand more of othercrops, of the world's hazelnuts, experienced an unexpected
especialy more soybeans Thus, a fall in com prices frost in 2014 The frost killed nearly 30 percent of
caused an increase in the supply ofsoybeans because uTkey s crop of hazelnuts,
causing hazelnutprices to
ether corn or soybeans can be grown on farmland in double immediately as thecurrent supply of hazelnuts
theMidwest using mostly the same kind of farming fell dramaticaly The decrease in the 2014 supply was
eguipment and labor resources. We should stress herereported to be especially severe because, unlike less
that comandsoybeans are not demand-side substitutes, severefrosts in other years, the 2014
frost harmed future
butrather supply side substitutes because consumers hazelnut crops by disrupting the winterpollination of
73
Find more at
61
CHAPTER emand, Supply, and Market Euilibrium
hazelnut flowes A A Comeequene,

s
wd widrinchuding farmers wlhoiazelnut farm- Ocean, This lobater
population boomthecau nifi
damage nt all changed their had no fro cant inC rease or
rightward shift in afsb
rice of hazelnuls in 2015. expectntions about the sters as lobater catchers supetor in
o be much They now
expected prices their In
began tirdiing umber of
higls* in 2015. 1his upward revision traps. other words, W1
Tarmers belels nbout 2015 in lobster catchers and lobster r
pots (i.e, lo0st traps),
the
CTs to hold in prices caused many farm-grcwing population of lobsters caused a a4ein
inventory some hazelnists that would
otherwise have been sold in 2014. the pronductive capacity of the heing
This upward tevi existingres
sion in
expected price pushed cutrent hazelnut stupply employed
even further to the lefl
in the lobster jndustry,
in 2014. The current decrease
hazelnut supply in These illusttations should reinforce your under
Tess severe if
brought by the frost would have been slanding of the underlying determinants of supply
farmers had not revised
forecasts aboul fulure hazelnut upward their the examples in Illustration 2.1 dia
as
0
mand.
tfaor
prices. you learn
sdoing in this
chapter, the essentíal skill for
Changes in Nunmber of lirms or Amount of demand and supply analysis of real-world
the
Productive Capacity (FD markets is the ability to identify, correctly all of
demand- and supply-shifters that are
Anything that changes either the number of firms underlying

inworking to cause market prices and quantie to
an
industry or the capacity of those firms to produce move higher or lower
the good or service will cause the supply curve to
shilt i n response. Mother Nature is frequently the Alexandra Wexler, "Chraper Sugar SendsCandy akers
cause of changes in the supply of goods and services.

Abroad, The Wall Stret fournal, October 21, 2013, p. AB
Stir
Unseasonably warm winter weather recently created Huileng Tan and Alexandra Wexler, "Hazelnuts
a srge n the number of large lobsters in the Atlantic Trouble in the Land of Sweets," The Wall Street jo1urnl
December 5, 2014, p. B1.
2.3 MARKET EQUILIBRIUM

of the be
framework for the analysis
Demand and supply provide an analytical to
Demand shows how buyers respond
havior of buyers and sellers in markets. are wiling
that determine quantities buyers
changes in price and other variables in price and
shows how sellers respond to changes
and able to purchase. Supply
interaction of buyers
other variables that determine quantities
offered for sale. The
Market equilibrium
market equilibrium and sellers in the marketplace
leads to market equilibrium.
c o n s u m e r s can buy
all of a go0od they
Is a situation in which, at the prevailing price,
A situation in which,
other words, equilibrium
at the prevailing Wish and producers can sell all
of the good they wish. In
consumers can buy all demanded equals quantity sup-
Occurs when price is at a
level for which quantity sold is
of a good they wish and and the quantity
In equilibrium,the price is called equilibrium price
producers can sell all of plied.
the good they wish. The called equilibrium quantity. we can use
the demand and
price at which Q, = 0 ,
To illustrate how market equilibrium is achieved, shows both the
de-
sections. Table 2.9
equilibrium price schedules set forth in the preceding schedule for , \8iver
Supply and the supply
he price
a Wn a, mand schedule for D. (given in Table 2.2) in the market occurs when price is
table shows, equilibrium to 800 units.
equilibrium quantity in Table 2.6). As the supplied are equal demanded.
The amount of a good demanded and quantity
$60 and bóth quantity than quantity
bought and sold in above $60, quantity supplied is greater
At every price
market equilibrium.
74
62
CHAPTER 2
TABLE 2.9
Market Equilibrium (1) (2) (3) 4)
Excess supply (+) or
Ouentity supplied Quantity demandedexcess demand (-)
Price
$140
a, -400+ 20P
2,400
a 1,400 10P
0,-Og
+2,400
120 2,000 200 +1,800
100 1,600 400 +1,200
30 1,200 600 +600
60 800 B00
40 400 1,000 -600
20 0 1,200 -1,200
excess supply
(surplus) Excess supply or a surplus exists when the quantity supplied exceeds the quantity
Exists when quantity demanded. The first four entries in column 4 of Table 2.9 show the excess supply
supplied exceeds At every price below $60, quantity supplied is
quantity demanded. or surplus each
at
price above $60. in which quantity demanded exceeds
excess demand
ess than demanded.
quantity is
called
A situation
(shortage)
guantity4suppliedtable excess demand or a shortage. The last two entries in
Exists when quantity column of the show the excess demand or shortage at each price below
the $60 equilibrium price. Excess demand and excess supply equal zero only
demanded exceeds in equilibrium. In equilibrium the market "clears" in the sense that buyers can
quantity supplied.
purchase all they want and sellers can sell all they want at the equilibrium price.
market clearing price Because of this ciearing of the market, equilibrium price is sometimes called the
market clearing price.
The price of a good
at which buyers can Before moving on to a graphical analysis of equilibrium, we want to reinforce
purchase all they want the concepts illustrated in Table 2.9 by using the demand and supply functions
and sellers can sell al from whiçch the table was derived. To this end, recall that the demand equation is
they want at that price. 1 , 4 0 0 - 10P and the supply equation is Q, = -400 + 20P. Since equilibrium
This is another name for requires that Q, =2, in equilibrium,
the equilibrium price.
1,400 1 0 P = -400 + 20P
Solving this equation for equilibrium price,
1,800 30P
P $60
At the market clearing price of $60,
Q 1,400 10(60) = 800
Q=-400 +20(60) 800
As these mathematicaly derived results are identical to those presented

expected,
in Table 2.9.
75
63
Find more at Market

Equilibrium
and
Supply,
CHAPTER 2 Demand, Using
units.
surplus
of 600
i
there is a
when price is $80,
According to Table 2.9, when P
=
80,
the demand and supply equations,
10(80) = 600
1,400 =1,200
Q,= -400 +20(80)
Therefore, when price is $80,

,-,
1,200 600 = 600
4. the demarnd
shown in column 2.5 shows
which is the result graphically, Figure Table 2.9. 1ne
solution in 2.3
the equilibrium the schedules
express associated with
o 2.1 artu
c u r v e S, in Figures A in
and the supply shown
curve D the demand and supply c u r v e s previously and quarntity at p o n . iea
are aiso price
and 800 units are
the equilibrium
d e m a n d e d equal
quantity supp
Clearly, $60 of $60 does quantity producers wai
at a price is $80,
igure 2.5. Only will drive price toward $60. If price units. An excess suPply
Market forces only
demand 600
from accu
1,200 units while in order to keep
consumers
ana
Supply Producers must lower price
e x c e s s supply
results,
units develops. $60,
o00 above
inventories. At any price
dtung unWanted units, W
producers will lower price. 1,000

and able to purchase
$40,
are willing
demand of
600 units result
ltprice isoffer
consumers
sale. An e x c e s s
only 400 units for Any Price
producers bid the price up. to Dia P
notsatisfied,
consumers
consumers
Since their demands
are
induces
e x c e s s demand,
and the shortage
leads to an
ow $oU bid up o r
down,
the price. from being
prevent price
1
that
GIven n o outside influences
attained. This
equilibrium price
are
an equilibrium price and quantity
FIGURE 2.5
Market Equilibrium 140

120
100
So
80F
60
40
Do
20
L- 1,200
0 200 400 600 800 1,000
Quantitly (y and O
64
CHAPTER 2
Demand, Supply, and Market quilibrium
the price that clears the market; both excess demand and excess
7ero in
supply are
cquilibrium. Equilibrium is attained in the market because of the
following:
Principle The equilibrium price is that price at which quantity demanded is equal to quantity Jupplied.
When the current price is above the equilibrium price, quantity supplied exceeds quantity demanded. The
resulting oxcess supply induces sellers to reduce price in order to sell the surplus. If the current price is
below equilibrium, quantity demanded exoeeds quantity supplied, The resulting exCess demand causes the
unsatisfied consumars to bid up price. Since prices below equilibrium are bid up by tonisumers and prices
abbve equlibrium are towerad by producers, the markot will convergeto the equilibrium price-quantity
Combination.
lt is
you to understand that in the analysis of demand and supply
crucial for
there will never be either a permanent shortage or a permanent surplus as long as
Price is allowed to adjust freely to the equilibrium level. In other words, assuming
that market price
adjusts quickly to the equilibrium level, surpluses or sliortages
do not occur in free markets. In the absencè of impediments to the adjustment
ot prices (such as government-imposed price ceilings or floors), the market is
always assumed to clear. This assumption greatly simplifies demand and supply
analysis. Indeed, how many instances of surpluses or shortages have you seen in
markets where prices can adjust freely? The duration of any surplus or shortage
Now try Technical is generally short enough that we can reasonably ignore the adjustment period for
Problems 12-13.
purposes of demand and supply analysis.
2.4 MEASURING THE VALUE OF MARKET EXCHANGE

Now that we have explained why market equilibrium occurs at the intersection of
demand and supply curves, we can use demand and supply curves to measure the
net gain created by voluntary exchange between the buyers and sellers in
markets.
:
Markets arise because buyers and sellers find it mutually beneficial to meet for the
purpose of voluntary exchange: buyers bring money to market to exchange tor
the commodities that sellers bring to market to trade for money. In free-market
exchange between buyers and sellers, no government agency or labor union forces
consumers to pay for the goods they want or coerces producers to sell their goods.
Throughout time, in societies everywhere, markets have formed for the mutual
benefit of consumers and producers. Indeed, history has recorded that even
"primitive" warring tribes regularly scheduled days of peace for the sole purpose
of allowing voluntary exchange between combatants. Ina more contemporary
example of the value of markets, you may have read in the newspaper that your
local NFL football team has raised the price of season tickets to $1,200, causing
many fans to complain about "high" ticket prices. Then, with their next breath,
many of these same fans rushed to the box office and purchased season tickets
These fans voluntarily traded $1,200 for a season ticket, and the team owner vol-
untarily sold them a seat for the season. In spite of the complaining, both the
ticket-buying fans and the ticket-selling team owner mutually benefited from the
exchange, otherwise these tickets would notthave been bought or sold! Clearly,
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CAPTER2 Demand, supply, arnd Market Equili
he market for NFT ootball tickets creates value for those

oth fans and
individ uai arket."
owners-who voluntarily choo.e to participa cfor all the
Ihdeed, every market where there is
voluntary exchange create
buyers and sellers trading in that
market.
Consumer Surplus
economie value Typically, consumers value the goods they purchase by an amount that mic
purehase price of the goods. For any unit of a good or service, the econ
The maximuim amount
any buyer in the market Valne of that unit is simply the maximum amount some buyer is wilg
is willing to pay for 1he pay for the unit. For example, professional real estate agents frequentiy
unit, which is measured remind people who are selling their homes that the value of their prop s
by the demand price for only as high as some buyer in the market is willing and able to pay, r e g n t
the unit of the
good. of how much the current owner paid for the home or how much hat
sprucing up the home. Recall that earlier in this chapter we explairn and
e a n d prices-the
prices associated with various quantities along the denia
Curve-gIve the maximum price for which each unit can be sold. Thus the ec
nomic value of a specific unit of a
good or service equals the
unit,because this price is the maxímum amount any buyer is willing and a
demand price 1o
pay for the unit:
Economic value of a particular unit = Demand price for the unit

Maximum amount buyers are willing to pay
Fortunately for consumers, they almost never have to pay the maxim
amount they are willing to pay. They instead must pay the market priCe,
is lower than the maximum amount consumers are willing to pay (excep
the last unit sold in market equilibrium). The difference between the econor
value of a good and the price of the good is the net gain to the consumer, anta
consumer surplus this difference is called consumer surplus. To illustrate this concept nume
The difference between cally, suppose you would be willing to pay as much as $2,000 for a 40-yard-ne
the economic value of a
good (its demand price
NFL season ticket rather than stay at home and watch the game on your nign
and the market price the definition television. By purchasing a season ticket at the price of $1,200, you enio
consumer must pay. a net gairn or consumer surplus equal to $800. In this way, consumer surplus ror
of the
each season ticket sold is measured by the difference between the value for
ticket-measured by the ticket's demand price-and the market price paid
season tickets.
Figure 2.6 illustrates how to measure consumer surplus for the 400th unit or a
good using the demand and supply curves developed previously. Recall from out
discussion about inverse demand functions that the demand price for 400 units,
which is $100 in Figure 2:6, gives the maximum price for which a total of 400 units
As you probably know, prices of NFL season tickets are not determined by the market forces
of demand and supply. NFL ticket prices are instead set by individual price-setting team owners
.e, they pOssess some degree of market power). Even though this chapter focuses on price-taking
firms, the concepts of consumer, producer, and social surplus developed in this section can be
applied to markets in which firms are either price-takers or price-setters.
Find more at
66 CHAPTER 2 Demand, Supply, and Matket Equilibrium
umusve
FIGURE 2.6
Moasuring the Value of
Market Exchange
100 .20-
100.10-
100
140
120 398 399 40o
Blow up
100
80 So
60
Do
20w
200 400 600 800 1,000
Quantily (Q and O
the demand price of $100

just mentioned,
can be sold (see point r). But, as we
the 400th unit of the good can be

also represents the maximum amount for which
who is just willing to buy
sold. Notice in the blow up at point r that the consumer
400th unit for even a penny more than
the 400th unit at $100 would not buy the
S100. It follows from this reasoning that the demand price
of $100 measures the
units. You can now see that
economic value of the 400th unit, not the value of 400
which is the
the consumer surplus for the 400th unit equals $40 (= $100 $60),
economic value) of the 400th unit and
difference between the demand price (or 400th unit is
of the
the market price (at point A). In Figure 2.6, consumer surplus
the distance between points r and s.
of the con
To measure the total consumer surplus for all 400 units -instead
distance between demand
sumer surplus for the single 400th unit-the vertical
and market price must be summed for all 400 units. Total
cornsumer surplus for
over the
400 units is equal to the area below demand and above market price
consumer surplus for 400 units is
output range 0 to 400 units. In Figure 2.6, total
measured by the area bounded by the trapezoid uvSr. One way to compute the
area of trapezoid uvsr is to multiply the length of its base (the
distance between
vand s) by the average height of its two sides (uv and rs): 400 x ($80 $40)/2)
+ =
$24,000. Of course you can also divide the trapezoid into a triangle and a rectangle,
and then you can add the two areas to get total consumer surplus. Either way, the
total consumer surplus when 400 units are purchased is $24,000.
Now let's measure total consumer surplus in market equilibrium. At point A
in Figure 2.6, 800 units are bought and sold at the market-clearing price of $60.
The area of the red-shaded triangle uvA in Figure 2.6 gives the total consumer
79
57
Find more at www.downloadslide.com Equilibrium
Market
and
CHAPTER 2 Demand,Supply,
of this triangle
is $I4,U who volun
in market equilibrium. The area c o n s u m e r s
e n t d e c i d e d
Surplus net gain to

all the
800 x $80). Thus, $32,000 measures the unit. If the goveT a n d if al
800 units from producers at $60 per this good,

ld disap-
buy
tarily of
consumption m a r k e t woou
for some reason to outlaw completely the then the rtunity too
consumers complied with the consumptior ban, losing the
oPP
consumers would be $32,000
w o r s e off by
pear, and
buy this good.
Producer Surplus
consumers*
who supply
we consider the net gain to producers receive more tharn nit
Next demand. Producers typically
80Ods
and services they their product imum
necessary to
induce them to supply tne
i.
imum payment received and
market price
the difference between the
called producer surpiu
ed when
Supplled, the unit is
would accept to supply 400th unit supPP
producer surplus Ce producers the supply
surplus for inverse s
For each unit supplied,
Figure 2.6, let's consider the producer about
o u r previous
discussion
in
the difference between market price is $60. Recall from
the 400th unit, gives the
market price and which is $40 for 400th u n i t . Ite
T u n c t i o n s that the supply price,
the minimum price to produce
and sell the
of the 400th unit is t
the suppliers
required by
producers would accept Payment
generated by the production and sale $40). 1
Producer surplus
-
which is $20 (= $60

to supply the unit
(its supply price). distance between points s and t, of eacrt o
Vertical producer surplus
for 400 units is the s u m of the below marke
producer surplus for 400 units is
the a r e a
units. Thus, total producer surplus In Figure 2.6, total Pi

+00 range 0 to 400.
and above supply over the output trapezoid vwrs, Dy
price the area of the
400 units is measured by two parallel sies
e r surplus for the average height
of the
the base us (= 400) times
lz,000
vwts is
mutiplying
can verify that
the a r e a of trapezoid
0W ($40) and st ($20), you
= 400x ($40 +$20)/2]. in market equilibrium.
At point
the total producer surplus vWA.
gray-shaded triangle
let's measure
Now the a r e a of the
x 800 X $40). By
A, total producer surplus equal to
in equilibrium is $16,000 (= 0.5
producer surplus $l6,000.
nus, total
business in this market, producers experience
a net gain of
doing
social surplus Social Surplus founa
be
The sum of consumer level of output can
to society aswhole from any specific
a
surplus and producer Ihe gain
net
surplus generated
at that
surplus, which is the total c o n s u m e r surplus and total producer
Dy adding
as social surplus.
area below demand and
specific level of output. This sum is known $48,000
above supply over the A in Figure 2.6, social surplus equals
range of output produced market equilibrium pointcan now see, the value of social surplus in equl-
At
and consumed. b52,000+ $16,000). As you to society from having
voluntary
libriuin provides a dollar measure of the gain
12 and 14, w e
between buyers and sellers in this market. In Chapters
exchange to transtorm,
used by firms with market power
will
examine pricing strategies surplus. In Chapter 16, w e
possible, consumer surplus producer
into
as
much as is maximized by letting
Now try Technical explain
Will the circumstances under which social surplus
market forces determine the prices at which market exchange takes place.
Problem 14.
20
68
CHAPTER 2 Demand, Supply, and Market Equilibrium
2.5 CHANGES IN MARKET EQuILIBRIUM
f demand and supply never changed, equilibrium price and quantity would
remain the same forever, or at least for a very long time, and market analysis
would be extremely uninteresting and totally useless for managers. In reality, the
variables held constant when deriving demand and supply curves do change.
Consequently, demand and supply curves shift, and equilibrium price and
quantity change. Using demand and supply, managers may make either qualita-
qualitative forecast
A forecast
that predicts
only the direction in
ive forecasts or quantitative forecasts. A qualitative forecast predicts only the
direction in which an economic variable, such as price or quantity, will move. A
which an economic quantitative forecast predicts both the direction and the magnitude of the change in
variable will move. an economic variable.
quantitative forecast For instance, if you read in The Wall Street Journal that Congress is considering
A forecast that predicts
both the direction and
a
tax cut, demand and supply analysis enables you to forecast whether the price
and sales of a particular product will increase or decrease. If you forecast that
the magnitude of the
change in ar economic price will rise and sales will fall, you have made a qualitative forecast about price
variable. and quantity. Alternatively, you may have sufficient data on the exact nature of
demand and supply to be able to predict that price will rise by $1.10 and sales will
fall by 7,000 units. This is a
quantitative forecast. Obviously, a manager would get
more information from a
quantitative forecast than from a qualitative forecast. But
managers may not always have sufficient data to make quantitative forecasts. in
many instances, just being able to predict correctly whether price will rise or faii
can be
extremely valuable to a manager.
Thus an important function and challenging task for managers is predicting the
effect, especially the effect on market price, of specific changes in the variables that
determine the position of demand and supply curves. We will first discuss the pro-
cess of adjustment when something causes demand to change while supply remains
constant, then the process when supply changes while demand remains constant.
Changes in Demand (Supply Constant)

To illustrate the effects of changes in demand when supply remains constant,
we have reproduced
D, and S, in Figure 2.7. Equilibrium occurs at $60 and
800 units, shown as point A in the figure. The demand curve D, showing an in
crease in demand, and the demand curve D, showing a decrease in demand, are
reproduced from Figure 2.2. Recall that the shift from D, to D, was caused by an
increase in income. The shift from D, to D, resulted from the decrease in income.
Begin in equilibrium at point A. Now let demand increase to D, as shown. A
the original $60 price, consumers now demanda' units with the new demand.
Since firms are still willing to s u p p l y o n l y 800 units at $60, a shortage of a ' - 800
units results. As described in section 2.3, the shortage causes the price to rise to a
new equilibrium, point B, where quantity demanded equals quantity supplied. As
you can see by comparing old equilibrium point A to new equilibrium point B, the
increase in demand increases both equilibrium price and quantity.
To illustrate the effect of a decrease in demand, supply held constant, we
return to the original equilibrium at point A in the figure. Now we decrease the
Market
Equilibrium"
CHAPTER 2 Demand,Supply, and
FIGURE 2.7
Domand Shilfts (Supply 160
Constant)
140
120
00
80 **.
60
40
D1
20 o
1,400 1,600
0 200 400 600 800 1,000 1,200

Quantity (O and O)
want to suPP*
of $60, firms still
demand to
D. At the original equilibrium price a" units. Thus, ther
now consumers want to purchase only
OU units,of but explained, a surplus
causes price to Tral
Surplus A a" units. As alreadywhen
-
C. Inerei
returns to equilibrium only the price decreases to point
market and quantity (COnpa
decreases both equilibrium price
the decrease in demand the following principle
points A and C). We have now established
Principle When demand increases and supply is constant, equilibrium price

and quantiy D
When demand decreases and supply is constant, equiljbrium priceand quantity botnTal
Changes in Supply (Demand Constant)

remains constant, We
the effects of changes in supply when demand
10 illustrate
reproduce D,and S, in Figure 2.8. The supply curve S,, showingare increase
an
showing a decrease in supply, reproduced

supply,and the supply curve
S,
from figure 2.4. Recall that the shift from S, to S, was caused by a decrease in u t
or
resulted from decrease in the number
price of an input. The shift from S, to S,
a
firms in the industry.

shown. At
Begin in equilibrium at point A. Let supply first increase S, to as
but sellers
the original $60 price consumers still want to purchase 800 units,
supply of a'- 800 units.
now wish to sell a' units,
causing a surplus or excess
The surplus causes price to fall, which induces sellers to supply less and buy-
ers to demand more. Price continues to fall until the new equilibrium is
attained at point B. As you can see by comparing the initial equilibrium point A
in figure 2.8 to the new equilibrium point B, when supply increases and demand
remains constant, equilibrium price will fall and equilibrium quantity will increase.
82
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70
CHAPTER 2 Demand, Suply. and Matket Fquilibri
FIGURE 2.8
Supply Shitts (Demand
Constant) 140
20
100
30
S
50
40
20
o
200 400 600 800 1,000 1,200 1,400
Quantity 1@j and )
To demonstrate the effect of a supply decrease, we return to the original input

price to obtain the original supply curve So and the original equilibrium at point A.
Let the number of firms in the industry decrease, causing
supply to shiftfroir S,
to S, in Figure 2.8. At the original $60 price, consumers still want to buy 800 units,
but now sellers wish to sell only a" units, as shown in the figure. This leads to a
shortage or excess demand of a" - A units. Shortages cause price to rise. The in-
crease in price induces sellers to supply more and buyers to demand less, thereby
the new equi-
reducing the shortage. Price will continue to increase until it attains
librium at point C. Therefore, when supply decreases while demand remains con-
stant, pricewill rise and sold will decrease. We have now established the
quantity
following principle
Principle When supply increases and demand isconstant, equilibrium price flls and equtbrium
quantity ises When supply decreases and demand is constant eguilibrium price
rises andequilibrium
quantityfalls.
Now try Technical
Problem 15.
Simultaneous Shifts in Both Demand and Supply
To this point, we have examined changes in demand or supply holding the other
indeterminate
curve constant. In both cases, the effect on equilibrium
Term referring to the price and quantity be
can
predicted. In situatiorns involving both a shift in demand and a shift in supply, it is
unpredictable change
in either equilibrium
possible to predict either the direction in which price changes or the direction in
price or quantity when which quantity changes, but not both. When it is not possible to predict the direction
the direction of change
of change in a variable, the change in that variable is said to be indeterminate.
depends upon the
relative magnitudes of
The change in either equilibrium price or quantity will be indeterminate when
the shifts in the demand the direction of change depends upon the relative magnitudes of the shifts in the
and supply curves. demand and supply curves.
83
Equilibrium
CHAPTER 2 maned, suppiy, and Market
ILLUSTRATION 2.3 and

Are U.S. Natural Gas Markts of supplying
natural g,
which lowers the cest
"Out of Whack"? to shift rightwar ift

causes supply of natural gas factors work
the to s
all three
below,
In this Ilustration we will show yois how to use
n
the figure rightward as indicated by t
demand and of natural pas
situation he supply
increase
in the U.5,
supply analysis to explain a
matket for natüral gas tlhat is confusins, to the couilibrium
increase price S, to S, gAss
of natural
from
supply
as the
he poui-
in supply
oint
several 1.ews
analysts at The Wall Street Journal. In a
titsritum quantity of natural gas incr The
recent article, The Wall Street Journal reported that the marently, E
from A to B. Apparently,
market for natural gas in the United States is "out of Of cquilibrium m o v e s natu
Wall Streel Journal reporters were cxpectT h iwhicn
ch
whack" because natural gas S,
prices are faling sharply to move down supply
curve
while, at the same time, production of na'ural gas ra gas market their (mistaken) belief that
is also would have matched
oTurther befuddle matters, as
rising." And to further befuddle matters, gas
Supply appears to be headed for even larger cxpan falls. vou knowshould
ral gasAsproduction from De r
this chapter, they nonse
forg to
sion inthe next couple of ycars. In well-functioning
markets-that is, ones not out of wlhack"-why
shift the supply curve for
natur
kig togethe
are working togetne
would the supply of the supply-side factors that
three States.
natural gas keep increasing when supplíes in the United
natural gas prices are falling? Are the "laws of increasc natural gas
reversE
supply These forces show no
and demand"
brokein in this industry? and until they do, or until some
otherimnedlabmand
demand or sup
We can apply the principles 'of demand and sup- prices
to counteract them, supply
Ply forces
ply analysis presented in this chapter to explain ratherwill emerge
continue to fall and gas production will continue
"whacked out
convincingly natural gas
that markets are in fact be-
having quite predictably, and we can do this using
rise. As c a n sec, there is nothing
to you
about this supply and demand story.
just the facts reported in The Wall Street Journal article.
Let's begin by examining the market forces causing
the "supply glut"of natural gas.Thereporters identify
three factors causing the "whacked-out behavior of
suppliers. First, high prices for crude oil have stimu-
lated production of crude oil, and this increases supply
of naturalgas because natural gas is freguently found
in the same well as crude oil. Second, natural gas wells
also contain large amounts of a valuablechemical used
to make plastics called ethane, and ethane prices are
rising. Third, U.S. energysuppliers recently began us-
ing a new, highly productive technology for exploring
and drilling for crude oiland naturalgas knownashy
draulic fracturing, or"fracking
As you know from our discussion of supply shifts,
all three of these forces causethe U.S.supply ofnatu-
ral gastoshiftrightwardThefirst twoofthesethree
factorsare simply reductionsinthe prices of goods
related in production (P): (1) a rise in the price of Quantiy ot natüral gas
crude oil increases the supply ofthe complementary
good natural gas, and (2) a rise in the price of ethane Dezember, "Glut
See Russell Gold, Daniel Gilbert, and Ryan
increases thesupply of thecomplementary good natu-Hits Natural-Gas Prices, The Wall Street Journal, Januaryl
Tal gas The third factor is a changein technology (1), 2012,p.Al
72
CHAPTER 2
Demand, Saupply, and Matket Equilibriun
FIGURE 2.9
Shifts In Both Demand
and Sumply:
Demand and Supply
Both lncredse
'
Quantity
In Figure 2.9, D and S are, respectively, demand and supply, and equilibrium
price and quantity are P and Q (point A). Supposedemand increases toD' and sup-
ply increases to S'. Equilibrium quantity increases to Q', and equilibrium price rises
from P to P (point B). Suppose, however, that supply had increased even more to
the dashed supply S" so that the new equilibrium occurs at point C instead of at
point B. Comparing point A to point C, equilibrium quantity still increases (Q to Q'),
both
but now price decreases from P to P". In the
equilibrium case where
and supply increase, a small increase in supply relative to demand causes price to
demand
price to fall. In the
rise, while a
large increase in supply relative to demand causes
case of a simultaneous increase in both demand and supply, equilibrium output
always increases, but the change in equilibrium price is indeterminate.
When both demand and supply shifttogether,either (1) the change in quantity can
be predicted and the change in price is indeterminate or (2) the change in quantity
is indeterminate and the change in price can be predicted. Figure 2.10 summarizes
the four possible outcomes when demand and supply both shift. In each of the
four
that
panels in Figure 2.10, point C shows an alternative point of equilibrium
reverses
the direction of change in one of the variables, price or quantity. You should use the
for each of the
reasoning process set forth above to verify the conciusions presented
four cases. We have established the following principle:
Principle When demand and supply both shift simultaneously, if the changeinquantity (price) can be
predicted. the change in price 1quantity) is indeteminate Ihe change in equilibrium quantity o price is
indeterminatë when the variable.can either fise or fall depending upon the relative magnitudes by which
demand and supply shift
5
A r b t leqilhriturr 3
HAPYER manl,vnpysy, ar
FIGURE 2 10
Summary of Simultanedus Shilts in Demand and Supply:
The Fom Possilble Cnses ereases
decreases and supply increo

B Demand
Penel A- Domond increases and supply intreases Panel
-
'
D'
Q
Price falls
Price may rise or tall rise or foll
Quantity rises QUantity may
Demand decreases
and supply decreases
Panel C- Demand increases and Panel D-
supply decreases S
D'
D
Price may rise or tall

Price rises
Quantiy may rise or fall Quantiy talls
***** *** ** *************************
36
Fitd more al downloadslele com
www
74
CHAPEN? Dnn, Supply, Hnl Market
vililviui
Prodicting tho Diroction of Change in Airfares: A Oualitative Analysis
i o e in 2016 yu manage the travel department for a large U.S, corporation
to call con custoners. Thee
yoit sales force makes heavy u s e of air travel
n next year inn
esident of the corporation wants you to reduce travel expenditures
2017. The extent to which yon will need t o curlb air travel next year will depend on
in 2017, you can satisfy the

what happens to the price of air travel. If airfares fall
Wants of both the president, who wants expenditures cut, and the sales personnel,
what will
who would be hurt by travel restrictions. Clearly, you need to predict
the fol-
read in The Wall Street Journal about
happen to airfares. You have recently affect the airline industry in 2017:
1owing two events that you expect will
and oth-
1. A nunmber of small airlines have recently entered the industry
new,
ers are exected to enter next year.
2. Broadband Internet videoconferencing is becoming a popular, cost-effective
The trend is ex-
alternative to business travel for many U.S. corporations.
telecommunications firms begin cutting
pected to accelerate next year as
prices on teleconferencing rates.
of
events would affect the price
We c a n u s e Figure 2.11 to analyze how these
travel in 2016
c u r v e s for air
air travel in 2017. The current demand and supply /
airfare is denoted P2016 at point in
are D2016 and S201G: The c u r r e n t equilibrium

Figure 2.11. The in-
An increase in the number of airlines causes supply to increase.
Because
shift in supply to S2017"
crease in is shown in Figure 2.11 by the
supply of
a r e substitutes,
a reduction in the price
Videoconferencing and air travel
FIGURE 2.11
for S2016
Demand and Supply
Air Travel 2017
P2016
S2017
P2017
D2016
D2017
Passenger miles
87
Equilibriun
Market
and
CHAPTER 2 Demand, Supply,
videoconferencing causes a decrease in demand. The decre

in Figure 2.11 by the shift in demand to D,a17 Thus, you must a c o m?aa n
sidt uc
aoti
m on
decrease The point

in which demand and supply shiftsimultaeously. fall in al
with the increase in supply leads ycu to predict a
fall when
bined airfares will derin
Bin Figure 2.11. Although you can predict that
demand decreases and supply increases, you cannot predict whe S in
(supply could instead shift to 207
quantity will rise or fall in this situation
indeterminate. The predicted fall in a
gure 2.11). The change in quantity is financially troubled airline indus You
5
gOod news for you but bad news for the an example of qualitative
analysib *
nis analysis of the air travel market is or trc Th
predicted only the direction of the price change, not magnitudedecrease.
the
or
are certainly interested in whether price will increase how
Vianagers
are also interested in how much price will increase or decrease. Determiningtative
To out qua
much price will rise involves quantitative analysis. carry
analysis, either you must be given the exact specification of the markelater han
must estimate them from market data. In ClWe
P P y equations or you frommarket ad
ters we will show you how to estimate demand and supply
where the demand ana d "
at an example of quantitative analysis
Now try Technical Wll look now
Problem 16. ply equations have already been estimated for you.
Advertising and the Price of Milk: A Quantitative Analysis
he American Dairy Association estimates next year's demand and

supP
functions for milk in the United States will be
Q, 410- 25P
2,= -40 + 20P
or
where quantity demanded and quantity supplied are measured in billions
pounds of milk per year, and price is the wholesale price measured in dollars
per hundred pounds of milk. First, we predict the price and quantity of milk next
demandea
year. The market clearing price is easily determined by setting quantity
equal to quantity supplied and solving algebraically for equilibrium price
410 25P -40 + 20P

450 45P
10 P
Thus, the predicted equilibrium price of milk next year is $10 per hundred pounds.
The predicted equilibrium output of milk is determined by substituting the mar-
ket price of $10 into either the demand or the
supply function to get
, Q,-
410- (25 X 10) = -40 + (20X 10) = 160
Thus, the equilibrium output of milk is predicted to be 160 billion pounds

next year.
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76
CHA1ER and, piy, nnd Mniket Fequililw
iutn
Even though thal's a lot of milk, the American
Dairy Aseciation plans to begin
nationwide advertising campaign to promote milk by
the nutritional
informing consumers of
bene 'its of milk-lots of calcium and vitamin D. The association
estimates the adverti-ing campaign will increase demand to
Q, 500 25P
Assuming supply is unaffected by the advertising, you would

obviously predict
the market price of milk will rise as a result of the
increase in demand. However, to determine the actual
advertising and the resulting
must equate the new

market-clearing price, you
quantity demanded with the quantity supplied
500 25P= -40 + 20P
P 12
The price of milk will increase to $12 per hundred pounds with the advertising
campaign. Consequently, the prediction is that the national advertising campaign
will increase the market
price of milk by $2 per hundred pounds. To make a
quantitative forecast about the impact of the ads on the level of milk sales, you
simply substitute the new market price of $12 into either the demand or the supply
function to obtain the new Q2
Q Q, =
500 (25 X 12)- -40 +(20 x 12) 200
Now try Technical This is an example of a quantitative forecast since the forecast involves both the
roblem 17. magnitude and the direction of change in price and quantity.
2.6 CEILING AND FLOOR PRICES
Shortages and surpluses can occur after a shift in demand or supply, but as we
have stressed, these shortages and surpluses are sufficiently short in duration that
they can reasonably be ignored in demand and supply analysis. In other words,
markets are assumed to adjust fairly rapidly, and we concern ourselves only with
the comparison of equilibriums before and after a shift in supply or demand.
There are, however, some types of shortages and surpluses that market forces
do
not eliminate. These are more permanent in nature and result from govern-
ment interferences with the market mechanism, which prevent prices from freely
moving up or down to clear the market.
Typically these more permanent shortages and surpluses are caused by
8overnment imposing legal restrictions on the movement of prices. Shortages
be
and surpluses can created simply by legislating a price below or above
equilibríum. Governments have decided in the past, and will surely decide
that
in the future, the price of a particular commodity is "too high
low" and will proceed to set a "fair price." Without evaluating the desirability
or "too
of such interference, we can use demand and supply curves to analyze the
effects these two types of interference: the setting of minimum
economic
and maximum prices.
of
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CHAPTER 2 Demand,Supply, and Market Equilibrium
FIGURE 2.12
Ceiling and Floor Prices
D
22 50 62 32 50 84
Quantity Quantily
Panel A-Ceiling price Panel B-Floorprice
ceiling price If the government imposes a maximum price, or ceiling price, on a goou
The maximum pricethe errect 1s a shortage of that good. In Panel A of Figure 2.12, a ceiling price of $l is set
government permits the
sellers to charge for a On some X. No one can legally sell X for more than $1, and $i is less than
good
equilibrium (market clearing) price of $2. At the ceiling price of $1, the maximum
good. When this price
is below equilibrium, a amount that producers are willing to supply is 22 units. At $1, cornsumers wl5t
of the $I
shortage occurs. to purchase 62 units. A shortage of 40 units results from the imposition
the to eliminate
to bid up
price ceiling. Market forces will not be permitted for more price
than $1. This type of
the shortage because producers cannot sell the good
the price ceiling or until shifts
shortage will continue until government eliminates
in either supply or demand cause the equilibrium price
to fall to $1 or lower. It is
cases. Some con-
Worth noting that "black" (illegal) markets usually arise such
in
Sumers are willing to pay more than $1 for good

X rather than do without it, and
Some producers are willing to sell good X
for more than $1 rather than forgo the
deterrent to the illegal trade of
extra sales. In most cases the law is not a sufficient
a good at prices above the ceiling
that the suppliers of the good are
Alternatively, the government may believe minimum price
not earning as much income as they
deserve and, therefore, sets a
floor price 2.12.
actions in Panel B of
the results of such Figure
The minimum price the or floor price. You can see
of 50, the
government permits Dissatisfied with the equilibrium price of $2
and equilibrium quantity
the cannot repeal the
sellers to charge for a of $3. Since government
government sets a minimum price units. Producers,
good. When this price reduce the amount they purchase to 32
of
law demand, consumers
is above equilibrium,a of X to 84 units in response to the
of course, are increase
going to their production
surplus occurs.
90
78
CHAPTER Demand, Supply, and Matket Rquilibeium
$3 prie. Now a surplhus of 52 units exists. Because the government is not allowing
the price of X to fall, this surplus is going to continue until it is either climinated
by the government or demand or supp'y shifts cause market price to rise to 7 or
highet. In order for the government to nsure that producers do not illegally sell
their surpluses for less than $3, the government must either restrict the production
of Xto 32 units or be willing to buy (and store or destroy) the 52 surplus units.
This section can be summarized by the following
principle:
Principle When the government sets a ceiling price below the equilibrium price, a shortage of excess
demand results because consumers wish to buy more units of the good than producers are willing to sell at
the
ceiling price. Hthe govemmnt sets a floor price above the equilbrium price, a surplus or excess supply
results becauso producers offer for sale more units of the good than buyers wish to consume at the floor price.
For
managers to make successful decisions by watching for changes in economic
conditions, they must be able to predict how these changes will affect the market.
have seen,
Now try Technical As hope you
we this is precisely what economic analysis is designed to
do. This ability to use economics to make predictions is one of the topics we will
Problems 18-19. emphasize throughout the text.
2.7 SUMMARY
T h e amount
of a good or service consumers are will- The direct supply function (or simply "supply") gives the
ing and able to purchase is called quantity supplied at various prices when all othe: factors
Six variabies influence quantity demanded.
quantity demanded: (1) price
of the good, (2) income of
affecting supply are held constant. Only when the good's
consumers, (3) prices of re- own price changes does quantity supplied change, caus-
lated goods, (4) consumer ing a movement along the supply curve. When any of
tastes, (5) expected future
price of the good, and (6) number of consumers in the the five determinants of supply change-input prices,
market. The direct demand function (or simply "de- prices of goods related in production, technology, ex-
mand") shows the relation between price and quantity pected price, or number of firms-a change in supply oC
demanded when all other factors affecting consumer curs and the supply curve shifts rightward or leftward.
demand are held constant. The law of demand states Increasing (decreasing) price causes quantity supplied
that quantity demanded increases (decreases) when to increase (decrease), which is represented by upward
price falls (rises), other things held constant. A change (downward) movement along a supply curve. (LO2)
n a good's own price causes a change in quantity de- Equilibrium price and quantity are determined by
manded, which is represented by a movement along the intersection of demand and supply curves. At the
the demand curve. When there is a
change in income, point of intersection, quantity demanded equals quan-
price of a related good, consumer tastes, expected tity supplied, and the market clears. At the market
price, or number of consumers, a "change in demand clearing price, there is no excess demand (shortage)
Occurs and the demand curve shifts rightward or left- and no excess supply (surplus). (LO3)
ward. An increase (decrease) in demand occurs when
demand shifts rightward (leftward). (LO1)
Consumer surplus arises because the equilibrium price
consumers pay is less than the value they place on the
Quantity supplied of a good depends on six factors: units they purchase. Total consumer surplus from mar-
1) price of the good, (2) price of inputs used in produc
tion, (3) prices of goods related in production, (4) level of
ket exchange is measured by the area under demand
above market price up to the equilibrium quantity.
available technology, (5) expectations of producers con- Producer surplus arises because equilibrium price is
cerning the future price of the good, and (6) number of
firms or amount of productive capacity in the industry.
greater than the minimum price producers would be
willing to accept to produce. Total producer surplus is
Chapter
Elasticity and Demand

After reading this chapter, you will bo able to:
6.1 Define price elasticity of demand and use it to predict changes in quantity
demanded and changes in the price of a good.
6.2 Explain the role price elasticity plays in determining how a change in price
affects total revenue.
6.3 List and explain several factors that affect price elasticity of demand.
6.4 Calculate price elasticity over an interval along a demand curve and at a point
on a demand curve.
6.5 Relate marginal revenue to total revenue and demand elasticity and write the
marginal revenue equation for linear inverse demand functions.
6.6 Define and compute the income elasticity of demand and the cross-price
elasticity of demand.
ost managers agree that the toughest decision they face is the decision
to raise or lower the price of their firms' products. When Walt Disney
LCompany decided to raise ticket prices at its theme parks in Anaheim,
California, and Orlando, Florida, the price hike caused attendance at the Disney
parks to fall. The price increase was a success, however, because it boosted Disney's
revenue: the price of a ticket multiplied by the number of tickets sold. For Disney,
the higher ticket price more than offset the smaller number of tickets purchased,
and revenue increased. You might be surprised to learn that price increases do not
always increase a firm's revenue. For example, suppose just one gasoline producer,
ExxonMobil, were to increase the price of its brand of gasoline while rival gasoline
producers left their gasoline prices unchanged. ExxonMobil would likely experi
ence falling revenue, even though it increased its price, because many ExxonMobil
customers would switch to one of the many other brands of gasoline. In is itua
tion, the reduced amount of gasoline sold would more than offset the higher price
of gasoline, and ExxonMobil would find its revenue falling.
197
2
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Demand
When
managers lower priceto attract rise
ail, again depending upon how resLonsívebuyers, revenues may
more
ion. example, in an unsuccessful

For consumers are to
a prie . duc
55,"
Mconald's Corporation lowered marketing strategy, calleda dors
the price of its Big Mac and
o S5 cents in an
effort to increase revenue. Quarter r
The price reduction resulted in lout
Teveue, and McDonald's abandoned the low-price
1ast meals-lower strategy for all but ts
prices did increase breakfast revenues.
Obviously, marnab
need to know how price increase decrease is going to affect
a
the
ana the revenue of the firm. In this chapter, you will learn how to usequarntity
or
s
the concep
ot price elasticity to predict how revenue will be affected by a change in the pe
O1 the
product. You can easily understand why
nd this chapter to be particularly useful; they canmanagers of price-setting irms
use knowledge about
elasticitics to help them make better decisions about raising or loweringdemarnd
And, even for managers of price-taking firms (i.e., firms in competitive price
where prices are determined by the intersection of market demand and supply mark
knowledge of price elasticity of industry demand can kelp managers predict tne
efect of changes in market price on total industry sales and total consumer
ditures in the
industry. expe
Managers recognize that quantity demanded and price are inverselyof related.
when they are making pricing decisions, as you saw in the examples Disney
EXXonMobil, and McDonald's, it is even more important for managers to knoW
Oy how much sales will change for a given change in price. A 10 percent decrease
n price that leads to a 2 percent increase in quantity demanded differs greatly
in eftect from a 10
percent decrease in price that causes a 50 percent i crease in
quantity demanded. There is a substantial difference in the effect on total revenue
between these two
responses to a change in price. Certainly, when making pricin8
decisions, managers should have a good idea about how responsive consumers
Will be to any price
The
changes and whether revenues will rise or fall.
majority of this chapter is devoted to the concept of price elasticityof demana,
a measure of the responsiveness of quantity demanded to a change in price along
a demand curve and an indicator of the effect of a price change on total consumer
expenditure on a product. The concept of pYice elasticity provides managers, econ
omists, and policymakers, with a framework for understanding why consumers in
some marketsare extremely responsive to changes in price while consumers in other
markeis are not. This understanding is useful in many types of managerial decisions.
we will begin by defining the price elasticity of demand and then show how
to use price elasticities to find the percentage changes in price or quantity that re-
Sult from movements along a demand curve. Next, the relation between elasticity
and the total revenue received by firms from the sale of a product is examined in
detail. Then we discuss three factors that determine the
degree of responsiveness
of consumers, and hence the price elasticity of demand. We also show how to
compute the elasticity of demand either over an interval or at a point on demand.
Then we examine the concept of marginal revenue and demonstrate the relationn
among demand, marginal revenue, and elasticity. The last section of this chapter
introduces two other important elasticities: income and cross-price elasticities.
q3
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CHAPTER 6 Elasticity and Demand 199

6.1 THE PRICE ELASTICITY OF DEMAND
As noted earlier, price
elasticity of demand measures the responsivencss or sensi-
tivity of consumers to changes in the price of a good or service. We.will begin this
section by presenting a formal
(mathematical) definition of price elasticity and
then show how price elasticity can be used to
predict the change in sales when
price rises or falls or to predict the percentage reduction in price needed to stimu
late sales by a given percentage amount.
price elasticity of
demand (E) Consumer responsiveness to a price change is measured by the price elasticity
The percentage change of demand (E), defined as
in quantity demanded,
divided by the percent- E %Q Percentagechange in quantity demanded
oAP Percentage change in price
age change in price.
E is
always a negative Because price and demanded are inversely related by the law of demand,
number because Pand a the numerator andquantity
denominator always have opposite algebraic signs, and the
are inversely related.
price elasticity is always negative. The price elasticity is calculated for movements
along a given demand curve (or function) as price changes and all other factors
affecting quantity demanded are held constant. Suppose a 10 percent price de-
crease (oAP-10%) causes consumers to increase their purchases by 30 percent
(oAQ +30%). The price elasticity is equal to -3 (= +30%/-10%) in this case.
In contrast, if the 10 percent decrease in price causes only a 5 percent increase in
sales, the price elasticity would equal -0.5 (= +5%/-10%). learly, the smaller
(absolute) value of E indicates less sensitivity on the part of consumers to a change
in price.
When a change in price causes consumers to respond so strongly that the
percentage by which they adjust their consumption (in absolute value) exceeds thee
elastic percentage change in price (in absolute value), demand is said to be elastic over
Segment of demand for that price interval. In mathematical terms, demand is elastic when 1%AQl exceeds
which E| >1.
1%APl, and thus IEl is greater than 1. When a charnge in price causes consumers to
respond so weakly that the percentage by which they adjust their consumption
in absolute value) is less than the percentage change in price (in absolute value),
inelastic demand is said to be inelastic over that price interval. In other words, demand is
Segment of demand for inelastic when the numerator (in absolute value) is smaller than the denominator
which |E <1.. (in absolute value), and thus IEl is less than 1. In the special instance in which the
unitary elastic percentage change in quantity (in absolute value) just equals the percentage change
Segment of demand for in price (in absolute value), demand is said to be unitary elastic, and IEI is equal
which |EI = 1. to 1. Table 6.1 summarizes this discussion.
TABLE 6.1 Responsiveness

Elasticityy E
Price Elasticity of Elastic |%Aq>|%AP E>1
Demand (E), Unitary elastic %A = |%AP|
E=1
E oAQ Inelastic %A < |%AP|
E 9%AP E<1
Note: Ihe symbol "il" denotes the absolute value.

rity tir rdrdinitirm rf prina tinetirity, itAokowrt Phat
25
-8} Thus, tre

-25
,
141h n bif f nlg ain tranigsiatiem, ) - 20%(
t 1 9 11tatalee by 2919ett ent Fyy eoveering price 8 perent A we t
infeYmatieom abeut industry demand
"
s r)e ntrviuetiom, tive elaefieitv
hely prire 1aking managere rvake redictieona abenut inedustry- or marke
PVel harnges. Fom eample, s1utypwse arn ine rease in inedrstry supply s expectet
tse market pricr to fall by 8 pereent, and the price elasticity of industry demand
6 equal to -2.5 for the segment of demand over which supply shiffs. Using the
Same algebraic steps just shown, total industry o u t p u t is predictec to tncrease oy
20 perent in this case
Predicting the Percentage Change in Price

over
uppose a manager of a different firm faces a price elasticity equal -0. to
the range of prices the firm would consider charging for its product. This mariager
WIshes to stimulate sales by 15 percent. The manager is willing to lower price
to accomplish the increase in sales but needs to know the percentage amount by
which price must be lowered to obtain the 15 percent increase in sales. Again us
that
ing the definition of price elasticity of demand, it follows
-0.5 = 15%
%AP
Thus, this
algebraic manipulation, %AP -30% (= 15%/-0.5).
=
so, after some
increase sales by 15 percent. As

we
manager must lower price by 30 percent to
in demanded,
explained in the case of predicting percentage changes quantity
elasticity of industry demand can also be used to make predictions about changes
in market-determined prices. For example, suppose an increase in industry supply
Is expected to cause market output to rise by 15 percent, and the price elasticity
of industry demand is equal to -0.5 for the portion of demand over which supply
shifts. Following the algebraic steps shown above, market price is predicted to fall
by 30 percert. As you can see, the techniques for predicting percentage changes
in quantity demanded and price can be applied to both individual firm demand
curves or industry demand curves.
As you can see, the concept of elasticity is rather simple. Price elasticity is noth-
demanded is
ing more than a mathematical measure of how sensitive quantity to a crucial
will now the of
concept elasti ty
price
Now try Technical
to
changes n price. We apply
question facing managers. How does a change in the price of the firm's product
Problems 1-2.
affect the total revenue received?
95
6.2 PRICE ELASTICITY

AND TOTAL REVENUE
Managers of firms, ás well as industry analysts, government policymakers, and
academic researchers, are frequerntly interested in how total revenue changes
total rovonue (TR)n when there is a movement along the demand curve. Total revenue (TR), which
ne total amount paid to also cquals the total expenditure by consumers on the commodity, is simply the
producers for a good or price of the commodity times quantity demanded, or
service (TR Px Q).
TR =Px
As we have emphasized, price and quantity demanded move in opposite direc
tions along a demand curve: If price rises, quantity falls; if price falls, quantity
rises. The change in price and the change in quantity have opposite effects on total
revenue. The relative strengths of these two effects will determine the overall ef-
fect on TR. We will now examine these two effects, called the price effect and the
quantity efect, along with the price elasticity of demand to establish the relation
between changes in price and total revenue.
Price Elasticity and Changes in Total Revenue
a manager raises the

When price of a product, the increase in price, by itself, would
increase total revenue if the quantity sold remained constant. Conversely, when
a manager lowers price, the decrease in price would decrease total revenue if the
quantity sold remained constant. This effect on total revenue of changing price; for
price effect à given level
The effect on total of output, is called the price effect. When price changes, the quantity
revenue of changing
sold does not remain constant; it moves in the opposite direction of price. When
price, holding output quantity increases in response to a decrease in price, the increase in quantity; by
constant. itself, would increase total revenue if the price of the product remained constant.
Alternatively, when quantity falls after a price increase, the reduction in quantity,
by itself, would decrease total revenue if product price remained constant. The ef-
fect on total revenue of changing the quantity sold, for a given price level, is called
quantity effect the quantity effect. The price and quantity effects always push total revenue in
The effect on total
opposite directions. Total revenue moves in the direction of the stronger of the two
revenue of changin9
effects. If the two effects are equally strong, no change in total revenue can occur.
output, holding price
constant. Suppose a manager increases price, causing quantity to decrease. The price ef-
fect, represented below by an upward arrow above P, and the quantity effect, rep-
resented by a downward arrow above Q, show how the change in TR is affected
by opposing forces
TR = P XQ
To determine the direction of movement in TR, information about the relative

strengths of the price
effect and output effect must be known. The elasticity of
demand tells a manager which effect, if either, is dominant.
If demand is elastic, IEl is greater than 1, the percentage change in Q (in abso-
lute value) is greater than the percentage change in P (in absolute value), and the
quantity effect dominates the price effect. To better see how the dominance of the
.
6
Find more at
202 CHAPTER
6
Elnsticity and Demand
quantity ellect determines the

direction in which TR moves, you ca
esent
the dominance of the than

quantity efect by drawing the arrow
above
the arrow above P. The
direction of the dominant effect-the ct here
tells a manager that TR will quantity erree h
fall when price rises and demand is
elastic
TR = PXQ
amanager decreases price when demand is elastic, the arrows in this diagram
everse directions. The arrow above Q is still the longer arrow because the quan
tity effect always dominates the price effect when demand is
NoW consider a price increase when demand is inclastic. When demana i
elastic.
asthc, IEl is less than 1, the percentage change in Q (in absolute value) is less tharn
e percentage change in P (in absolute value), and the price effect dominates the
quantity effect. The dominant price effect can be represented by an arrow
above P that is longer than the downward arrow above Q. The direction or t upwar o
counant effect tells the manager that TR will rise when price rises and demand
is inelastic
TR PXQ
when a manager decreases price and demand is inelastic, the arrows n tnis
lagram would reverse directions. A downward arrow above P would be a long
arrow because the price effect always dominates the quantity effect when demand
is inelastic.
When demand is unitary elastic, IEl is equal to 1, and neither the price effect nor
the quantity effect dominates. The two effects exacthly offset each other, so price
changes have no effect on total revenue when demand is unitary elastic.
elation Ihe effect of a change in price on total revenue (TR P x Qis determined by the price
elastciy ofdemand Whendemand iselasticlinelasticl.the,quantity(oricel effect domnates Totalrevenue

aways movesinthesamedirectionas thevarablePor Ohavingthedominant efect Whendemandis
Unitary.elastic, nerther effect dominates, and.changes in priceleave total revenue unchangea.
Table 6.2 summarizes the relation between price changes and revenue changes
under the three price elasticity conditions.
TABLE 6.2
Relations between
Elastic Unitary elastic Inelastic
%AQ> 1%AP| 1%AQ= %AP|. 6AQ %AP|
Price Elasticity and Total Q-effect dominates
Revenue (TR) No dominant effectPeffect dominates
Price rises TR falls No change in TR TR rises
Price falls TR rises No change in TR TRfalls
7
Changing Price at Borderline Video Emporium: A Numerical Example

The manager at Borderline Video Emporium faces the demand curve for Blu-ray
DVD discs shown in Figure 6.1. At the current price of $18 per DVD Borderline
can sell 600 DVDs each week. The manager can lower price to $16 per DVD and
increase sales to 800 DVDs per week. In Panel A of Figure 6.1, over the interval a
to b on demand curve D the price elasticity is equal to -2.43. (You will learn how
to make this calculation in Section 6.4.) Because the demand for Blu-ray DVDs
is elastic over this vange of prices (1-2.431 > 1), the manager knows the quantity
effect dominates the price effect. Lowering price from $18 to $16 results in an in
crease in the quantity of DVDs sold, so the manager knows that total revenue,
which always moves in the direction of the dominant effect, must increase.
To verify that revenue indeed rises when the manager at Borderline lowers the
price over an elastic region of demand, you can calculate total revenue at the two
prices, $18 and $16
Pointa: TR = $18 x 600 $10,800

Pointb: TR = $16 x 800 $12,800
FIGURE 6.1
Changes in Total Revenue of Borderline Video Emporium
24 Quantity effect dominates Price effect dominates
24
F -2.43
8
13
11
E = -0.50
600 800 I0O 1300 2,400 0 600 800 1,500 1700 2,400
Quantity of DVDs per week Quantity of DVDs per week
Panel A - An elastic region of demand
Panel B An inelastic region of demand
8
Find more at
204 CHAPTER 6
this
Total revenue
by $2,000 (= 12,800 10,800) when price is reduced
rises over
elastic region of demand.

Although Borderline carns less torevet
sold, the number of DVIDs sold each week rises enough more than onset u
downward
price effect, causing total revenue to rise. disc
oSuppOse the manager at Borderline is charging just $9 per compac
and sells 1,500 DVDs per weck (see P'anel B). The manager can lower pricetod
nand
dise
and inerease sales to 1,700 1DVDs per week. Over theinterval cto d on aen
D, the elasticity of demand cauals -0.50, Over this range of prices tor
curve
the demand is inelastic (1-0.501< 1, and Borderline's manager knows the price
tect dominates the quantity effect. If the manager lowers price from $9 to / , ota
revenue, which always moves in the direction of the dominant effect, must decreasc
o verify that revenue falls when the manager at Borderline lowers priCe over
an inelastic region of demand, you can calculate total revenue at the fwo prices,
$9 and $7
Pointc: TR = $9 x 1,500 $13,500

Point d: TR = $7 x 1,700 $11,900
lotal revenue falls by $1,600 (ATR = $11,900 $13,500 = -$1,600). Total revenue
aiways falls when price is reduced over an inelastic region of demand. Borderline
aun earns less revenue on each DVD sold, but the number of DVDs sold each week
does not increase enough to offset the downward price effect and total revenue fals.
r the manager decreases (or increases) the price of Blu-ray DVDs over a
unitary-elastic region of demand, total revenue does not change. You should ver-
Tythat demandisunitary elastic over the interval fto g in Panel Aof Figure 6.1.
Note in
Figure 6.1 that demand is elastic over the $16 to $18 price range butin
elastic over the $7 to $9 price range. In general, the elasticity of demand varies
along any particular demand curve, even one that is linear. It is usually incorrect
to say a demand curve is either elastic or inelastic. You can say only that a demand
curve is elastic or inelastic over a particular price range. For example, it is correct
Now try Technical tosay that demand curve D in
Problems 3-5. and inelastic over the $7 to $9
Figure 6.1 is elastic over the $16 to $18 price range
price range.
11LUSTRATION 6. 1
PxQMeasures More Than Just Business SLure the anmount spentby consumers whobuyQunits
Total Revenue
ofthe good atprceP.Inother words,totalrevenue for
As you Know fromn our explanation in Section 6.2, abusinessisexactlyequal tothe total expenditure by
demand elasticity provides the essentialpiece of in COnsumers
formationneeded topredict how total While business owners and managers TOeu
increases,decreases, or stays the samerevenuechanges
when the price
PXO as measuring their revenue for the purpoSe o
3 300dor service changes. We mention inthatdisComputin8 their business profitPoliticians and gov
uSSIOn thatpncemultiplied by quantity can alsomeaernment policymakers
frequently viewPX Qas mea
suring the "burden' on consumers buying the good
or service. And
clasticity of demand topolicymakers
thus can use the
predict how price changesprice
are Another example demonstrating the usefulness
of interpreting P x Q as a measure of total consumer
to atfect the total
Cy amount spent by consumers to
spending, rather than as a measure of total revenue, in
buy a product. For example, policymakers belicve rais-
volves the "taxi cab" fare war going on in Manhattan.
g taxes on
cigarettes causces cigarette prices to rise The current price war in Manhattan was
and, by the law of demand, will reduce the quantity the entry of new "car-service" firms such as
sparked by
O Cigarettes purchased and improve smokers' healtlh. and Uber that pick up riders who use their
Gett, Lyft,
ntortunately, however, the demand for cigarettes smart-
remans phones to "hail" cab rides." Before these new competi
"stubbornly inelastic," and this causes total tors.entered the market in Manhattan, taxi cab fares
Cxpenditure on cigarettes by smokers to rise
tially with higher iaxes on cigarcttes. Critics ofsubstan were high enough to be positioned in the elastic region
cigarette taxes point out that, with the
higher of the demand for car rides. The
price elasticity of de
cigarette tax
ncreases, smokers' health probably deteriorates
mand is important in this situation because,
for now,
even drivers at the new companies are not
more rapidly because smokers will only decrease the about falling fares. Their
complaining
number of cigarettes they smoke by a small amount, incomes are rising, measured
ney willsimply spend more income to buy the cigarettes, by.multiplying the cab fare times the number of rides
(i.e., Px ) because demand is elastic at the current
eavingless money for other, more healthful grocery fares. And, with rising
incomes for their drivers, Gett
ems. Policymakers sometimes defend the higher Lyft, and Uber are able to expand the number of cars
x s by (perversely and correctly) noting that furtlher servicing
8arette price hikes Manhattan. Of course, if cab fares continue
willeventually move smokers into
he elastic region of their demand curves 'so that higher falling, eventually demand will become inelastic and
driver incomes, P x
Prices would then cause significant declines in the drivers willnot be soQwill decline. At that point, cár
happy withthe fare war
guantity demanded and reduce the amount spent
on
sAlthough we cannot dispute the analytical
Conclus1on that cigarette demand will become elastic the
These new carservicecompaniesarenotlegally definedas
"taxi cabs and therefore they cannot legally pickkup riders on
t only the price is high enough, getting to that price street who hail with a hand raised. Nonetheless, riders vieW
hailing one ofthese "apP.car service ndes
POint on cigarette demand is very likely to take a lot phones with their sima
as nearly identical to by hand a yellow taxi cab
nore income out.of smokers pockets before we see Source: Anne Kadet "Car- Apphailing Car Services Compéle for Passen
any decline in spending on cigarettes gers with owFares"The Wail Street Journal,October10, 2014
6.3 FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

Price elasticity of demarid plays such an
that managers should understand not
important role in business decision making
only how to use the concept to obtain infor-
mation about the demand for the products they sell, but also how to recognize the
factors that affect price elasticity. We will now discuss the three factors that make
the demand for some products more elastic than the demand for other
products.
Availability of Substitutes
The availability of substitutes is
by far the most important determinant of price
elasticity of demand. The better the substitutes for a given good or service, the more
elastic the demand for that good service. When the price of a
or
ers will substantially reduce
good rises, consum-
consumption of that good if they perceive that close
substitutes are readily available. Naturally,
consumers will be less responsive toa
price increase if they perceive that only poor substitutes are available.
206 CHAPTER6 Elasticity and Demand
and
jets,
fruit, corporate
lifeSome goodsAlternatively,
insurance. for which demand
goodsisfor
rather elastic
which include perceive
consumers renetendgood
to
substitutes haye low price elasticities of demand. Wheat, salt, and lable--for
have low pricc elasticities because there are only poor substitutes avas
instance, corn, pepper, and diesel fuel, respectively
The definition of the market for a good greatly affects the num k
and thus the good's price elasticity of demand. For example, r a nef rocery
milk
stores in a city raised the price of milk by 50 cents per gallon, total sa onlu
much. If, on the other haria, ony
naoubtedly fall-but probably not by
sales of Food King
ne
rood King chain of stores raised price by 50 cents, the grooa
probably fall substantially. There are many good substitutes for

wouldbut
milk, there are not nearly as many substitutes for milk in genera
Percentage of Consumer's Budget

is spent on the commodity 15 also
percentage of the consumer's budget that All other things equal, we would
portant in the determination of price elasticity. the percentage of consumers
pect the price elasticity to be directly related
to
is
the For example, the demand for refrigerators probaDiy
Dudgets spent on good.
more price elastic than the demand for toasters because the expendirure reu
or a
of the buaget
larger percentage
purchase refrigeratorwould
a make upa
"typical" consumer.
Time Period of Adjustment

of the time period used in measuring the price elasticity
mag
affects the
The length
nitude ofprice elasticity. In general, the longer the time period of measurement, tue
This relation
will be (in absolute value).
larger (the more elastic) the price elasticity to the price change
is the result of consumers' having more time to adjust in the price o
an increase
consumers would adjust
to
onsider, again, the way of
all producers miik
farmers' association is able to convince
milk. suppose
nationwide to the dairy
raise their milk prices by 15 percent. During the first week tne prie
lists alreaay
increase takes effect, consumers come
to the stores with their rocery
made up. Shoppers notice the higher price

of milk but have already plannedtotheir
will react immediately tne
meals for the week. Even thougha few of the shoppers
amount ofmilk they purchase,
many shoppers will
higher milk prices and reduce the week before. If the
ahead and buy the same amount of milk as they purchased the ror
go the elasticity of demand
data and measures price
dairy assOCiation collects sales be to see that the 15 percent
milk after the first week of the price hike, they will happy
a modest reduction
in milk sales.
increase in the price of milk caused only
c o n s u m e r s begin looking
for ways to con
Over the coming weeks, however,
nutritional composition
sume less milk. They substitute
foods that have similar
increase. Some consumers
to milk; consumption of cheese, eggs,
and yogurt all
milk needs-
will even switch to powdered milk
for some of their less urgent
increase,
use in cooking. Six
months after the price
perhaps to feed the cat or to milk. Now the price
association measures the
again price elasticity of
the dairy
CHAPTER6 Flasticityand Demand 207
clasticity of demand is probalbly much larger in absolute value (more elastic)

because it is measured over a six-month time period instead of a onn-week
time period.
For most goods and services, given a longer time period to adjust, the demand
for the commodity exhibits more responsiveness to changes in price-the demand
becomes more elastic. Of course, we can treat the effect of time on elasticity within
the framework of the effect of available substitutes. The greater the time period
available for consumer adjustment, the more substitutes become available and
Now try Technical economically feasible. As we stressed earlier, the more available are substitutes,
Problem 6. the more elastic is demand.
6.4 CALCULATING PRICE ELASTICITY OF DEMAND
is equal
As noted at the beginning of the chapter, the price elasticity of demand to
the ratio of the percentage
change in quantity
demanded divided by the percent
avoid
age change in price. When calculating the value of E, it is convenient to
elastic-
computing percentage changes by using a simpler formula for computing
ity that can be obtained through the following algebraic operations
oAQ AQ
O X 100
E)AP APx 100
demand
Thus, price elasticity can be calculated by multiplying the slope of
(AQ/AP) times the ratio of price divided by quantity (P/Q), which
avoids making
tedious percentage change computations. The computation of E, while involving
the rather simple m ma cal formula derived here, is complicated somewhat
by the fact that elasticity can be measured either (1) over a n interval (orE arc) along
demand or (2) at a specific point o n the demand curve. In either case, still m e a -
sures the sensitivity of consumers to changes in the price of the commodity.
The choice of whether to m e a s u r e demand elasticity at a point or over a n
interval of demand depends on the length of demand over which E is measured.
If the change in price is relatively small, a point measure generally suitable
is
Alternatively, when the price change spans a sizable arc along the demand
curve, the interval measurement of elasticity provides a better measure of
consumer responsiveness than the point measure. As you will see shortly,
point
elasticities are more easily computed than interval elasticities. We begin withha
interval (or arc) discussion of how to calculate elasticity of demand over an interval.
elasticity
Price elasticity calculated Computation of Elasticity over an Interval
Over an interval off a
demand curve: When elasticity is calculated over an interval of a demand curve (either a linear
E-AXAverage P or a curvilinear demand), the elasticity is called an interval (or arc) elasticity. To
AP Average Q measure E over an arc or interval of demand, the simplified formula presented
02
Find more at
208
CHAPTER 6
earlier-slope of demand multiplied by the ratio of P divided
modified slightly. The
modification only requires that by Q--needs to be
over the interval
be used: the average values of P andQ
E=XAverage
E P
AP Average Q
Recall from
to
our
previous discussion of Figure 6.1 that we did not show
compute
ihe two values of the interval you how
now make these elasticities given in Figure 6.1. You can
above formula forcomputations
for the intervals of demand ab and
cd using the
interval price elasticities
are used): (notice that average values for P and Q
E-x-243
E x -0.5
Relation When calculating the price elasticity of demand overan interval of demand, use the
arcelasticity formula: interval or
Now tryTechnical EA0x

Average P
Problem 7. F Average O
Computation of Elasticity at a Point

Aswe
explained previously, it is appropriate to
measure
elasticity at a point on
a demand curve rather than over an interval
when the price
a small interval of
demand. Elasticity change covers only
point elasticity computed
point elasticity of demand. Computing the price
at a
point on demand is called
A measurement of is
accomplished by multiplying the slope of demand elasticity at a point on demand
demand elasticity (AQ/AP), computed at the
calculated at a,point on point of measure, by the ratio P/Q, computed using the values of P and Qat the
a demand curve rather of measure. To show you how this is done, we can point
than over an interval. compute
Figure 6.1 when Borderline Music Emporium charges $18 and $16
the point elasticities in
disc at points a and b, per compact
respectively. Notice that the value of AQ/AP for
demand in Figure 6.l is -100 (= the linear
point elasticities are computed as
+2400/-24) at every point along D, so the two
E,-100 X- 3
E,-100x R-2
Relation
RelationWhen calculating the price elasticity of demand at a point.on demand, multiply the slope of
demand AOAP,.computed at the point of measure, by the ratioPIQ computed using the values of Pand
atthepoint otmeasure.
****
1o3
CHAPTER6 Elasticity and Demand 209
ILLUSTRATION 6.2
Texas Calculates Price
Elasticity decreased because fewer were
produced. So the move
n addition to from $25 to $75 was the right move.
its regular icense
lexns, as do other states,
plales, the state of Moreover, let's suppose that the price elasticity be-
sells personalized or "van- tween $75 and $40 is approximately cqual to the value
ty icense plates. To raise nddiional revenue, the
slate calculated for the movement from $25 to $75 (-0.86),
wil sell a vehicle owner a license plaie saying We can use this estimate to calculate what happens to
whatever the owner wants as long as it uses six ietters revenue if the state drops the price to 540. We must
(or numlbers), else has the same license as the
no one
find what the new quantity demanded will be at $40.
first
one
requested,and it isn't obscene. For this
service Using the arc elasticity formula and the price elasticity
the stale charges a higher price than the price for stan-
dard licenses. of-0.86,
Many people are willing to pay the higher price FAQ Average P
rather than
display a license of the standard form,
such as 387 BRC. For
AP Average
example, an ophthalmologist an-
nounces his practice with the license MYOPIA. Others 60,000 x (75+40)/2=
7540(60,000 +Q/2 -086
tell their
personalities with COZY-1 and AlLL MAN.
When Texas decided to increase the price for van- where Q is the new quantity demanded. Solving
ity plates from $25 to $75, a this equation for Q, the estimated sales are 102,000
lHouston 150,000 down
ported that sales of these plates fell fronmnewspaper re (rounded) at a price of $40. With this quantity de
to 60,000 manded and price, total revenue would be $4,080000,
vanity plates. As it turned out, demand was
e r nelastic over this range. As you can calculate iis- representing a decrease of $420,000 from the revenue
ing the interval method, the price elasticity was at $75 a plate. If the state's objective is to raise revenue
The newspaper -086 than
wspaper reported that that vanity
vanity plate revenue roseby selling vanity plates, it should increase rather
plate reven
atter the price
increase ($3.75 million to $4.5 million), adecrease price
whidh would be
expected for a price increase when de This Illustration actually makes two points First
mand is inelastic. even decision makers in organizations that are notrun
for profit, such as govermment agencies, should be able
ewspaper quoted the assistant director of
eexas Divisionof Motor Vehicles as saving Sinceto use economicanalysis Second,managers whose firms
ne demand dropped the state didn't make money are in business to make a profit should make an effort
nengherplatestees, so the price for next year's per- toknow (or at least have a g0od aPProximation for) the
Onalized will be $40: If the objective of thelasticity.of demand tor the products they sell. Only with
tresto make money from these licenses and if the s information will they know what price to charge
numbers in the article are correct this is the wrong t was, of course, quantity demanded that decreased not
thing to do It's hard to see howthe statelost moneydemand
byincreasing the price from $25 to S75the revenueSource: Adapted from Batbara Boughton ALicense tor
ncreased and the cost
of producing plátes must have VanityHoistonPost October 19,1986,pp.1G. 10G.
Point elasticity when demand is linear Consider a general linear demand

function of three variables-price (P), income (M), and the price of a related
good (P)
Q =a + bP + cM + dP
Find more at www.downloadslicde.com
210 CHAPTERA Flastirity atd Dman

or
on specific values
the related cood
take
and theprice of
come terim
Tespectively Recall from Chapter 2 when valuesof the of the

constant
part
they beceme
(M and P, in this case) are held constant,
the direct demand funetion:
Qa' +bP measures
the rate of
course,
The slope p a r a m e t e r b, of O Thus price
where a at cM + dP in price:
b AQ/4P,
=
change in quantity demanded per unit change can be calculated

a point on a linear demand curve
elasticity at
E-b of m e a s u r e . For
quantity at
the point
and at price
a n d Qare
the values of price
for Borderline Music a
compute the elasticity of demand for yourself
that
ple,et's You c a n verify
of $9 per CD (see point c in Panel 6.1). Figure 1 00
b =
2,400 100P, so
function is Q =
aton
for
thedirect demand
and
E=-10050 -0.6
the ratio P/Q is rather simple, there happens to
Even though multiplying b by elasticities of demand. This
be easier formula for computing point price

even
alternative point elasticity formula is
E-p
is to be measurea,
at the point demand where elasticity
Where P 1s the price on
the linear demand equation
of demand.' Note that, for
and A is the price-intercept this alterna
is -a'/b. In Figure 6.1, let us applythis case, the
=a+ bP, the price intercept A at point c (P =$9).
In
tive formula to calculate the again elasticity
price-intercept A is $24, so the elasticity is
E-g -0.6
the slope
which is exactly equal to the value obtained previously by multiplying p
P/Q.
the ratio We must stress that, because the two
formulas band
ofdemand by
identical values for point
p-Aare mathematiçally equivalent, they always yield
price elasticities.
is derived in the mathematical appendix

This alternative formula for computing price elasticity
for this chapter
05
CHAPTER6 Elasticity and Denand 211
Relation for linoar iemand functions 0 a' b} the price elasticity of desnarnd can be conputed
using either of two equivalent formulas
P
Now try Toohnical whero Pand 0 are the values of price and quantity demanded at the point of mieasure on dernarnd,.
Probloms 8-9. and A a /b is the price-intercept of demand.
Point elasticity wBen demand is curvilinear When demand is curvilinear, the

formula E AQ
-
can be used for computing point elasticity simply by sub

stituting thetheslope of theThis
curved demand at the point of for the value of
be accomplished by measuring the slope of the
measure
AQ/AP in formula. can

tangent line at the point of measure. Figure 6.2 illustrates this procedure.
In Figure 6.2, let us measure elasticity at a price of $100 on demand curve D.
We first construct the tangent line T at point R. By the "rise over run" method,
the slope of T equals -4/3 -140/105). Of course, because P is on the vertical
(
axis and Q is on the horizontal axis, the slope of tangent line T gives AP/AQ not
AQ/AP. This is easily fixed by taking the inverse of the slope of tangent line T to
get AQ/AP = -3/4. At point R price elasticity is calculated using -3/4 for the
slope of demand and using $100 and 20 for P and Q, respectively
ER 100 -2.5
30
FIGURE 6.2
Calculating Point
Elasticity for Curvilinear 140
Demand
100 ER =-2.5
0
R
40 Es=-0.8
30 105
Quantily
212 CHAPTER 6 Elasticity and Demand elas-

computing
point «
As it turns out, the alternative formula E
= P/P
-
A) for elasticities
on
cur-
Computing
point as iie
linear demands can also be used for line T se
rves
ticity on
the tangent point R
vilinear demands. To do so, the price-intercep of elasticity at
value of A in the formula. As an example, we can recalculate line
price-intercept
of
tangern
6.2 using the formula E = P/p - ) . The
gure
Tis $140
1 0 0 = -2.5
As expected, -2.5 is the same value for E, obtained earlier or

te
doesn't require the slope of demand
E P/(P A) -
S in Figure b.2
nce the formula
=
like point
in sítuations
E
t can be used to compute to be able
to multiply siope oy
available information is insuficient formula
into the
nere the the price-intercept of T' (=
$90)
ratio. Just substitute
E =
P/(P-A) to get the elasticity at pointS
40=-0.8
usIng eitner
price elasticity at a point can be computed
nelatlon Forcurvilinear demand functions,
the
of two.equivalent formulas:
slope
eeauIStheslope ofthecurved demand at
the pointof measure which is the inverse ofthe the
quantity demandedat
0 thetangentline at the pointofmeasurel, PandQare the values of priceand
lineextended tocross the price-axis.
DointoTmeasure, and Ais the price-intercept of thetangent
established that both formulas for computing point

elasticlties
We have now
elasticity of demand whether demand is

Willgive the same value for the price ask which formula
1s
the
or curvilinear. Nonetheless, students frequently
linear identical values for E, neither one 1s
formulas
"best one. Because the two other. We give that you
better or more accurate than the
should remind you, however,
both So you
information to compute E ways,
may not always have the required 6.2 at
should make sure you know both methods. (Recall
the situation in Figure
the
we recommend computing
point 5.) Of course, when it is possible to do so, calculation is
elasticity
Now try Technical elasticity using both formulas to make sure your price
Problem 10. correct!
Demand Curve
Elasticity (Generally) Varies along a
same demand curve have

In general, different intervals or points along the
demand curve is linear. When
differing elasticities of demand, even when the constant. Even though the
demand is linear, the slope of the demand curve is
O7
CHAPTE R6 Elastiity and Denand 213
absolute tate at which quantity demanded changes as price changes (AQ/AP)

remains constant, the proporlional rate of change in Qas Pchanges (%sO/"%aP)
varies along a linear demad curve. To see why, we can examine the basic
formula for elasticity, E A Moving along linear demand does not

a
cause the term AQ/AP tochange, but elasticity does vary because the ratio P/Q
changes. Moving down demand, by reducing price and selling more output,
causes the term P/Q to decrease which reduces the absolute value of E. And, of
course, moving up a linear demand, by increasing price and selling less output,
causes P/Q and IEl to increase. Thus, P and IEl vary directly along a linear de
mand curve.
For movements along a curved demand, both the slope and the ratio P/Q vary
continuously along demand. For this reason, elasticity generally varies along cur
vilinear demands, but there is no general rule about the relation between price and
elasticity as there is for linear demand.
As it turns out, there is an exception to the general rule that elasticity varies
along curvilinear demands. A special kind of curvilinear demand function exists
for which the demand elasticity is constant for all points on demand. When de-
mand takes the form Q = aP', the elasticity is constant along the demand curve
and equal to b2 Consequently, no calculation of elasticity is required, and the price
elasticity is simplythe value of the exponent on price, b. The absolute value ofb
can be greater than, less than, or equal to 1, so
that this form of demand can be
elastic, inelastic, or unitary elastic at all points on the demand curve. As we will
show you in the next chapter, this kind of demand function can be useful in statis-
tical demand estimation and forecasting
Figure 6.3 shows a constant elasticity of demand function, Q aP", with
=
the values of a and b equal to 100,000 and -1.5, respectively. Notice that price
elasticityequals -1.5 at both points U and V where prices are $20 and $40,
respectively
P-A 20
20-33.33
33-1.5
40 -1.5
EP-A0-66.67
you never need to compute the price elasticity of demand for this
Clearly, kind
of demand curve because E is the value of the exponent on price (b)
Relationn general, the price elasticity of demand varies along a demand.curve. For linear denand
Curves, priceanid 1e varydirectly The higher lower)the price the more (less) elastic is demand. For acur
Now try Technical
Vilinear demand, there is no generalrule aboutthe relation between price and elasticity, except for the
Problem 11.
Special case of aaf which.has a constant priceelasticity(equalto b for all prices
See the appendix at the end of this chapter for a mathematical proof of this result.
8
Find more at
214 CHAPTER6 Elasticity and
Demand
FIGURE 6.3
Constant Elnsticity
of Demand
80
D: Q 100,000P-1.5
66.67
60
40
VE,-1.5
33.33
20 E1.5
1,000 2,000 3,000

Quantily
6.5 MARGINAL REVENUE, DEMAND, AND PRICE

ELASTICITY
ne responsiveness of consumers to changes in the price of a good must be co
Sideredby managers of price-setting firms when making pricing and output dect
S1ons. The price elasticity of demand gives managers essential information about
how total revenue will be affected by a change in price. As it turns out, an equally
Thargina revenue M
The addition to total
inmportant concept for pricing and output decisions is marginal revenue. Marginal
revenue (MR) is the addition to total revenue attributable to selling one additional
revenue attributable to
unit of output:
selling one additional
unit of output; the slope
of total revenue. MR ATR/AQ
Because marginal revenue measures the rate of change in total revenue as quan-
tity changes, MR is the slope of the TR curve. Marginal revenue is related to price
elasticity because marginal revenue, like price elasticity, involves changes in total
revenue caused by movements along a demand curve.
Marginal Revenue and Demand

As noted, marginal revenue is related to the way changes in price and output at
fect total revenue along a demand curve. To see the relation between marginal
revenue and price, consider the following numerical example. The demand sched-
ule for a product is presented in columns 1 and 2 of Table 6.3. Price times quantity
gives the total revenue obtainable at each level of sales, shown in column 3.
Marginal revenue, shown in column 4, indicates the change in total revenue
from an additional unit of sales. Note that marginal revenue equals price only
Find more at
CHAPTER 6
TABLE 6.3 Elasticity and Demand 215
Domand and Marginal (1) (2) (3)
Rovenu (4)
Unit sales Price Marginal revenue
Totol revenu
0
$4.50 (ATRIAQ)
4.00 4.00
2 $4.00
3.50 7.00
3 3.00
3.10 9.30
4 2.30
2.80 20
5
1.90
40 12.00
6 0.80
2.00 12.00 0
1.50 10.50 1.50
for the first unit sold. For the first unit

1 unit The first unit sold adds
sold, total revenue is the demand price for
$4-the price of the first unit-to total revenue, and
the marginal revenue of the first unit
sold equals $4; that is, MR P for the first
=
unit. If 2 units are sold, the second unit should

contribute $3.50 (the price of the
second unit) to total revenue. But total revenue for 2 units is
that the second unit adds only $3 (= $7- $4) to total revenue. only
$7, indicating
Thus the marginal
revenue of the second unit is not equal to price, as it was for the first unit. Indeed,
: examining columns 2 and 4 in Table 6.3 indicates that MR <P for all but the first
unit sold.
Marginal revenue is less than price (MR < P) for all but the first unit sold be
cause price must be lowered in order to sell more units. Not only is price lowered
on the marginal (additional) unit sold, but price is also lowered for all the inframar-
inframarginal units ginal units sold. The inframarginal units are those units that could have beensold
Units of output that
at a higher price had the firm not lowered price to sell the marginal unit. Marginal
could have been sold at
a higher price had a firm revenue for any output level can be expressed as
not lowered its price to
sell the marginal unit. Revenue lost by lowering price
MR =Price
on the inframarginal units
The second unit of output sells for $3.50. By

itself, the second unit contributes
$3.50 to total revernue. But marginal revenue is not equal to $3.50 for the second
unit because to sell the second unit, price on the first unit is lowered from $4 to
$3.50. In other words, the first unit is an inframarginal unit, and the $0.50 lost on
the first unit must be subtracted from the price. The net effect on total revenue of
selling the second unit is $3 (= $3.50 $0.50), the same value as shown in column4
of Table 6.3.
If the firm is currently seling 2 units and wishes to sell 3 units, it must lower
$3.10.
price from $3.50 to $3.10. The third unit increases total revenue by price,
its
To sell the third unit, the firm must lower price on the 2 units that could have
been sold for $3.50 if only 2 units were offered for sale. The revenue lost on the 2
2). Thus the marginal revenue of the third

inframarginal units is $0.80 (= $0.40 x
Find more al
16
C4APTER Elnstieity hnd Detmarnd www.downloadslide.com
unit is $2.30
(= $3.10- and marginal revenue is less than the price or the
S0.80), marginal
third unit. revenue is less na
1s now
easy to
pTice is not lowered see
on
why P MR for the first unit sold. For the
firstu
it sold,
any inframarginal units. Because
Se itional
of sales
units, marginal
(output).
price
revenue must be less than pricemust level
at every
Ore
As
shown in column 4, marginal revenue declines for each adaitionai nit sold.
Notice that it is
positive for each of the first 5 units sold. a l rev-
enue is 0 for the
sixth unit sold, and it Howevet, t is, the
seventh unit sold actually causes total becomes negative thereafter. n
to decline. Marginal revern

e
pOSitive when the effect of lowering pricerevenue

on the
than
contributed by the added sales at the inframarginal units 15 revent
s
the revenue
te
1s negative when the effect of lowering price on thelower price. Margina
than the revenue
contributed by the added sales at the inframarginal units is grea ter
lower price
Relation Marginal revenue must be less than price for all units sold after the first,
Ust De lowered to sell more units. When marginal sevenue is because price
y increases. When marginal revenue is negative, positive, total revenue increases ne
9inal revenue.is cgual to 0 when total,.revenue decreases when quantity increo3

total.revenue.is maximized.
Figure 6.4 shows
graphically the relations among demand,
and total revenue
for the demand schedule in Table 6.3. As mar8inai reve
noted; MK 1S below
price (in Panel A) at
every level of output except the first. When total revenue
Fanel B) begins to decrease, marginal revenue becomes negative. Demana anu
marginal revenue are both negatively sloped.

Sometimes the interval over which ter
than one unit of
marginal revenue is measureu 6
output. After all, managers don't necessarily increase output oy

Just one unit at a time. Suppose in Table 6.3 that we want to
enue when
compute marginal rev
output increases from 2 units to 5 units. Over the interval, the change
in total revenue is
$5 (= $12 $7), and the change in output is 3 units.
Marginal
-
revenue is $1.67 (=
ATR/AQ = $5/3) per unit change in output; that is, eacnOr d
3 units contributes
(on average) $1.67 to total revenue. As a general rule, whenever
the interval over which
marginal revenue is being measured is more than a singie
unit, divide ATR by AQ to obtain the nmarginal revenue for each of the units of
output in the interval.
AS mentioned in Chapter 2 and as you will see in Chapter 7, linear demand

equations are frequently employed for purposes of empirical demand estimation
and
demand forecasting. The relation between a linear demand equation and its
marginal revenue function is no different from that set forth in the preceding rela-
tion. The case of a linear demand is special because the relation between demand
and marginal revenue has some additional properties that do not hold for nonlin-
ear demand curves.
When demand is linear, marginal revenue is linear and lies halfway between
demand and the vertical (price) axis. This implies that marginal revenue must
be twice as steep as demand, and demand and marginal revenue share the same
ind mo at www downloadslide.cn
CHAPTER 6 Elastícity and Dernand 217
FIGURE 6.
Demand, Marginal Rovonuo, ana Total Rovanue
4 00
3.50
3.00
12.00
2. 50
TR
10.00
00
1.50 .00
1.00
6.00
0.50
4.00
- Q
-0.50
2 7 2.00
Quanlily
-1.00
7
-1.50
MR
QUantity
Panel A Panel B
intercept on the vertical axis. We can explain these additional properties and show
how to apPply them by returning to the simplified linear demand function (Q=
a+ bP + cM + dPR) examined earlier in this chapter (and in Chapter 2). Again we
hold the values of income and the price of the related good R constant at the spe-
cific values M and PR, respectively. This produces the linear demand equation Q
a+bP, where a' =a + cM + dP. Next, we find the inverse demand equation by
solving for P = {Q) as explained in Chapter 2 (you may wish to review Technical
Problem 2 in Chapter 2)
P-+
= A+ BQ2
where A -a'/b and B = 1/b. Since a' is always positive and b is always nega-
tive
(by the law of demand), it follows that A is always positive and B is always
negative: A>0 and B<0.Using the values of Aand B from inverse demand, the
equation for marginal revenue is MR = A +2BQ. Thus marginal revenue is linear
has the same vertical irntercept as inverse demand (A), and is twice as steep as in-
verse demand (AMR/AQ = 2B).
12
218 CHAPTER G
revenue is also e
nersecis the when
fit nverse
vertical
demand is same P=
(price) axis at thelinear, pointA+ BOIA>
demand 0.and
does,
marqinal
B<is0),twice as steep as the inverse de
mand tunction. Ihe equation of the lincar marginal revenue curve is MR= A+ 280 igioadiat
Tgire . 5 shows the linear inverse demand curve P = 6-0.099 nal
t t i s negative because P and Q are inversely related.) The associated mag
evenue curve is also lincar, intersects the price axis at $6, and is twice as ste
the
demand curve. Bccause it is twice as steep,
marginal revenue
quantity axis at 60 urits, which is half the output level for which demand ir
intersectis
sects the quantity axis. The equation for marginal revenue has the same verta
intercept but wice the slope: MR = 6- 0.10Q.
Marginal Revenue and Price Elasticity

Using Figure 6.5, we now examine the relation of price elasticity to demand ana
marginal revenue. Recall that if total revenue increases when price falls and quan
tty rises, demand is elastic; if total revenue decreases when price falls and guai
tty rises, demand is inelastic. When marginal revenue is positive in P'anel A, ro
à
quantity of 0 to 60, total revenue increases as price declines in P'anel B; thus a
mand is elastic over this
range. Conversely, when marginal revenue is negative, at
any quantity greater than 60, total revenue declines when price falls; thus demanc
must be inelastic over this range. Finally, if marginal revenue is 0, at a quantity O
60, total revenue does not change when quantity changes, so the price elasticity Or
demand is unitary at 60.
FIGURE 6.5
Linear Demand, Marginal Revenue, and
Elasticity (Q =
120
20P
E=1
Inverse D:P = 6-0.050
El1
El>
TR=Px@ 6Q-0.0502
El-1 180
E<
10 60 120 60 120
Quantily Quantily
MR = 6- 0.100
Panel A Panel B
3
CHAPTER 6 Elastícity and Demand 219
TABLE 6.4
(1) 2) (3)
Marginnl Rovonuo, Totnl Marginal revenue Total revenue Price elasticity of demand
Ravonuo, nnd Prico
Elasticity of Demand MR0 TRincreases as Qincreases (Pdecreases)
Elastic(E>1)
MR0 TRis maximized Unit elastic (|E| = 1)
MA<0 TR decreases as Q increases (Pdecreases)
Inelastic(El<1)
Except for marginal revenue being linear and twice as steep as demand, all the
preceding relations hold for nonlinear demands. Thus, the following relation (also
summarized in Table 6.4) holds for all demand curves:
Relation When MB is positivenegative), total revenue increases (decreases) as quantity increases,

and demand is elastic(inelasticl When MRis equal to 0, the price elasticity of demandisunitary
The relation among marginal revenue, price elasticity of demand, and price at
any quantity can be expressed still more precisely. Ás shown in this chapter's ap-
pendix, the relation between
or curvilinear demands, is
marginal revenue, price, and price elasticity, for linear
MR-P(1+E)
where E is the price elasticity of demand and P is product price. When demarnd is
elastic (IEI > 1), 11/El is less than 1, 1 + (1/E) is positive, and marginal revenue
is positive. When demand is inelastic (1El < 1), 11/El is greater than 1, 1 + (1/E) is
negative, and marginal revenue is negative. In the case of unitary price elasticity
(E=-1), 1 +(1/E) is 0, and marginal revenue is 0.
To illustrate the relation between MR, P, and E numerically, we calculate
marginal revenue at 40 units of output for the demand curve shown in Panel
A of Figure 6.5. At 40 units of output, the point elasticity of demand is equal to
-2[= P/(P - A) = 4/4- 6)]. Using the formula presented above, MR is equalto
2 [ 4(1 1/2)]. This is the same valu for marginal revenue that is obtained byy
0.1(40) 2.
substituting Q 40 into the equation for marginal revenue: MR 6
= - =
=
Relation Forany demand curve,whendemand is elastic(1>1, marginal revenue is positive. When

demand isinelastic (EKI),marginal.revenue is negative. When demand is unitary elastic (El= 1). mar
ginal revenue is G. For aldemand and marginalrevenue curves
Now try Technical

Problems 12-14.
where Eis the price elasticity of demand
6.6 OTHER DEMAND ELASTICITIES
Sometimes economists and business decision makers are interested in measuring

the sensitivity of consumers to changes in either income or the price of a related
nd re al wwv downloadslidio.com
220 CHAPTER 6 Elasticity ard Denand
income elnsticity (E
good. Income clasticity measures the responsiveness of quanti Con-
Ameasure of the respon

siveness of quantity changes in income, holding all
other variables in the generaa ied to
demnded to changes stant. Cross-price elasticity measures the responsiveness of quan the general
in income, holding all
Canges n the price of a related good, when all the other variables
in
nd
other variables in the show how to calcuia
cemand function remain constant. In this section we
general demand function these
constant.
interpret two elasticities.
cross-price elasticity Income Elasticity (EM

(Ex n
A measure of the respon AS hoted, income elasticity measures the responsiveness of quantity purchasea
siveness of quantity income changes, all else constant. Income elasticity, E, is the percentagel other
demanded to changes quantity demanded divided by the percentage change in income, hold nt
in the price of a related Variables in the general demand function constant, including the good's own p r
good, when all the other
variables in the general
demand function remain E AM/M M M
constant. be
on the sign of AQ/AM,
which may p
is normal) Ey
i
E rn see, the
the good
sign of or depends
negative (if the good is inferior). Thus if the 8o0u
tic-
normal, the income elasticity is positive. If the good is inferior, the incOtle
ity is negative.
like price elasticity of demand, can bemeasured either over
One elasticity, the interval measut
or at a on the general demand curve. For
a nterval point
of income elasticity, compute AQ/AM over the interval and multiply tnis siope
the ratio of average income divided
by average quantity
AQAverage
EMAM ^ Average M
When the change in income is relatively small, the point measure of income elas
ticity is calculated by multiplying the slope AQ/AM by the ratio M/@O
of income
inear demand function, Q a + bP + cM + dP., the point measure
=
elasticity is
E
because slope parameter c measures AQ/AM, as you learned in Chapter 2.
To ilustrate the use of income elasticity, consider Metro Ford, a new-car dealer
ship in Atlanta. The manager of Metro Ford expects average household income
in Fulton County to increase from $45,000 to $50,000 annually when the current
recession ends, causing an increase in the demand for new cars. At a constant av-
erage price of $30,000 per car, the increase in income will cause sales to rise irom
800 to 1,400 units per month. Panel A in Figure 6.6 illustrates this situation. The
increase in income shifts the demand for n e w cars rightward-a new car is a n o r
mal good. To calculate the income elasticity of demand, we use the arc elasticity
method of computing percentage changes over an interval. The income elasticity
of demand in Panel A is
600 4/,5UU= 5.18

EAM Average 5,000 1,100
S
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CHAPTERG Elastícity and Demand 221
1GURE 66
Caleuatinu tneeme flastieity ot Demand
u5.18 M.33
12,000
30,000 DuA5,00
DMAS,000 DM-50,000
Diys0,00
800 1,400 0 400 800
Quonlity of new cors (per monlh) Quantity of used cars lper month)
Panel A Normal good Panel B- Inferior good
We should mention that the choice of $30,000 as the price at which to measure
income elasticity is arbitrary. The manager at
Also notice that
Ford
Metro probably choseMa price
for Q and
of
used
are
$30,000 as a
typical new-car price. averages
because the income elasticity is for
computed the interval A B
to
Now consider Lemon Motors, a used-car dealership in Atlanta. Panel B in
6.6 the demand for used cars at Lemon Motors. The increase in
Figure depicts
household income in Fulton County causes a decrease in demand for used cars
from D to D-used cars are assumed to be inferior goods in this example. If used-
car prices hold at $12,000, sales at the used-car dealership fall from 800 to 400 units
the
per month. Again using the arc method of computing percentage changes,
income elasticity of demand is
E A x Average M -400 47,500 -6.33
MAM Average 5,000 600
As expected, the income elasticity is negative for an inferior good.
Relation The ncome elasticity.measuresthe responsiveness.of.consumers to changesin income when

theprice of thegood and al otherdeteiminants.of demand are held.constant. The income elasticity is posi-
tivenegative) for normal(inferiorlgoods
Cross-Price Elasticity (Ex

The a good, as already noted, measures the
cross-price elasticity of responsive-
ness of quantity demanded of one good to changes in the price of a related
16
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Find more
222 CHAPTER6 Ehsticity and Demand remain con

function
demand good
general question (X) and
another
good R, when all the other variables in the in the

between the goodt change
elasticity
stant. 1he cross-price
of the
percentage
change
in
(R)-denoted Ey-is caleulated by taking the rali

by the
percentage
demanded of good X (%AQ) and dividing

quantity
the price of the other good R (»dPp)
%AQ AQ,/Q,
XRYoAPAP,/P, be positive
which can
AQ,/AP
Note that the depends on the sign of
sign Eyp
of
or negative. Recall from Chapter 2 that if
an incrcase nt
the
cgoods are
ubsti-
subs
increase,
to the quantit
causes the quantity purchased of another good of ood causes
tutes (i.e., AQ,/AP, > 0). If the rise in the price one
complements (.e, a0y/fR
of another good to fall, the goods are 8 two
Prchased the other good, tne

in the quantity purchased of X and K are suosu
tuere is nochange pOsitive when
(i.e., AQ,/4P, 0). Thus E.. is
=
efutes;ndependent
Ex is negative when X and R are complements." be mea
demand, can
income elasticities of
like price and
As before, obta
to
OSSprice elasticity, demand curve.
over intervals or at points on the general and muiupiy
surea AQ/AP, over the
interval
measure of elasticity, compute averag
ne intervaltimes ratio of
tnis the average price of the
related good divided by
siope
quantity:
ExR AQ Average
AP ^ Average
the point mea*

is relatively small,
when change in the price of the related good
the
the ratio Pp/Q.
For tne
is calculated by multiplying the slope AQ/AP, by
Sure of Exa the point measure
of ExR 5
inear demand function, Q =a + bP + cM + dP
because, as explained in Chapter 2, d measures AQ/AP,

the Tampa Bay Buccaneers
is studying the
Suppose the general manager of is the sensitivity
or
demand for Buccaneer football tickets. Of particular concern
hockey
Bucaneer fans to the price of Tampa Bay Lightning tickets (P,)-Tampa's
football games at Raymond James Stadium (p
team-and the price of parking for for Buccaneer tootball
and a complementary good, respectively,
a substitute good owner of the Lightning plans
fans. The Bucs' general manager has learned that the
"low" ticket price of $45 hockey game by 5 percent. Ater
to cut its already per
ticket
the Buccaneers became Super Bowl champions in 2003, general seating
3We should note that the cross-price elasticity of X for R need not equal the cross-price elasticity
of R for X, although the two will generally have the same signs.
Find moro at www downloadslicde.com
CHAPTERG Elasticity arnd Demand 223
piees (P) were raised to $75 per game. Since the Super Bowl victory, average
household income has stagnated at $50,000 (M). So, rather than raiseticket prices
any urther at this time, the general manager plans to increase parking fees by
10 percent (urrently $15 per vehicle), unless, of course, ticket demand turns out to
be quite sensitive to jparking fees.
The Buccaneer general manager obtains from a consulting firm the following
statistically estimated demand for tickets in the general seating areas, which ex-
cludes chb and luxury seating
Q 49,800 750P + 0.85M+400P, - 625Pp
The general manager decides to calculate the cross-price elasticities for

hockey tickets and parking fees, Ex and E respectively, at the point on de-
mand corresponding to the current values of the demand variables: P = $75,
M $50,000, P, = $45, and P, = $15. The estimated quantity demanded of
Buccaneer football tickets in the general seating areas is 44,675 [= 49,800
(750 x 75) + (0.85 x 50,000) + (400 x 45) - (625 x 15)]. The cross-price elastic-
ity of Buccancer ticket demand with respect to Lightning ticket prices (Bg) can
be calculated as follows:
Ext 400 146750.40

Note that the cross-price elasticity between Buccaneer and Lightning tickets
is positive (for substitutes) but rather small, indicating football and hockey are
rather weak substitutes in Tampa. Similarly, the cross-price elasticity of Buccaneer
ticket demand with respect to parking fees (Exp) is computed as
E -0.21
The cross-price elasticity between football and parking is negative (as expected
for complements) but small, indicating that Buccaneer fans are not particularly
responsive to changes in the price of parking
With such small absolute values of the cross-price elasticities, the Buccaneers
general manager can reasonably conclude that falling hockey ticket prices and
rising parking fees are not likely to have much effect on demand for general seat-
ing football tickets. More precisely, the 5 percent drop in Lightning ticket prices
is likely to cause only a 2 percent (= 5% X 0.40) decrease in the quantity of Bucs
tickets sold, and the 10 percent increase in parking fees is predicted to decrease
ticket sales by just 2.1 percent (=10% x -0.21).
.
Relation Thecrose price elasticitymeasurestheresponsivenessofthequantity dermandedofone good
when thepriceofanothergooddhanges,holding
the proeofthegoodandallother determinantsofdemand
constant.Crosspriceelasticity
ispositive (negative)whenthetwo goodsaresubstitutes(complements)
I8
Find more at
224 CHAP1ER laatity nnd emaned
of
1LLUSTRATION 6.3 elasticities
inicome
Normal goods
have positive have
negative in
Empirical Elasticities of Demand (,), and
i n f e r i o r gonds
potatoes
a r e inferior
beef and
emand
When we Use Ihe appropriale data and statistical tech- Ground more strong'y
coime elasticities. Steaks are
that a given
is negative.
niques, it is prussible lo estimale ptice, income, and gods since l,
chicken or pork,
indicating
a
fourfold
Cross-price clasticities from actual demand schedules. notmal than

in
income
causes
over
than
chicken
We have collected a sample of estimated demand elas pCrcentage

increase
consumption
normal
in steak strongly
ticities from a varieiy of sources and present them in (fivefold)
velold) increase n win
increase
Wine is more
demand
for
of
theaccompanying table. In the apler
chapter on empirical
demand funetions, we will show how lo estimate ac-
empirical
(pork)beer.
consumption.
The high
income
elasticity
demand for for-
than
consuner
indicates
that
tual demand elasticities. reign
travel
Looking at the price elasticities
s presented
presented in the cign travel is quite resp for both Japanese an
table, note that demand ffor some basic agricultural Lifc insurance is a norma
the demand
that the d for life insurance 15
note
products such as butter, chicken, pork, ond eggs is in- Americans, but Japanescdechanges in incomé.as
U.s
sensitive to
clastic. Fruit, for which consumers can find many sub- ncarly twice as
elas-.
stitutes, has a much more clasticdemand than chicken demand for life insuran that cross-price
the text for
pok, or eg8s. Whether ground into hamburger or cut We cxplained in substitutes
and negative
for
into steaks, beef is usially morc expensive
than the ticitics are positive goods
in the table are
other two basic meats, chicken and pork. Because beef complements. All four P o d chicken are weak sub
represents a larger fraction of households' grocery bill, substitutes (Fxy0). 5tearustterseem to be rather
consumers are more sensitive to change,in beef prices stitútes, while margarine anu d r i n k e r s substitute
Beer and wine
than to changes in chicken prices. And, because steaks strong substitutes.
willstrong
substitutes. eer era. but apparently
beverages
beef, consumers the two alcoholic
be more sensitive toasteakground
between
d prices. Apparently consum- not with much enthusiasm. h e extei
can find few.substitutes price elasticity of demand

of beer, wine, and igarettes between e 5 rsof
ers are quite brands of raisin bran cereal, suggests tnat
for 1tems
these for since demand
the elasticities
inelastic all three. Demand for clothing, something Kellogg's brand possess strong Dra
most of us are unwilling to go without is inelastic. A quite unwilling to switch to the r o s g
recent study found that buyers of dynamic random

access memory (DRAM) chips are so insensitive to Elasticities ofDemand
Price changes that it estimated demand to be perfectly Table of Empirical
inelastic for DRAM chips! We do not wish to dispute Priceelasticities of demand (E 0.24
the results of this study, but we suspect the demand for BUter 0.30
DRAM chips is perfectly inelastic only for.a very nar Chicken 0773
Pork
rowrange of prices. As prices for:bandwidth decline 0.26
Internet service providers (ISPs) apparently goBble.up Eg9 101
bandwidth to transmit data between different.coun Beeflground)
tries on fiber-optic cables. For any particular type and Beef steaks) 3.02
brand of ready-to-eat cereal consumers can find plenty ruit 0:20
of readilyavailable substitutesConsequently, the de Beer 0.67
mand for raisin bran cereal is rather large for both lead Wine 0.51
ingbrands Another factor affecting price elasticity is Cigarettes 0.67
the length of time consumers haveto adjust to a price Clothing 0:2
change. For example, electricity demandis more price Jaxi cabs New York Ciy 00
responsive in the long Tun than in the shortrun. Itis in Dynamic Random ACcéss Memov(DRAM Chips
teresting thatgasoline demand isinelasticintheshort Transnationalfiber-optic bandwidth
run but elastic in the long rún.
19
ind more al www.downloadslide.com
CHAPTER6 Elasticity and Dernand 225
Kellogo's Raisin Bran Irtin No. 1821, Rconomic Rescarch Service, U.S.
06
f Agriculture,
Department
Prt Raisin an
03
September 1993. For eigarettes price elastic
ity, ser Frantk Chaloupka, "Rational Addictive Behavior and
Elettricity (short un) 0.28 Cigarette Smoking," Journal of Political k.conomy, August
Electricity long run) 0.90 1991, For clothing price elasticities, see Richard Blundell,
Gasolino (shi1 tun) 043
P'anos Pasl ardes, and Guglíelno Weber, "What Do We
Ivarn about Consumer Demand Patterns from Micro Data,"
Bosoline (long run) 1 50
Intomo nlnsticitios ol domnnd American conomic Revieu, June 1993, For alcohol elasticities,
Boet (ground)
(E) see Jon Nelson, "Broadcast Acdvertising and U.S. Demand
0.19 for Alcoholic Beverages," Southerh Economic Journal, April
Beel (stoaks 1.87
1999. For ereal elasticities, see A. Nevo, "Mergers with Dif-
Chieken ferentiated P'roducts: The Casc of the Ready to Eat Cereals
042 Industry" RAND Jornal of Lconomles, Autumn 2000. For
Pork short-run and long-run gasoline and electricity elasticities,
0.34
Polatoes 0.81 see Robert Archibald and Robert Gillingham, "An Analysis
Beer of Short-Run Consuner Demand for Gasoline Using
0.76 Houselhold Survey Data," Revicw of Economics and Statistics,
Wine 1.72 November 1980;and Chris King and Sanjoy Chatterjee,
Life insurance in Japan 99 "Predicling California Demarid Response: How Do Custom-
Life insurance in United States ers React to Hourly Prices?" Puhlic Utilities Fortnightly 141,
1.65
Cross-price elasticities of demand (E no.13 ((uly.1, 2003) For income elasticity of demand for
Beef (steaks) and chicken
0.24
electricliy, sec Cheng1Hsiao and Dean Mountain, Estimat
Margarine and butter . ing lhe Short-Run Income Elasticity of Demnand for Electric
1.53 ily.by Using Cross-Sectional CalegorizediData," Journal of
Beer and wine 0.56 Ihe American Siatistical Associalion,June 1985 For the price
Kellogg's Raisin Bran and Post Raisin Bran elasticity of fiber-optic bandwidth, see the editorial"Fear
0.01
of Fiber-Optic Glut May be Misguided, Lightwave 17, nó.9
(August 2000). Lite insurance elasticities can be found in
Dai I. Chi, "Japan'Life, But Not as We Know It" Euromoney,
Sources: For price, cross-price, and income elaslicities lor October 1998. For the price elasticity.of DRAM chips, see
agricultural products, see Dale Heien, "The Structure of Jim Handy, "Has the Market Perked Up Yet?" Electrornics
Food Demand:
Interrelatedness and Duality, Times, June 5, 2000 For taxi cab elasticity, see Bruce Schaller
nal of Agricultural Economics, May 1982; and K. Anerican Jour
S.Huang,AA "Elasticities for Taxicab Fares and Service Availability
Compiete System of U.S. Demand for Food" Techinical Biul Transportation 26 (999
6.7 SUMMARY
Price elasticity of demand, E, measures responsiveness or The effect of changing price on total revenue is deter-
sensitivity of consumers to changes in the price of a good mined by the price elasticity of demand. When de-
by taking the ratio of the percentage change in quantity mand is elastic (inelastic), the quantity (price) effect
demanded to the percentage change in the price of the dominates. Total revenue always moves in the same
good: E= %AQ,/%AP The larger the absolute value of E, direction as the variable, price or quantity, having the
the more sensitive buyers will be to a change in price. De- dominant effect. When demand is unitary elastic, neither
mand is elastic when IEl> 1, demand is inelastic when effect dominates, and changes in price leave total reve
TEl 1 , and demand is unitary elastic when El = 1. If nue unchanged. (LO2)
price elasticity is known, the percentage change in quan- Several factors affect the elasticity of demand for a good:
tity demanded can be predicted for a given percentage (1) the better and more numerous the substitutes for a
change in price: %AQ, = %AP X E. And the percentage
good, the more elastic is the demand for the good; (2) thee
change in price required for a given change in quantity greater the percentage of the consumers' budgets spent
demanded can be predicted when E is known: %AP =
on the good, the more elastic is demand; and (3) the lon-
%%AQ,E. (LO1) ger the time period consumers have to adjust to price
20
The Theory of Individual Behavior
HEADLINE Ledrbing Objectives

Afler completing this chapter, you will be
able to:
Packaging Firm Uses Overtime Pay LO1 Explain four basic properties of a con
to Overcome Labor Shortagee sumer's preference ordering and their
ramifications for a consumer's indiffer
Boxes Ltd. produces corrugated paper containers
at a small plant in Sunrise Beach, Texas. Sunrise
encecurves
LO2 1llustrate how changes in prices and
Beach is a retirement community with an
aging
and over the past decade the size of its income impact an individual's
population, opportunities.
working population has shrunk. In 2010, this labor
shortage hampered Boxes Ltd.'s ability to hire 103 1llustrate aconsumer'sequilibrium.choice
enough workers to meet its growing demand and ond how it changesin response to
production targets. This is despite the fact that it changes in prices ond income
pays $10 per hour-almost 30 percent more than 104Separate the impact of a price chonge
the local average-to its workers. iniosubstitution and income effects
Last year, Boxes Ltd. hired a new manager
who instituted an overtime wage plan at the firm. L05 Showhowto derive anindividual's
Under her plan, workers earn $10 per hour for the demgnd curve from inditerence curve
first eight hours worked each day, and $15 per hour
analysis and market demand trom a
for each hour worked in a day in excess of eight
group ot individuals demands
hours. This plan eliminated the firm's problems, as L06llustratehow buyone, get one free
the firm's production levels and profits are up by deals and gitcertificates impact a con-
20 percent this year. sumer's purchase decisions
Why did the new manager institute the overtime LO7 Apply the income leisure choice frame
plan instead of simply raising the wage rate in an work to illustrate the opportunities,incen
attempt to attract more workers to the firm? tives, ond choices of workers and
managers.
117
2-
nnd Butinees Stna"gy
18 MaHngniol Peommiee
INTRODUCTION
understand the behavior
of individ
a manager
that help
This chapler develops tools workers, and the impart of alternatíve
incentives
and use com
1als, such as This is not as simple as you might tlink. Human beingscapable
consumers
their decisions. decisions, arnd the

human brain is o
to make is purnp
plicated thought processes moment your heart
nformation. At this very
vast quantities of and expe
processing are providing oxygen
throughout your body, your lungs brain processe
ng blood and your eyes are scanning
this page while your
and sop
Carbon dioxide, supercomputers
it. The human brain can do what even
inlormation on
are incapable of doing.
cated "artificial intelligence" technology need a mo0e
processes, managers
the complexities ofhuman thought
Despite marketplace and in the
work environn
explains how individuals belave in the the full range or i
individual behavior cannot capture of indi
course, attempts to model be firms if the behavior
world behavior. Life would simpler for nanagers of rewards for being a manaB
On the other hand, the
VIduals were not so complicated. achieve an understanding
of individual Dea
a fim would be much lower. If you
Or you succeed
in the business word
a marketable skill that will help
will
gain the way indiviau
ou
of behavior will necessarily
be an abstraction of
that focuses
ur model
ais really make decisions. We must begin
with a simple model
to enhance
would do little
behavioral features that
ESsentials instead of dwelling on of an eco
our study
these thoughts in mind as we begin
Our
understanding. Keep
nomic model of consumer behavior.
CONSUMER BEHAVIOOR
behavior must
be an
Now that you recognize that any thed about individual
us understand noW
a model to help
abstraction of reality, we may begin to develop A consumer
is
them.
consumers will respond to the alternative
choices that confront
services from firms for
the purpose or co
an individual who purchases goods and consumes the
interested not only in who
Sumption. As a manager of a firm, you are but is not
six-month-old baby consumes goods
80od but in who purchases it. A a manufacturer
of baby
for purchase decisions. If you are employed by
responsible not the babys.
food, it is the parent's behavior you must understand, but distinct raC
are two important
In characterizing consumer behavior, there Consumer
consumer preferences.
tors to consider: consumer opportunities and
consumers can afford to
services
oPportunities represent the possible goods and be con-
consume. Consumer preferences determine which of these goods will
thus have the
afford (and
Sumed. The distinction is very important: While I can are
liver each week, my preferences
oPportunity to consume) one pound of beef
liver at all. Keeping this
such that I would be unlikely to choose to consume beef
distinction in mind, let us begin by modeling consumer preferences.
for sale. However,
In today's global economy literally millions of goods are offered
to focus on the essential aspects of individual behavior and to keep things manageable,
22
119
Th1heory of Individual Bebavlm
Is made
goods exist in the economy. This assumption
we will assume that only two
frorn this tw0-good
All of the conchusions that we dliaw
purely to simplify our analysis: the quantity of
there are many goods. We will let Xrepresent
setting remain valid when notation to represent the
one good and Ythe quantity
of the other good. By using this
be any two goods
model in the sense that Xand Ycan
two goods, we have a very general
rather than restricted to, say, beef and pork.
for alternative bun-
Assume a c o n s u m e r is able to
order his or her preferences
l e t d e n o t e this order-
frem best lo worst. We will
dles or combinations of goods bundle A to bundle
B. If the
and write A > B whenever the c o n s u m e r prefers or he is
ing we will say she
c o n s u m e r views the two
bundles as equally satisfying, > B,
Band use A Bas shorthand notation. If A
indifferent between bundles A and c o n s u m e r will
choose
bundle A and bundle B, the
then, if given a choice between bundle A and bundle B,
choice between
bundle A. If A ~
B, the consumer, given a is assumed to

she gets. The preference ordering
will not care which bundle he or marginal
m o r e is better, diminishing
satisfy four basic properties: completeness,
Let us examine these properties and their
rate of substitution, and transitivity.
in more detail.
implications
A and B-either A> B,
Property 4-1: Completeness. For any twobundles-say,
B> A, or A~ B. a s s u m e the c o n s u m e r
is capable
a r e complete, w e
By assuming that preferences all bundles. If preferences
or indifference among,
of expressing a preference for, would claim not to
where a consumer
there might be cases
w e r e not complete,
bundle A to B, preferred
B to A, o r w a s indiffer-
know whether he or she preferred his o w n prefer-
cannot express her o r
bundles. If the consumer
that
ent between the two
indifference among
the manager c a n hardly predict
goods,
ence for or
with reasonable accuracy.
individual's consumption patterns
much of every good
as
Is Better If bundle A has at least as
Property 4-2: More is preferred to
bundle B.
s o m e good, bundle A
bundle B and m o r e of consideration as
the c o n s u m e r views
the products under
If m o r e is better, northeast
this implies that as we m o v e in the
of "bads." Graphically, better
"goods" instead that the c o n s u m e r
views as being
m o v e to bundles
direction in Figure 4-1, w e bundle A is preferred to
southwest. For example, in Figure 4-1
than bundles to the Bundle Cis
good Xand m o r e of good Y
bundle Dbecause it has the s a m e amount of bundle Bis
bundle D, because it has m o r e
of both goods. Similarly,
also preferred to
preferred to bundle D information about
more is better provides important
While the assumption that for all
determine a consumer's preference
c o n s u m e r preferences,
it does not help us
the "more is better property
indifference curve note in Figure 4-1 that
A curve that possible bundles. For example, bundle B is preferred to bundle A or bundle A is.preferred
defines thhe does not reveal whether we will need to
make s o m e
combinations of to bundle B. To be
able to make such comparisons,
two goods that give additional assumptions. Ythat give the
a consumer the defines the combinations of goods Xand
An indifference c u r v e indifferent between
same level of
level of satisfaction; that is,
the c o n s u m e r is
c o n s u m e r the s a m e
satisfaction.
123
120
Managinl eomennies and Business
Steatesgy
FIOURE 4-1 The Indilierence Curve
any combination of goods along an indifference curve. A typical indifference cu e

Saepicted in Figure 4-1. By definition, all combinations of Xand Ylocated on n
nanrerence curve provide the consumer with the same level of satisfaction.
example, if you asked the consumer, "Which would you prefer-bundle A, bundie
or bundle C the consumer would reply, "I don't care," because bundles A, 5, anu
a l l lie on the same
indifference curve. In other words, the consumer is indifrere
among the three bundles.
h e shape of the indifference curve depends on the consumer's preferences.
Different consumers generally will have indifference curves of different shapes.
Une important way to summarize information about a consumer's preferencesisin
marginal rate of terms of the marginal rate of substitution. The marginal rate of substitution (MRS)
substitution 1s the absolute value of the slope of an indifference curve. The marginal rate of sub-
(MRS) stitution between two goods is the rate at whicha consumer is willing to substitute
The rate at which a
consumer is one good for the other and still maintain the same level of satisfaction.
willing to The concept of the marginal rate of substitution is actually quite simple. n
substitute one good Figure 4-1, the consumer is indifferent between bundles A and B. In moving from
for another good A to B, the consumer gains 1 unit of good X. To remain on the same indifference
and still maintain
curve, she or he gives up 2 units of good Y Thus, in moving from point A to point
the same level of
satisfaction. B, the marginal rate of substitution between goods Xand Yis 2.
The careful reader will note that the marginal rate of substitution associated witn
moving from A to B in Figure 4-1 differs from the rate at which the consumer is will
ing to substitute between the two goods in moving from B to C. In particular, in mov-
ing from B to C, the consumer gains 1 unit of good X. But now he or she is willing to
this
give up only I unit of good Yto get the additional unit of X. The reason is that
indifference curve satisfies the property of diminishing marginal rate ofsubstitution.
2
Thr Theory of Individual Bebavlo 121
Property 4-3: Diminishing Marginal Rate of Substitution. As a consumer

oblatns more of good X, the amount of good Yhe or she is willing to give upto
obtain another unit of good Xdecreases.
This assunmption implles that indifference curves are convex from the origin;
that is, they look like the indifference curve in Figure 4-1. To see how tine locations
of varlous indifference curves can be used to illustrate different levels of consuner
satisfaction, we must make an additional assumption: that preferences are transitive.
Property 4-4: Transitivity. Forany three bundles, A, B, and C, ifA> Band B-C
then A>C. Similarly, if A Band B- C, then AC.
~
The assumption of transitive preferences, together with the more-is-better

assumption, implies that indifference curves do not intersect one another. It also
eliminates the possibility that the consumer is caught in a perpetual cycle in whiich
she or he never makes a choice.
To see this, suppose Billy's preferences are such that he prefers jelly beans to
licorice, licorice to chocolate, and chocolate to jelly beans. He asks the clerk to fil
a bag with jelly beans, because he prefers jelly beans to licorice. When the clerk
hands hima bagful of jelly beans, Billy tells her he likes chocolate even more than
jelly beans. When the clerk hands him a bagful of chocolate, he tells her he likes
licorice even more than chocolate. When the clerk hands him a bagful of licorice,
Billy tells her he likes jelly beans even more than licorice. The clerk puts back the
licorice and hands Billy a bagful of jelly beans. Now Billy is right back where he
started! He is unable to choose the "best" kind ofcandy because his pferences for
kinds of candy are not transitive.
The implications of these four properties are conveniently suinmarized. in
Figure 4-2, which depicts three indifference curves. Every bundle on indifference
curve III is preferred to those on curve II, and every bundle on indifference curve ll
is preferred to those on curve I. The three indifference curves are convex and do not
cross. Curves farther from the origin imply higher levels of satisfaction than curves
closer to the origin.
FIGURE 4-2 A Family ofIndifference Curves
III
2.5
122 Maingerind eomonies and lRutiness Strategy
INSIDE BUSINESS 4-1
Indifference Curves and Risk Preferences

and the
e vvcl
er of
Have you ever wondered whysome individunls choose between a higher reward
(return)
to undertake tisky prospects, such as skyliving andd salely ofthe investment. drawn in
curves
indifference
investing in risky flinancial ascets, while othets choose
safer activities? Indifference curve ahalysis provldes an
The relativelysteep
an investor
who has a high mar
panel (a) describe between return and sarey,
nSwer to this question. rate of substitution induced to
Bnal a large
return to be
The accompanying figures plot three potential or he must reccive
She of safety. The indicale1d
relatively
investment options (represented by polnts A. B, and glve up a small amount in panel (b)
an
C). cach with different expected returns and risks. curves drawn
nditference ratc of substitution
Option A is the safest investment, but it offers the low marginal
nvestor with a This individual is willing
lowest return a (2.94
safety, with percent);
moderate option
return B percen);
(4.49 is of medium
and to give upreturn and
a lot of safcty,
safety t o g 0 aS h a s those
return.
in
DCIwccn
those in
curves such as
fund C is the least safc, but it carries the highest Aninvestor with Indifference most attractive,
option A
potential return (6.00 percent).
anel (a) finds Ihvestment ine
associated with the highest
nvestors view safety and the level of the return becausc it iscontrast, with indifference
on an investment as "goods"; investments with higher Curve. In Investor an
evels of safety are preferred to curves such as those in pancl () achieves the
ng oth
d u mgner
investments with lower returns and lower levels of indifference curve with nves ninvestor is
Sarety. Investors are willing to substitute between the types of investors are rational,-but on
Ievel of return and the level of safety. Given the three illing to give upsomeadditional financialreu
options, from an investor's viewpoint, there is a tradeoff more safety
Return Return
6.00 6.00
4.49
2.94
Safety
Satety
0 Low MediumHigh Low Mediuin High
a): Safety Chooser Risk Chooser
CONSTRAINTS
In making decisions, individuals face constraints. There are legal constraints, time
constraints, physical constraints, and, of course, budget constraints. To maintain
our focus on the essentials of managerial economics without delving into 1SSues
26
The Theory of Indlvdual Bebavlo 123
beyond the scope of this course, we will examine the role prices and income play in
constraining consumer behavior.
The Budget Constraint

Simply stated, the budget constraint restricts consuiner behavior by forcing the
consumer to select a bundle of goods that is affordable. Ifa consumer has only $30
in his or her pocket when reaching the checkout line in the supermarket, the total
value of the goods the consumer presents to the cashier cannot exceed 530.
To demonstrate how the presence of a budget constraint restricts the con-
sumer's choice, we need some additlonal shorthand notation. Let M represent the
consumer's income, which can be any amount. By using M instead of a particular
value of income, we gain generality in that the theory is valid for a consumer with
any income level. We will let R and P, represent the prices of goods and Y
budget set respectively. Given this notation, the opportunity set (also called the budget se)
The bundles of
may be expressed mathematically as
goods a consumer
can afford.
PX+ P Y M
In words, the budget set defines the combinations of goods Xand Ythat are afford-
able for the consumer: The consumer's expenditures on good X, plus her or his
expenditures on good Y, do not exceed the consumer's income. Note that if the con-
sume spends his or her entire income on the two goods, this equation holds with
budget line equality. This relation is called the budget line:
The bundles of
goods that exhaust PX+ RY-M
a consumer's
income. In other words, the budget line defines all the combinations of goods X and Ythat
exactly exhaust the consumer's income.
It is useful to månipulate the equation for the budget line to obtain an alterna-
tive expression for the budget constraint in slope-intercept form. If vwe multiply
both sides of the budget line by 1/P, we get
Solving for Yyields
Note that Yis a linear function of Xwith a vertical intercept of MP, and a slope of
-PJP
The consumer's budget constraint is graphed in Figure 4-3. The shaded area
represents the consumer's budget set, or opportunity set. In particular, any combi
nation of goods and Ywithin the shaded area, such as point G, represents an
affordable combination of Xand Y Any point above the shaded area, such as point
H, represents a bundle of goods that is unaffordable.
27
124
FIOURE A-3 1he Budgot Set
ne upper boundary of the budget set in Figure 4-3 is the budget line. If a con
A WOud
Sumer spent her or his entire income on good X, the expenditures on good
exactly equal the consumer's income:
PX= M
By manipulating this equation, we see that the maximum affordable quanuty o
good Xconsumed is
M
This is why the horizontal intercept of the budget line is
M
P
Similarly, if the consumer spent his or her entire income on good Y, expenditures on
Ywould exactly equal income:
RY= M
market rate of
substitution Consequentiy, the maximum quantity of good Ythat is affordable is
The rate at which
one good may be M
traded for another
in the market; P
of the budget line is given of
slope of the
budget line.
The slope byPIP,and represents the market rate
Substitution between goods Xand Y To obtain a better understanding of the market
2
The
Theny of
Individual Behavio
FIGURE A-4 The 125

Budget line
Budget line
0 2 X
10
rate of substitution between goods

X and Y, consider Figure 4-4, which
budget line for presents a
who has $10 in income and faces a price of $1 for
a consumer
Xand a price of $2 for good Y If we substitute these values of good
P, Pp and Minto the
formula for the budget line, we observe.that the vertical intercept of the budget line
(the maximum amount of good Ythat is affordable) is MIP, = 10/2 = 5. The hori-
zontal intercept is MP = 10/1 = 10 and represents the maximum amount of good X
that
can be purchased. The slope of the budget line is P/R=-(1/2).
The reason the slope of the budget line represents the market rate of substitution
between the two goods is as follows. Suppose a consumer purchased bundle A in
Figure 4-4, which represents the situation where the consumer purchases3 units of
good Yand 4 units of good X. If the consumer purchased bundle Binstead of bundle A.
she would gain one additional unit of good Y But to afford this, she must give up 2
units (4 2 = 2) of good X. For every unit of good Ythe consumer purchases,she
must give up 2 units of good X in order to be able to afford the additional unit of
is AYAX = (4 -3)/(2- 4) -1/2, =
good Y. Thus the market rate of substitution

which is the slope of the budget line.
Changes in Income
and the consumer's
The consumer's opportunity set depends on market prices
income. As these parameterS change, so
will the consumer's opportunities. Let us
on the opportunity set of changes in income by assuming
now examine the effects
prices remain constant.
consumer's initial income in is M. What happens if
Figure 4-5
Suppose the the slope of the
to M while prices remain unchanged? Recall that
M increases
Under the assumption that prices
remain
budget line is given by PIP
126
Managrtlal Feonomie s and Business
Strategy
FIGURE 4-5 Chongos in Incomn Shrink or Expand Opporlunitios
M
M<MeM
M
Increase
Inconie
Decrease
In Income
cnanged, the increase in income will not affect the slope of the budget i
However, the vertical and horizontal intercepts of the budget line both iner
our-
as the consumer's income increases, because more of each good can oP
e
chased at the higher income. Thus, when income increases from M to
g e t ne shifts to the right in a parallel fashion. This reflects an increase in
ne consumer's opportunity set, because more goods are affordable after
M from
rease n income than before. Similarly, if income decreases to
the budget line shifts toward the origin and the slope of the budget line remaino
unchanged.
Changes in Prices
Now suppose the consumer's income remains fixed at M, but the price of good A
decreases to P<P. Furthermore, suppose the price of good remains
FIGURE4-6 ADecreaseinthe Price of Good X

P
New budget line
Initial
budget line
130
127
s ngrd Sime the
i sievgr the beget ine is given by
grrwl hanget the slope, . the rerductinn in
i m hrmennt f making it flatter than bhefore Since the
gowl that can te pre
g o d Adme ehange thhe
haseed is MA, a rerluction in the
111) munt of
goi X that (an be Yintercept of the tbuelget line But the
maxi
1 uedget line) is M. whieh purehased at the lower price (the Xintercept
1rdntion in the price of is greater than M" Thus, the ultimate effect
s in Fige 4-6. gool Xis te rotate the budget line
Similarly. an increase in the price of gond Xleadscounterclockwise,
tontim of the
budget line, as the next
teo
demonstraiion protblem inelicates.
a
clockwise
Demonstration Problem 4-1

A consumer has
initial income
budget line, and show how it of $100 and faces pr ices of $I andP,
-
=
$5. Graph the
changes when the price of
good Xincreases to = $5.
Answer:
nitially, if the consumer spends his entire income on
100 units
of X. This is the horizontal intercept of thegood X he can purchase
initial
MIP= 100/1
consumcer spends his entire
income budget line in Figure 4-7. If the
Y. This is the vertical on good
Y, can purchasc
he
intercept of the initial budgct line. The MI,of the100/5
=
20 units of=
is
/R= - 1/5. slope initial budget line
When thc price of
good X increases to 5, the
purchase is reduced to MP= 100/5= 20 units maximum amount of X the consumer can
new
budget linc in Figure 4-7. If the consumer spends of X. This is the horizontal intercept of the
his entire income on
purchase MP =
100/5 =
20 units of Y. Thus, the vertical good Y, he can
remains unchanged; intercept of the budget line
the slope clhangesto
-P/R= -5/5=-1.
FIGURE 4-7 An Increase in the Price of Good X
New budget
line
20
Initial budget line
X
20 100
31
128 Managrrlal conomes and Business Stuategy
cONSUMER EQUILIBRIUM
m a x i m i z e s
bundle
that
The objective of the consumer is to choose the consu nption propery
m o r e - i s - b e t t e r
contained
his or her ulility, or satisfaction. Ifthere was no scarcity, the that

bundles con
would imply that the consumer would want to onsume the

scarcity is tha
infinite amounts of goods. However, one implicati of a f f o r d a b l e
that is, an of
sumer must select a bundle that lies inside the|budget set, our
with
analysis
preferences
bundle. Let us combine our theory of consumer
a f f o r d a b l e
constraints to see how the consumer goes about selecting the De

nd Y
Xand
bundle.
Consider a bundle such as A in Figure 4-8. This
ombination ofgoods
Isumer
on tdhe budget line, so the cost of bundle A completely exhausts tn line, ca
es to the budget erence
income. Given the income and prices correspon indiffe
achieve a higher or he
consumer do better-that is, can the
consumer instead of bundle D
H,
e
curver Clearly, if the consumer consumed bundle B

e
would be better off since the indifference curve through B liesisa ahle, In
A. Moreover, bundle B lies on the budget line and
thus arrorda
hrough bundle A because D
Short, it is inefficient for the c o n s u m e r to consume
both is affordable and yields a higher level of well-being mer's
Is bundle B optimal? The answer is no. Bundle B exhausts tne c Niaté
bundle that is even better: bundle C. TNo
dget, but there is another affordable the prefers more
than Dud
are bundles, such as D, that consumer
Lhat there
but those bundles are not affordable. Thus, we say bundle Crepresents tne o
consumer
that tne co
to the fact
equilibrium Sumer s equilibrium
Sumer has choice. The term equilibrium refers
no incentive to change to a different affordable bundle once this po
The equilibrium
Consumption is reached.
is that at the equilibrium col
bundle is the
affordable bundle An important property of c o n s u m e r equilibrium
is equal to the slope o
that yields the Sumption bundle, the slope of the indifference curve
the slope of the indifference cu
greatest satis-
budget line. Recalling that the absolute value of
faction to the
consumer.
FIGURE 4-8 ConsumerEquilibrium
Consumer
equilibrium
132
129
is ralled the marginal rntr of substitntion and the slope of the budget line is given
by : , we sere that at a pwint of consumer equilihrlum
MRS
this conditton did not hold, the personal rate at which the consumer is willing to
stabstiute between goods Nand Ywould dffer from the market rate at which he or
she is able to sulbstitute between the goods. For example, at point A in Figure 4-8,
the slope of the indifference curve Is stecper than the slope of the budget line. This
means the consumer is willing to give up more of good Yto get an additional unit of
good X than she or he actually has to give up, based on market prices. Conse-
quently, it is in the consumer's interest to consume less of good Yand more of good
X This substitution continues until ultimately the consumer is at a point such as C
in Figure 4-8, where the
MRSis
equal to the ratio of prices.
COMPARATIVE STATICS
Price Changes and Consumer Behavior
A change in the price of a good will lead to a change in the equilibrium consump
tion bundle. To see this, recall that a reduction in the price of good X leads toa
counterclockwise rotation of the budget line. Thus, if the consumer initially is at
equilibrium at point A in Figure 4-9, when the price of good Xfalls to P, his or her
opportunity set expands. Given this new opportunity set, the consumer can achieve
FIGURE 4-9 Change in Consumer Equilibrium Due to a Decrease in the Price of Good X (Note
thatgcod Yis a substitute for X.)
Y
PP
33
130
Managerinl Pe nomi s and usiness Strategy
INSIDE BUSINESS 4-2,

Price Changes and Inventory Management for
Multiproduct ir
Onc of the more
inmp rtant decisions a manager mst price of a
make is how much more subtle aspect ofa reduction in the
tle inventory meansinventory
to have on hand. Too lit for, and optina
on the demand
an
insuficicnt quantity of prod rict is its impact If a retailersells many
ucts to meet the demand of
consumers, ventorles of, substitute goods. are substitures,
In which
your customers may desect to case
another store. The prodticts, and some of the products will lead to a
of product
opportunlty cost of rediuction in the price one
substtute goods.
that could be carnedinventory
is the forgone interest 's sale3 ofthese
reduction in t
on the
moncy tied up in inven- of Xbox 360 game con
tory. Inperforming inventory managemcnt, an Tor instance, when the price of Xbox 360 consoles
tive
manager recognizes the effec SOCs is recluced, the consumption
relationship
among products in the slorc and the
that exists
1asesas a direct consequence
ofthe price reductuon.
of a
change in the price of one product on impact
the required
However, notc that the consurnpu c as A result of
inventorics of other products. For PlayStation3 game consolcs wl
in the price of video example, a decline the reduction in the price o
ADOfor the mnact
game consoles not only increases impact of a price
the quantity demanded of game consoles, but also ne manager docs not account or
increases the demand Teduction on the consumption of subsut PlavSta-

for video games, which are
ccations for
mentary goods. This result has obvious impli- tion3 consoles when the price of Xbox 360 gamecon
inventory management. soles decreases.
a higher level o fsatisfaction. This is illustrated as a movement to tne new juilib-

rium point, B, in Figure 4-9.
line
Frecisely where the new equilibrium point ies along the new budget ar
a price change depends on consumer preferences. Accordingly, it is usetul toi
he derinitions of substitutes and complements that were introduced in Chapter
im
First, goods X and Yare called substitutes if an increase (decreasej u
price of X leads to an increase (decrease) in the consumption of Y. Most coi
increased,
Sumers would view Coke and Pepsi as substitutes. If the price of Pepsi
people would tend to consume more Coke. If goods Xand Yare substitutes,
amost
reduction in the price of Xwould lead the consumer to move from pointA
Figure 4-9 to a point such as B, where less of Yis consumed than at point A.
tne
increase (decrease) in
Second, goods Xand Yare called complements if an
of good . Beer
price of good Xleads to a decrease (increase) in the consumption
and pretzels are an Example of complementary goods. If the price of beer increased,
most beer drinkers would decrease their consumption of pretzels. When goods A
to
Xwould lead the consumer
and Y are complements, a reduction in the price of more of Y1s
CO"
as B, where
move from point A in Figure 4-10 to a point such
sumed than before. in
the key thing to note is that changes prices
From a managerial perspective, goods. various
substitute among
affect the market rate at which a consumer can Price changes
the behavior of consumers.
neretore, changes in prices will change Ur they
within your own firm.
occur because of updated pricing strategies
might
131
The Thevny f ndividual riavim 131
FIGURE -10 When the Price of Good X Falls, the Consumption of Complementary
Good YRisos
might arise because of price changes made by rivals or firms in other industries.
Ultimately, price changes aller consumer incentives to buy different goods, thereby
changing the mix of goods they purchase in equilibrium. The primary advantage of
indifference curve analysis is that it allows a manager to see how price changes
affect the mix of goods that consumers purchase in equilibrium. As we will see
below, indifference curve analysis also allows us to see how changes in income
affect the mix of goods consumers purchase.
Income Changes and Consumer Behavior

A change in income also will lead to a change in the consumption patterns of con-
sumers. The reason is that changes in income either expand or contract the con
sumer's budget constraint, and the consumer therefore finds it optimal to choose a
new equilibrium bundle. For example, assume the consumer initially is at equilib-
rium at point A in Figure 4-11. Now suppose the consumer's income to
increases
M so that his or her budget line shifts out. Clearly the consumer can now achieve a
higher level of satisfaction than before. This particular consumer finds it in her or
his interest to choose bundle B in Figure 4-11, where the indifference curve
through point B is tangent to the new budget line.
As in the case of a price change, the exact location of the new equilibrium point
will depend on consumer preferences. Let us now review our definitions of normal
and inferior goods.
Recall that good Xis a normalgoodif an increase (decrease) in income leads to
an increase (decrease) in the consumption of good X. Normal goods include goods
such as steak, airline travel, and designer jeans. As income goes up, consumers typ-
ically buy more of these goods. Note in Figure 4-11 that the consumption of both
goods and Yincreased due to the increase in consumer income. Thus, the con-
sumer views Xand Yas normal goods.
135
Mmpnini umeme wwd Banres SM
to
(decrease) in
income lea
increase generic
Recall that good Xis an nlertor goodif
an
X. Bologna, bus travel, and

in the consunption of good typically
ecrease (ncreasc) inferlor calling the
consurners
As Income goes up,

jeans are cxamples of goods. that
Dy
is important to repeat
Used
use
less of these goods and services. It simply a term
Sume are of quality: it is
goods inferior, we do not imply that they poor FISe.
their incomes
purchase less of when
ood
deline products
to consuiners
for the case go Wnen
increase in income
depicts the effect of an from i t
gure -lz When income increases, the
consumer moves oint
san nterior good. satisfaction given
to maximize his or her
the higher incone, d o Yis
that BDou
point B more of good Ythan at point A, we know
b h e consumer consumes
X-An
or
FIGURE 4-12 An Increase in Income Decreases the Equilibrium Consumplion

Inferior Good
M>M
M
P P
136
The Thry f tethssl Benvi 133
aomal good However, note that at point B less of go is consumed than at

oint A. s we know this ronsuner views a s an inferio
Substitution and Income Efects

We can combine our analysis of price and income gain a better under-
chan
standing of the effect of a price changeon consumer beha Supposea consumer
initially is in equilibrium at point A in Figure 4-13, alon budget lineconnect
ing points F and G. Suppose the price of good Xincreas o that the budget line
rotates clockwise and becomes the budget line connect oints F and iH. There
are two thinggs to notice about this change. First, since the get set is smaller due
to the price incroase, the consumer will be worse off al the price increase. A
lower "real income" will be achieved, as a lower indiffe e curve is ail that can
be reached after the price increase. Second, the increase
i price of good Xleads
t0 a budget line with a steeper slope, reflecting a higher et rate of substitution
between the two goods. These two factors lead theconsuto move from the ini-
ial consumer equilibrium (point A) to a new equilibriunm int C) in Fipure 4-13.
It is useful to isolate the two effects of a price chan see how cach effect
individually alters consumer choice. In particular, ignor the moment the fact
that the price increase leads to a lower indifference cur
uppose th:a after the
price increase, the consumer is given enough incone thieve the rdget line
connecting points J and in Figure 4-13. This budget E1as the sani lope as
budget line FH, but it implies a higher income than b tline FH. Given this
FIGURE 4-13 An Increase in the Price of Good X Leads to a Subst n Effeci (A lo ! and an
Income Effect (B to C)
Y
137
134
MaNagerint Bconomes wnd hutness Sttegy
budget line, the consumer will achleve equllibrlum at point B, where A good
to B15
is consumed than in the initial
substitution effeet sltuation, point A. The movemereact
called the substitutlon ellect, it reflects hoW a con
onsumer will
too
The movement
along a given market rate of substitutlon. The substitution effect Is the dfffere on
ie
Figure 4-13, Importantly, the movqment from A to B leaves the

c o n s u m e r
indifference curve by implied

that results from a same indifference curve, so the reduction In the consumption ot Bo ed "real
change in the rela that movement reflects the higher market rate of substitutlon, not the reuu
tive prices of Income," of the consumer but
goods, holding roal The consumer does not actually face budget line JI when the price
increases
income constant.
instead faces budget line FH. Let us now take back the income wegave toack, the
sumer to compensate for the price increase, When this income is taken reduc
a redue
budget line shifts from JI to FH. This shift in the budget line reflects only mov
tion in income; the slopes of budget lines JI and FH are identical, Thus, E nce
income effect
The movement fromn ment from Bto C is called the income elfect. The income effect i5 tedhe cof
one indifference *"-in Figure 4-13; it reflects the fact that when price increase13, the
Curve to another that sumer's "real income" falls. Since good Xis a normal good in Figure
results from the reduction in income leads to a further reduction in the consumption ot
change in real substitution and inco
income caused by a netotal effect of a price increase thus is composed of
effects. The substitution effect reflects a movement along an inditteren effet
price change. isolating the effect of a relative price change on consumption. 1he ne relucer
results from a parallel shift in the budget line; thus, it isolates the eifect or redu
INSIDE BUSINESS 4-3
IncomeEfects and the Business Cycle

to
An important consideration in running a im s thethe decline indemand for normal goontes a 50-50
impactcf changes in prices on the demand for lhe fim'ssay that the optimalmix of products invovntimal
goods; indeed, tne p
product.Supposeyou are the manager of afim that sels mix of normal and inferior own risk preference. 1he ala
product that is anormal good and are considering mix will dependon
vour s
expandin8 your product line to include another goodsis does suggesthigher that running a gourmet foo
here are several things you may wish to consider in likely involve a
level ofrisk than runninga
making your decision Since your product is a normal marketnomal In particular, gourmet shops sell almost
have
economy is,sively goods, while supermarkets a This
good, you will
sell more of it
when the
portfölio of normal and infer0r
Eou
booming (consumerincomes are high than when times balancedwhy during recessions, many noL.gourmetshops
product is a cyclical explains
are tough incomes are low) Your while supermarkets do
product that is sales vary directly with the economyout ofbusiness know the magnit
f the
when considering Itis also useftuil to
This information may be useful to you effect when designing marketing campa
a
alternative products fto include in your store If you income

expand your oftferings to include more nomal goods,IF the productis a normalgood, it is most likely.in
more firm's interest to target advertising campalgns
you willcontinue to have an operation that sellsButifindividuals with higher incomes. These factors.spo
during aneconomielboom than during a recession thebe considered.when determiningwhich magazines a
youinclude in your operation some inferior goods, shows are the best outlets
for adverusi
during bad eco-television

demandforthese products willincrease
nomic times (when incomes arelow andperhaps offset messages
138
T Trwy f ttvdurl Bravm
135
real income" on consumption and is represented by the movement from B to C. The

total effect of a price increase, which is what we observe in the marketplace, is the
ovement fromA to C. The total effect of a change in consumer behavior results not
only from the effect ofa higher relative price of good X (the movement from A to B)
i t also from the reduced real income of the
consune (the movement from B to C).
APPLICATIONS OF INDIFFERENCE CURVE ANALYSIS
Choices by Consumers
Buy One, Get One Free
very popular sales technique at pizza restaurants is to offer the following deal:
Buy one large ptzza, get one large plzza free (limit one free pizza per customer).
lt is temptingtoconclude that this is simply a 50 percent reduction in the price of
pizza so that the budget line rotates as it does for any price decrease. This conclusion
is invalid, however. A price reductlon decreases the
price of each unit purchased.
The type of deal summarlzed above reduces
only the price of the second unit pur-
chased (in fact, it reduces the price of the second large pizza to zero). The offer does
not change the price of units below one
pizza and albove two pizzas.
The "buy one, get one free" marketing scheme is quite easy to analyze in our
ramewok. In Figure 4-14, a consumer initially faces a budget line connecting
points A and B and is in equilibrium at point C. Point C represents one-half of a
large pizza (say, a small pizza), so the consumer decides it is best to buy a small
pizza instead of a large one. Point D represents the point at which she buys one
large pizza, but, as we can see, the consumer prefers bundle C to bundle D, since it
lies on a higher indifference curve.
FIGURE 4-14 A Buy One, Get One Free Pizza Deal
Other
goods
()
Pizza
B (X)
139
136 Managerlal Economies and Buslness Strategy
budget line
deal, her she
When the consumer Is offered the one, get "buy one free" pizza,
becomes AlDEF. The reason is as follows: If she buys less than
than o
one large n a m e l y
n e lau
remains as
it was, the
gets no deal, and her budget line to the left of one
ne pizza
thisinstan
AD. But if she buys one large pizza, she gets a secondone free. In p r i c e
becomes DEF as soon as she buvs one pfza. In other wordha

that the
Dudget line pizzas. This implies
ofpizza is zero for units between one and two large the slope
budget line for pizzas is horizontal between one and two units (recal ui wants
consumer
of the budget line is - (P/P), and for these units
i s zero). If the rices.
But
to consume more than two large pizzas, she must buy them at regular than she
note that if she spent all of her income on pizza, she- could buy one more t wo
in excess
cOuld before (since one of the pizzas is free). Thus, for pizzas deal is
units, the the line connecting points E and F. After u bu

budget constraint is affordable
offered, the opportunity set increases. In fact, undle E is now an u m e r ' s
Moreover, it is clear that bundle E is preferred to bundle C, and the c o o has
optimal choice is to consume bundle E, as in Figure 4-14. The sales te

auced the consumer to purchase more pizza than she would have otherw
Cash Gifts, In-Kind Gifts, and Gift Certificates to

r
long with death and taxes, lines in refund departments after Christmas app
DE an unpleasant but necessary aspect of life. To understand why, and to De a
pose a potential solution to the problem, consider the following story. ing
One Christmas morning, a consumer named Sam is in equilibrium, consu
bundle A as in Figure 4-15. He operns a package and, to his surprise, it c o d a
a
$10 fruitcake (good X). He smiles and tells Aunt Sarah that he always wa
fruitcake. Craphically, when Sam receives the gift his opportunity ser expa
FIGURE 4-15 A Cash. Gift Yields Higher Utility than an In-Kind Gift
Y
Budget
line with $10
cash gift
M+$10
Budget Gift of $10

line worth of X*
before gift
M+$10
P
137
m wde oim B in Vigne 415 Bownel is pyst ike tvnelie Aexenpt that it has one
we frute k (grl ) than Hrredle (,eor this nr ippirtrnity set, Sam moves
h igh iiftrrewe evrvn therxgly peine Pt after eereivtng the gift
While Sam likrt frvite akr anwl it hueter esff after rer niving if, the pift is not what
h wmwl avr gn*r hard tavl Aut varah given bim tho e ash she spent en the frwit
k Po 4 r eteee, trpgws thw er nf the fruitr ake wat 810 Flael Sam been
givrn $19 in eth, bis buwigrn line wwnlel have shifter! ent paralfel to the old budget
i bt thnrnagh v i t B,s in Pigone 4 1 Tn see why, rste that when Sam gets
diiomal imome prires ate wn hangol the slepie nf the hudget line is
wm hnngred Noe also that if Sam eed the m9ney te bay orne mere fruite ake, he
wowld exn tly exhaust his ineome. Thus. the udget line after the rash gift must go
throueh poit anl.given the cash gift, Sam would ar hieve a higher level of sat
isfnctiem at point C compared to the gift of a fruite ake (pnirt B)
Thus, a cash gift generally is preferred tr an in kinel gift eof erqual value, unless
the in kind gifi is exactly what the consumer would have purchased personally.
This explains why refund departments are so busy after the Christmas holidays:
individuals exchange gifts for cash so that they can purchase bundles they prefer.
One way stores attempt to reduce the nunber of gifts returned is to sell gift cer
tificates. To see why, suppose Sam received a gift certificate, good for $19 worth of
merchandise at store X, which sells goorl X, instead of the $10 fruitcake. Further. sup-
pose the certificate is not good at store Y, which sells good By receiving a gift cer-
tilicale, Sam cannot purchase any more of good Ythan he could before he received
the centificate. But if he spends all his incomne on good Y. he can purchase $10 wort
of good X, since he has a certificate worthh $10 at store X. And if he spends all his
income on good X, he can purchase $10 more than he could before because of the gift
certificate. In effect, the gift certificate is like money that is good only at store X.
Graphically. the effect of receiving a gift certificate at store X is depicted in
Figure 4-16. The straight black line is the budget line before Sam receives the gift
FIGURE4-16 A Git Certificate Valid al Store X

Y A
Budget
line with S10
gift certificate
at store X
M:S10
P
L4
t r o n e t r a l n t h e c o m e s
e i f i . When he tereivee the $10 gift (oifir ate, the bwrelg tup t o S 1 0
the rd
ttaight line.
wt1h of govd Awithnt
In off1 the gift eerifiuate allows the nme r n g o t h e r
speuling n dime of his wn monveydoperls, am
wehavior
Thr effr1 gift otifuatet m (omtmer whn happens
things, o whether gowd Nis a nwtmal on inferion gonl. To examine strpprne a consun
tn belnvim when a (onsumet eives a gift certificate, let us What
initially is in squililwium at point A in Fig1ne 4-16, spernding $10 on gooo ns in store
happens if the consumer is given a $10 gift certificate gooxl only To on
X7 If both X and Yare normal goods, the nsumer will desire to spend mno the con-
s,
oll goods as goods are normal B r
income increases. Thus, if both s to
simer moves from A to C in Figure 4-16. In this instance, the consur equal value.
the gift c e i l i c a t e just as she or he would have reacted to a cash g i t o

an
the analysis of gift certificates ist presented change if good were na
Od
good?
Answer:
n this instance, a gift of $10 in cash would result in a movement from point Cieate is
4-17 to a point like D, since X is an inferior good. However, when a m ebundle E.
received, bundle Dis not affordable, and the best the consumer can doi would have
had the consumer been given cash, his her budget ine or If
Cxlended words,
other up along the dotted line, and point D would have been an affordaDie D
Cash Gih Yields Higher Utility than a Git Certificate ofEqual DolO
FIGURE4-17 Here, a
Y
M+S10 Cash equivalent

P
Jcaslh
Certificate
X
M+$10
X X'
2
The Production Process and Costs
Learning Objectives
HEADLINE you will be
After completing this chapler,
able to:
Boeing Loses the Battle but Wins LO1 Explain allernative ways of measuring the
the War productivily of inputs and the role of the
manager in the production process.
After nearly eight weeks, Boeing and its International LO2 Calculate input demand and the cost
Association of Machinists and Aerospace Workers
minimizing combination of inputs and
use
Union (IAM) reached an agreement that ended a strike
isoquant analysis to illustrate optimal inpui
involving 27,000 workers. The strike followed several
days of "last minute," around-the-clock talks that began substitution
when management and union negotiators failed to 103 Calculate a cost function from.a produc
explain how economic
reach an agreement over compensation and job pro- fionfunction and
tection issues. costs differ from accounting costs.
between and the
As a result of the agreement, IAM workers won L04Explain the difference costs, sünk
benefits in areas that include healthcare, pensions, economicrelevance of fixed
costs.
wages, and job security for 2,900
workers in inventory variable costs, and marginal
costs,
management and delivery categories. Boeing also 105 Calculate average and marginal
costs from
off or displaced. illustrate
agreed to retrain workers who are laid algebraic ortobular
cost data and
for Boeing and
Despite these concessions, a spokesman the relationship between average
us the
was quoted as saying that the agreement "gives" marginal costs
The four-year
flexibility we need to run the company. subcontract-
agreement allows Boeing to retain critical 106Distinguish behween shortrun and long
it won in struggles with the union. run production decisions and illustrate
past
ing provisions
one analysis concluded
all this, theirimpact on costs and econemies of
Commenting on scale
battle and Boeing
that "the union probably won the
pro
probably wins the war." Can you explain
what this LO7Conclude whether a muliple-output of
analyst means? duction processexhibits economies
scope or cost complementarities and
their.significance for managerial
CNNMoney.com
explain
Sources: C. Isidore, "Union Strikes Boeing." decisions
"Boeing Contract Offers Pay
September 6, 2008; S. Freeman, Post, October 29, 2008. 155
Job Protections, The Washington
"
Raise,
43
156
Managerinl Peonomes and Bssiness
Strategy
INTRODUCTION
Companies as well as nonproft of producing
goods or providing services,
g anl organizations
and their
24tions are in the business
are es managers to
oplimally choose the quantity and types successful

optimall of inputs tooperation
use in therecqu
production process.
The successful the
operation
of a
consulting business, for instance, requires getting
ong these and
Tight quan:ity and mix of employees and optimally substituting a
other inputs as
wages and other input
prlces change.
s chapler provides the economic foundations needed to succeed i
a positions such as production and pricing management. The
Tion and costs
presented below are also important in their wn ig concepheythe serve
as the
basic building blocks for
ations, managerial business areas that include human resou
accounting. and strategic management.
THE PRODUCTION FUNCTIOON
We will
begin by describing the technology available for
producing
O8 Summarizes the feasible means of converting raw inputs, Ou
such as s
hor, and
achinery, into an output such as an automobile. The technology effectivey n d a-i
T12es
engineering know-how. Managerial decisions, such as those concer
tureson research and
development, can affect the available technoloEy c t
anter.
we will see
how a manager can exploit an existing technology greatest notential.
potential.
n
subsequent chapters, we will analyze the decision to improve a
technoro
Degin our analysis, let us consider a production process that utilizes two
s Capital and labor, to produce output. We will let Kdenote the quantity of cap
t h e quantty of labor, and Qthe level of output produced in the production
process. Although we call the inputs capital and labor, the general ideas pie
here are valid for any two inputs. However, most production processes involve
machines of some sort (referred to by economists as capital) and people a v
and this
terminology will serve to solidify the basic ideas.
The technology available for
production marized in the production function.
converting capital and labor into output is Su
function The production function is an engineerug
tion that defines the
A function that maximum amount of output that can be produced with a giv
set of inputs.
defines the maxi- Mathematically,the production function is denoted as
mum amount of
output that can be Q= FK, L)
produced with a
given set of inputs. that 1s, the maximum amount of output that can be produced with Kunits of capital
and L units of labor.
Short-Run versus
Long-Run Decisions
As amanager, your job
is to use the available function efficiently,
production ths
means that you must determine how much of each input to use to produce output. in
the short run, "some factors of production are fixed, and this limits your choices im
157
fined n maing inpnt dec isioms. For example, it takes several years for automakers to
drvelop anml bnsild new assembly lines for provlucing hyhrids. The level of capital is
gOrrally fixed in the short run. However, in the short run automakers can adjust
heir use of inputs such as Jalbor and steel; such inputs are called variable factors of
production
atljust in the showt The shor1 run is defined as the time frane in which there are fixed factors of
1 Vartablr production. To illustrate, suppose capital and labor are the only two inputs in pro
duction and that the level of capital is fixed in the short run. In this case the only
an aljust to nlter short-run inpu! decision to be made by a manager is how much labor to utilize. The
reodntion. short-run production function is ecsentially only a function of labor, since capital is
fixed rather than variable. If K" is the fixed level of capital, the short-run produc-
tion function may be written as
Q- AL) = HK", L)
Columns 1, 2, and 4 in Table 5-1 give values of the components ofa short-run
production function where capital is fixed at K* = 2. For this production function,
5 units of labor are needed to produce 1.100 units of output. Given the available
technology and the fixed level of capital, if the manager wishes to produce
1,952 units of output, 8 units of abor must be utilized. In the short run, nore labor
is needed to produce more output, because increasing capital is not possible.
The long run is defined as the horizon over which the manager can adjust all
factors of production. If it takes a company three years to acquire additional capital
machines, the long run for its management is three years, and the short run is less
than three years.
TABLE 5-1 The Produclion Function
M AP
Variable Change Oupui Marginal Average
npur nput Prodtc Products
ICapital Labor) Labor of Labor of 1abor
civen Given Given] A4A2 T4(2)1
76
248 72; - 124
A92 244 164
784 292 196
1100 316 220
1708 244
1952 244
2,124 236
2,200 76 220
5
Manngerinl Feomies ael
Bassintt StratesRY
Measures of Productivity
An important component of managerial decision is the
roductivity of inputs used in the production makingAs we will aee see,
these meas
ures ate useful for process. W we mak-
evaluating the effectiveness of a production pro measures o f

ing input decisions that maximize
profits. The three most
productivity are total product, average product, and marginalimportai
prou
Total Product
total produet
The maximum Totalpoduct (TP) is simply the maximum level of output that can be produced
duction
with given product of the prod S i n c e
a amount of inputs. For example, the
level of output that total 00.
can be produced process described in Table 5-1 when 5 units a r e employed
is
with a given the production of
function defines the maximum amount of labor be pro-
annount of inputs. output

uced with a given level of inputs, this is the amount that would be prO daced
t
if the
forth
units ot labor put forth maximal effort. Of course, if workers did not P
aximal effort, output would be lower. Five workers who drink coffee all de can
not produce any output, at least given this production function.
Average Product
pro
ln many instances, managerial decision makers are interested in the avers
cductivity of an input. For example, a manager may wish to know, on avation is
nuch each worker contributes to the total output of the firm. This inforna t
average product Summarized in the economic concept of average product. The avera put.
A measure of the or
output produced (AP) ofan input is defined as total divided by the quantity used
product
In particular, the average product of labor (AP) is
per unit of input.
AR-
and the average product of capital (AP) is
AP- K
n
unit of input. i
product is a measure of the output produced per
hus, average d
able -1, for example, five workers can produce 1,100 units of output,
amounts to 220 units of output per worker.
Marginal Product
marginal product The marginal product (MP) of an input is the change in total output attributaDie
The change in total the last unit of an input. The marginal product of capital (MP)
therefore 1s tne
output attributable
change in total output divided by the change in capital:
to the last unit of
an input. AQ
MPk AK
6
The Proditon P'rot and Costs 159
The marginal product of labor (MP) is the change in total output divided by the
change in labor:
AQ
MR AL
For example, in Table 5-1 the second unit of labor increases output by 172 units, so
the marginal product of the second unit of labor is 172.
Table 5-1 illustrates an important characteristic of the marginal product of an
input. Notice that as the units of labor are increased from 0 to 5 in colun1n 2, the
marginal product of labor increases in column 5. This helps explain why assemblyY
lines are used in so many production processes: By using several workers, each
performing potentially different tasks, a manager can avoid inefficiencies associ-
ated with stopping one task and starting another. But note in Table 5-1 that after
5 units of labor, the marginal product of each additlonal unit of labor declines and
eventually becomes negative. A negative marginal product means that the last unit
of the input actually reduced the total product. This is consistent with common
sense. If a manager continued to expand the number of workers on an assembly
line, he or she would eventually reach a point where workers were packed like sar
dines along the line, getting in one another's way and resulting in less output than
before.
Figure 5-1 shows graphically the relationship among total product, marginal
product, and average product. The first thing to notice about the curves is that
FIGURE 5-1 Increasing, Decreasing, and NegativeMarginal Returns

-
Total product, Increasin8 Decreasing Negative

average product, marginal marginal marginal
marginal product returns returns returns
to to to
labor labor labor
Total
product
(TP)
4P Variable
.
01 2 input
3 4 5 6 7 8 9 10I (labor)
MPL
47
160
Minapral Fooomies and Business Stuategy
incrensing total product increases and its slope gets steeper as we m o v e from psob
lnetw
A ee
to
marginal returns
Range of input point E along the total
product curve, As the labor increases
use of
sage over which points A and E, the slope of the total increases ( b e c o m e s s t e e p e r ) ;
1atginal prodet thus, ma ginal product increases as product curve i The range
icreases. over which

we move from
point aa to
t pofnt reastng mar-
marginal product increases is known as the range o

deerensing ginal eturns.
(diminishing) In Figure 5-1,
we see that marginal maximum at po. 5th
marginal returns where 5 units of labor are product reaches its the
Range of input employed. As the usage of labor
increa his is wny
Isage over which through the 10th unit, total output increases, but at a decreasing rat
ve. The
marginal product marginal product declines between 5 and 10 units of labor but is su
range
declines. over c the
tne
rage
of
which marglnal product is positlve but declining is known as
negative decreasing or diminishing marginal returns to the variable inpu of
marginal returns In igure 5-1, marginal product becomes negative when more
Range of input labor are employed. After a point, using additional units ofinput actuallyreduces over
usage over which product, which is what it means for marginal product to be he range
marginal product which marginal product is negau ina/ returns

is negative. negative is known as the range of negalive B
Principle Phases of Marginal Returns

As the usage of an input increases, marginal product initiallyincreases (increasir
ginal returns), then begins to decline (decreasing marginal returns), and evenla
becomes negative (negative marginal returns).
of
n stuaying for an exam, you have very likely experienced various phasE
marginal returns. The first few hours spent studying increase your gradedo mui
the last few hours. For example, suppose you will make a 0 if you notSu
than of the first 0 nou
Dut will make a 75 if you study 10 hours. The marginal product
the exan, n e
thus is 75 points. If it takes 20 hours of studying to score 100 on
8inal product of the second 10 hours is only 25 points. Thus, the marginal improve
ment in yOur grade diminishes as you spend additional hours studying. If you have
ever pulled an and ended up sleeping through an

"all-nighter"
exam perio or
in the range of negative marginal rerurD

poorly due to a lack of sleep, you studied resources in this range.
Clearly, neither students nor firms should ever employ
Process
The Role of the Manager in the Production
earlier is tworold
guiding the production process described
The manager's role infirm function and (2) to ensure tnat
() to ensure that the operates on the production the
the firm uses the correct level of inputs. These two aspects
ensure that irm
aspects of produc
on the production function. These two
operates at the right point
tion efficiency are discussed next.
Produce on the Production Function

most dif-
but it is one of the
The first managerial role is relatively simple to explain, maximum
function describes the
ficult for a manager to perform. The production
48
Tr P'rln tin P'rre and Cets 161
possible output that can be produced with gliven inputs. For the case of labor, this
means that workers must be putting forth maximal effort. To ensure that workers
ae in fact working at full potential, the manager must institute an incentive
stucture that induces them to put forth the desired level of effort. For examnple,
the manager of a restaurant must institute an incentive scheme that ensures that
food servers do a good job waiting on tables. Most restaurants pay workers low
wages but alow them to collect tips, which effectively provides the workers
with an incentive to perform well on the job. More generally, many firms insti-
tute profit-sharing plans to provide workers with an incentive to produce on the
production function. A more detailed discussion of this role of the manager is

presented in Chapter 6.
Use the Right Level of Inputs

The second role of the manager is to ensure that the firm operates at the right point
on the production function. For a restaurant manager, this means hiring the "cor
rect number of servers. To see how this may be accomplished, let us assume that
the output produced by a firm can be sold in a market at a price of $3. Furthermore,
assume each unit of labor costs $400. How many units of labor should the manager
hire to maximize profits? To answer this question, we must first determine the ben-
efit of hiring an additional worker. Each worker increases the firm's output by his
or her marginal product, and this increase in output can be sold in the market at a
This
price of $3. Thus, the benefit to the firm from each unit of labor is $3 MP.
X
value marginal number is called the value marginal product of labor. The value marginal product
product of an input thus is the value of the output produced by the last unit of that input. FFor
The value of the example, if each unit of output can be sold at a price of P the value marginal prod-
output produced uct of labor is
by the last unit of
an input. VMP= PX MP
and the value marginal product of capital is
VMP= Px MP
labor is $400. As
In our example, the cost to the firm of an additional unit of
Table 5-2 shows, the first unit of labor generates VMP, = $228 and the VMP; of
first unit of labor
the second unit is $516. If the manager were to look only at the
and its corresponding VMP, no labor would be hired. However, careful inspection
of the table shows that the second worker will add $116 in value above her or his
cost. If the first worker is not hired, the second will not be hired.
In fact, each worker between the second and the ninth produces additional out-
whose value exceeds the cost of hiring the worker. It is profitable to hire
units
put
of labor so long as the VMP, is greater than $400. Notice that the ViMPz of the 10th
unit of labor is $228, which is less than the cost of the 10th unit of labor. It would
not pay for the firm to hire this unit of labor, because the cost of hiring it would
exceed the benefits. The same is true for additional units of labor. Thus, given the
data in Table 5-2, the manager should hire nine workers to maximize profits.
Business tuategy
162 Manapeial Eronomir and
TABLE 5-2 Tho Voluve Marginol Product of lobor (5)
VMP P x MP
A
AL
MP UnhCost
of
Marginal Valuo Marginal Labor
Varlable Prico Produet Product

of of Labor of Labor
Given
Input IColumn 5 of
U2 x(3)1
Output
(Lalbor able -11
4 0 0
IGlven] IGlven AO0
400
3 $228
76 A00
516
172 732 A00
24 876 AO0
292 9A8 400
400
316 948
316 A00
876
292 732 A00
244 516 400
172 228 A00
9
76 132
10 -A4
the marB bO
Profit-Maximizing Input Usage at which
or
inputs at levels
Principle 1o m a x i m i z e profits,
a manager
should use
when the cost

of each additionalunt i n the
cost. More specifically, where V E L

equals
the marginal labor up to the point
continue to employ
IS W, themanager should
product.
range of diminishing marginal
demand for input of an Dy

defines the product
input usage rule marginal
value
he protit-maximizing
5-2 the iat
For example, Figure
in wage
firm. utilized.
When the
profit-maximizing
of the quantity of
labor
a function
labor isgraphed as
FIGURE 5-2 The Demand for Labor
W Demand
for labor
Profit
maximizing
point
VMP L
50
163
INSIDE BUSINESS 5-1
Where Does Technology Come From?
function from that used by the

n this chapter, we simply assme that the manager different preduction
kows the mmderlying technology available for produc- original developer.
ingg gooms. How do managers acquire information
aboul technology? A study by Richard L.evin suggests HIRING EMPLOYEES OF INNOVATING
there are sven pricipal methods. FIRMS
often have informa-
F'ormer employees of other firms
INDEPENDENT R&D tion about the production process.
The most important means of acquiring product and
PATENT DISCLOSURES
process innovations is independent research and devel-
the holder the exclusive rights to an
opment (R&D). This essentially involves cngincers A patent gives
invention for a specified period of time-17 to 20 years
cmployed by the fimm who devise new production
processes or products in most countries. However, to obtain a patent an inven-
tor must file detailed information about the invention,
LICENSING TECHNOLoGY which becommes public informatior. Virtually any-

The firm that for develop- one can look at the information filed, including competi-
was originally responsible
many instances, this information can enable
a
to the Lors, In
ng the technology and thus owns the rights that does n0i
technology often sclls the production function to competitor to clone the productin way
a
another fim for a licensing fec. The fee may be.fixed, infringe on the patent. Interestingly, while a patent is
in which case the cost of acquiring the technology is a pending. this information is not publicly available. For
1Ixed cost ofproduction. The fee may involve pay this reason, stretching out the time in which a patent is
ments based on how much output is produced. In this pending often provides more protection for an inventor
instance, the cost of the technology is a variable cost than actually acquiring the patent.
of production.
CONVERSATIONS WITH EMPLOYEES OF
PUBLICATIONS OR TECHNICAL MEETINGS INNOVATINGFIRMS
Trade publications and meetings provide
Despite the obvious benefits of keeping trade
aforum f relay
the dissemination of information about production secrets secret, employees inadvertently
processes.
information about the production process to com
petitors. This is especially common in industries
where tirms are concentrated in the same geo
REVERSE
AS the termENGINEERING
suggests, this involves working back-8raphic region and employees from different firms
nonbusiness settings.
ward: taking a product produced by a competitor andnterminglein
devising a method of producing a similar product Source:RichardC Levin Appropriability,R&D
hetypical result is a product that differs slightly Spending,and Technological Performance American
from the existing product and involves a slightly Economic Review 78 (May 1988 Pp. 424-28
is w, the profit-maximizing quantity of labor is that quantity such that VMP, = w

in the range of diminishing marginal returns. In the figure, we see that the profit-
maximizing quantity of labor is Ly units.
The downward-sloping portion of the VMP, curve defines demand for labor by
a profit-maximizing firm. Thus, an important property of the demand for an input is
151
Since
aml uusinerst Snatey

returns.
of
Maapruthl Pe omne v a l u e
164 m a r g i n a l
margg the
diminishing
d e m a n d
used,
the law of
S i g
is
downward because of the
that it slopes declines as
a s more of that i n p u t S i n c e
tused.
inpu diminishinE
procduct of an iuput
nes
is e f fo
ecft , e a c h a d a
the marginal more of the
fnput
the raIn ofit-maximnizing

also dec
declines as
in
in
the range
the marginal product input

product off the pul
a l s o
the value marginal

Tor an input is slopes down'war
the demand for an inpul
than the previous un
marginal returns,
inpu.
of an inpul adds less profits u n t of
an
tional unit tional
acdditi
cach
to pay less for
firms thus are willing o n c e p t su n d e r -
Functions
Production
Forms of expresseu
Algebraic to illustrate un be
JHke those d i s -
lables and graphs f u n c t i o n

can
until now, we
have relied on
p r o d u c t i o n
f u n c -
fu.
Up The underlying
notion of a
statistical technique p r o d u c t i o n
lying production. to use for a

e n c o u n t e r e d
po
a l g e b r a i c
in fact it is possible
tora
and form
f orm
mathematically, functlonal
particular I c t i o nf u n c t i o n
cussed in Chapier 3 to estimate a commoniy.

more
some
section, we highlight most simpie P
Inthis with the
functions. We begin
forms of production
a linear function of the inputs.
function is
The linear production
linear production ak+ bl are per
Q= FK, L)
=
inputs nd total
function function,
A production func- production
inputs
all the
luce what
a constants. VWith a linear between

tion that assumes where a and b are to pro linear with
linear relation four
hours
perfect linear rela-
substitutes. There is
a perfect at a plant
f is
tionship between it takes workers funcuo
instance, suppose the production
output. For case
all inputs and total can make in
one hour. In this
machine
a
output.
a
=
4 and b=1: 4K+L

L)
p r o d u c t i v e
=
Q=FK, times as of
is always 4 that 5
units
that capital know

mathematical way of stating 1(2)
== 22,
This is the
A{5,2) =4(5)
+
since output.
as labor. Furthermore, 22 units of
labor will produce
capital and 2 units of byis given
function
The Leontief production
Leonticf min {bK, cL} the
Q= FK, L)
=
called
production function
is also
function The
tion
Leontief productio that inputs
are
used
A production func- pro-
because it implies
constants. word
care
where b and function, function
for a
tion that assumes production oduction
that inputs are
ixea-proportions
To s e e this, suppose
the produ
the
number ofkeyboards
fixed proportions. think of Kas impliesd
used in fixed b= c= 1; then
Leontief, with
function
proportions. firm is The p r o d u c t i o n hour, two y

Cessing of keyboarders.
number o n e paper
per
L as the can produce s o forti. Du
hour, and
and
and o n e keyboard hour
per
produce per
p a p e r s
one keyboarder two
c a n produce
and two
keyboards keyboards
and five to the extent
Doarders can one
keyboarder useful only
words, key-
are
papers keyboards
now many is paper.
Additional
In other
them.
only o n e to use keyboarder
ne answer keyboarders
are
available
proportion
of o n e
that
additional
the fixed
be used in
and keyboarders must
boards
for every keyboard.
I52
165

The engincrers at Morris Industries obtained the
function
following estimate of the firm's production
Q PR, L) = min {3K, 4L}
How much output is produced when 2 units of labor and 5 units of capital are
employed
Answer:
We simply calculate /F5, 2). But F5, 2) = min(3(5), 4(2)} = min{15, 8). Since the minimum
of the numbers and "8" is
"15 8, we know that 5 units of capital and 2 units of labor pro-
duce 8 units of output.
A production function that lies between the extremes of the

linear production
function and the Leontief production function is the
Cobb-Douglas function. The Cobb-Douglas production function is
Cobb-Douglas production
production given by
function Q FK, L) = KL'
A production func-
tion that assumes where a and b are constantsS.
some degree of Unlike in the case of the linear production function, the relationship between
substitutability output and inputs is not linear. Unlike in the Leontief production function, inputs
among inputs. need not be used in fixed proportions. The Cobb-Douglas production function
assumes some degree of substitutability between the inputs, albeit not perfect
substitutability.
Algebraic Measures of Productivity
Given an algebraic form of a production function, we may calculate various
measures of productivity. For example, we learned that the average product of an
input is the output produced divided by the number of units used of the input.
This concept can easily be extended to production processes that use more than
one input.
1o be concrete, suppose a consultant provides you with the following estimate
of your firm's Cobb-Douglas production function:
Q= F(K, L) = KRLun
What is the average product of labor when 4 units of labor and 9 units of capital are
employed? Since F(9,4) = 92412 = (3)(2) = 6, we know that 9 units of capital and
4 units of labor produce 6 units of output. Thus, the average product of 4 units of
labor is AP = 6/4 = 1.5 units.
Notice that when

output is produced with both capital and labor, the average
product of labor will depend not only on how many units of labor are used but also
on how much capital is used. Since total output (Q) is äffected by the levels of both
inputs, the corresponding measure of the average pröduct depends on both capital
53
166
Manaperial Fconomles and Business
Strategy
and labor. level of
Likewise, the average product of o n the
capital but also on the level . Pcapital

l a ldepends
depends not only
not
Recall that the Oof labor usod to produce

labor used ult
marginal product of an input is the changge inal
rom a given change in, the input. When the production
function is
procduct of an input has' a very
simple
tla reveals.
representation, as the following
Formula: Marginal Product for
If the produc-
tion
a Linear Production Funnction
function is linear and
given by
Q- FIK, L) = ak + bl
then
MPk= a
and
MP = b
A Calculus to
arginal product of an input is the derivative of the production function witn rE
Alternative the input. Thus, the marginal product of labor is
M=
aL
and the
marginal product of capital is
MP= aK
For the case of the linear production function, Q = aK+ bL, so
MP= O K a and
and
MP b
aL
Thus, for a linear production function, the marginal product of an inputi5

ply the coefficient of the input in the production function. This implies that the l a
ginal product of an input is independent of the quantity of the input used wneriev
O
the law
the production function is linear; linear production functions do not obey
diminishing marginal product.
In contrast to the linear case, the marginal product of an input for a Cobb-Dougias
production function does depend on theamount of the input used, as the IOLLOW
formula reveals.
Function. f the
Formula: Marginal Product for a Cobb-Douglas Production
production function is Cobb-Douglas and given by
Q- FK, L) = K°L°
54
Th
167
hen
MbK:"
and
M ak
AC lus The marginal product of an input is the derivative of the production function with
Alte tive the respect to
input. Taking the derivative of the Cobb-Douglas production function ylelds
M ak'"
and
Q
M bK°'L=
which correspond to the equatlons above.
Recall that the profit-maximizing use of an

value marginal product of an
input occurs at the point where the
input equals the price of the input. As the next prob-
lem illustrates, we can apply the same principle to algebraic functional forms of
production functions to attain the profit-maximizing
use of an input.

Afirm produces output that can be sold at a price ofS10. The production function is given by
Q= FK, L) = K\/2[1/
If capital is fixed at l unit in the short run, how much labor should the firm employ to max-
imize profits if the wage rate is $2?
Answer:
We simply set the value marginal product of labor equal to the wage rate and solve for L
Since the production function is Cobb-Douglas, we know that MP = bK°L-1 Here a = 1/2
b 1 / 2 ,and K = 1. Hence, MP .5L2-1, Now, since P= $10, we know that VMP = Px
MP 5 - . Setting this equal to the wage, which is $2, we get 5L-2 = 2. If we square
both sides ofthis equation, we get 25/L =4. Thus the profit-maximizing quantity of labor is
L = 25/4 = 6.25 units.
Isoquants
Our next task is to examine the optimal choíce of capital and labor in the long
run, when both inputs are free to vary. In the presence of multiple variables of
production, various combinations of inputs enable the manager to produce the
55
168
Managerinl Peonomes ard Brsines«
Sttategy
FIGURE S-3 A fomily of
soquants
Increasing
Outpu
labor for cap

Substiuting
r for capital
Q 300 units of output
2 0 0 units of outpu
1 0 0 units of output
can produce
Same level of
output. For example, an automobile assembly lne
rs per hour by using 10 workers and one robot. It can also produce ro-
cars by using only two workers and three robots. To minirnize u

ation of
aucing T,000 cars, the manager must determine the efficient co1rative
u s e to produce them. The basic tool for understanding how alter
isoquant mputs can be used to produce output is an isoquant. An isoquant detines
Defines the combi- that
nations of inputs binations ofinputs (Kand L) that yield the producer the same leve o
that yield the same sa
tne same
level of output.
any combination of capital and labor along an isoquant produces
level of output. sa
nd B
1gure -3 depicts a typical set of isoquants. Because input bundles A
Doth lie on the same isoquant, each will produce the same level of output, naI
units. Input mix A implies a more capital-intensive plant than does input my
AS more of both inputs are used, a higher isoquant is obtained. Thus as we mov n
the northeast direction in the figure, each new isoquant is associated witn ing
and higher levels of output. re
Notice that the isoquants in Figure 5-3 are convex. The reason is0quan
typically drawn with a convex shape is that inputs such as capital and labor ae
perfectly substitutable. In Figure 5-3, for example, if we start at point A and Deg
substituting labor for capital, it takes increasing amounts of labor to replace eau
unit of capital that is taken away. The rate at which labor and capital canSubstt
marginal rate for each other is called the marginal rate of technical substitution (MRIS). 1tes
of technical MRIS of capital and labor is the absolute value of the slope of the isoquant and is
substitution simply the ratio of the marginal products:
(MRTS)
The rate at which
a producer can MP
substitute between MRTSRL MPk
two inputs and
Dirferent production functions will imply different marginal rates of technical
maintain the sarne
level of output. substitution. For example, the linear production function implies isoquants that are
linear, as in Figure 5-4(a). This is because the inputs are perfect substitutes tor
each other and the rate at which the producer can substitute between the inputs is
156
169
Th l'rodction P'rocess nned Cosis
FIGURE 5-4 lineor andloontiof lsoquonts
-Q2
- O1
(a) Linear (b) Leontief
independent of the level of input usage. Specifically, for the linear production func-
tion Q = a k + bL, the marginal rate of technical substitution is bla, since M P = b
and MP= a. This is independent of the level of inputs utilized.

The Leontief production function, on the other hand, implies isoquants that are
L shaped, as in Figure 5-4(b). In this case, inputs must be used in fixed proportions;
the manager cannot substitute between capital and labor and maintain the same
level of output. For the Leontief production function there is no MRTS, because
there is no substitution among inputs alorg an isoquant.
For most production relations, the isoquants lie somewhere between the perfect
substitute and fixed-proportions cases. In these instances, the inputs are substi-
tutable for one another, but not perfectly, and the rate at which a manager can
substitute anmong inputs will change along an isoquant. For instance, by moving
from point A to point B in Figure 5-5, the manager substitutes 1 unit of capital for
1 unit of labor and still produces 100 units of output. But in moving from point C to
FIGURE 5-5 The Marginal Rate of Technical Substitution

K
AK=34 Slope -i=-MRTSKL

AL
Stope - fn -MRTSxL
O o = 100
AL =-1 AL= -1
I57
170
MHNReiNl Rermomut atM Betttnnt
Strategy
poin D, the manager would for f ditin-
prohuce 100 units of output. have
Thus, tothesubstitte 3 tuniis of capital the law oldimin
production functiorn saatisfies
diminishing shing maginal rate ol trchntcal substittion: As a procucer uses less of an inpul,
marginnl rnte of
technieal incteasingly more of the other
ubstitutionof
A
outu. It Can be shown that the inpnt must be
Cobb-Douglas employed to 'unction
ocuction ro implies isoquar
opety a that have a diminishingg marginal rate of technical substitution. v .
enever an ísoquan
tohction functio exnibils a diminishingg marginal rate of technical substitution, tne Figure 5-3.
iso
statig that as less
of one input is uanis are convex from the origin; that is, they look like the Isoquan
Uscd, inceasing
anounts of another Isocosts
nput must be output.
level of
employed to pro- Isoquants descrlbe the combinations of inputs that produce d given the
duce the same level
of output.
Nolice that
different combinations of cavital and labor end up cOs same amount
saime amount. The combinations of inputs that will cost the firim ue
isocost line comprise an isocost line. this

A line thal
repre-
sents the com- he relatlon for an Isocost line is graphed in Figure 5-6. To
undersnr plus
binations of inputs concept, suppose
the cost of
the firm spends exactly $Con inputs. Then the COst
that will cost the capital exactly equals $C:

producer the same
wL+rK=C
(5-1)
amount of money.
were1 s the wage rate (the price of labor) and ris the rental rate (the pre
cap
tal. his equation represents the formula for an isocost line
may oblain a more convenient expression for the slope and intercep
1SocOst line as follows. We multiply both sides of Equation 5-1 by 1/rand
C
L+K=
or
FIGURE 5-6 Isocosts

K
58
The l'rodttion Process and 171
Cost
FIGURE 5-7 Changos in lsocosis
Combinations of Inputs costing C"
C (more expensive Input bundles)
Combinatns of inputs costing C Due to increase

less expensive input bundles) in wage rale
(ww)
C C
1W w w
(a) b)
K--"
Thus, along an isocost line, K is a linear function of L with a vertical intercept of
Crand a slope of -wl
Note that if the producer wishes to use more of both inputs, more money must be
spent. Thus, isocosts associated with higher costs lie above those with lowercosts. When
input prices are constant, the isocost lines will be parallel to one another. Figure 5-7(a)
illustrates the isocost lines for cost levels C and C, where C< C.
Similarly, changes in input prices affect the position of the isocost line. An
increase in the price of labor makes the isocost curve steeper. while an increase in
the price of capital makes it flatter. For instance, Figure 5-7(b) reveals that the iso
cost line rotates clockwise when the wage rate increases from w' to w.
Principle Changes in Isocosts

For given input prices, isocosts farther from the origin are associated with higher costs.
Changes in input prices change the slopes of isocost lines.
Cost Minimization
The isocosts and isoquants just defined may be used to determine the input
usage that minimizes production costs. If there were no scarcity, the producer
would not care about production costs. But because scarcity is an economic real
ity, producers are interested in cost minimization-that is, producing output at
the lowest possible cost. After all, to maximize profits, the firm must first pro-
duce its output in the least-cost manner. Even not-for-profit organizations can
achieve their objectives by providing a given level of service at the lowest pos-
sible cost. Let us piece together the tools developed thus far to see how to
choose the optimal mix of capital and labor.
Consider an input bundle such as that at point A in Figure 5-8. This combi-
nation of L and K lies on the isoquant labeled and thus produces Q% units of
5
172
MAnageial Bconomles and
Business Strategy
FIGURE 5-8
Inpul Mix B
Minimizos the Cost of
Producing
cing 100 Units of Output
100
= 100 units
of output
output. It also lies on the isocost

input mix A, he or
she will
line through point A.
Thus, if the ses
the produce Qa units of output at a prou h
Cost-minimizing
Dy using input mix Bway to
produce the
total co
given level of output? cleariy , for
instead of A, the
Ouput lower cost, namely C?. Inproducer could produce tne sa
at a 1ount
use input mix A, because short, it is inefficient for the or fo
lower isocost line. input mix B produces the
same output ad
proau
A the cost-minimizing input
mix, the slope of the
E1SOcost line.
Recalling that the absolute value isoquant
is equal to the
slope
rerlects
line is
the
margial rate of technical of the slope of the isoquan
given by wi, we see that at substitution and that the slope of the isoc0s
-
the
cost-minimizing input
mix,
If this
condition did
MRTS wr
not hold, the
between Kwould differ fromtechnical
L and rate at which the
producer
between the inputs. For example, at the market rate at which she or he could su
could substiu
steeper than the slope point in Figure 5-8, the slope of the
A
of isocost line.
producer finds it in his orthe isoquant i
Consequently, capital is too expensive,u

her interest to use
given level of output. This less capital and more labor to
point such as B, where the substitution continues until ultimately the produce u
the MRTS is equal to the ratio of producer is
at a
cost-minimizing use of
inputs also be
input prices. The condiuon 10r
To see
why this condition must hold tostated in terms of mnarginal producis.
can
ducing a given level of be able to minimize the cost of

basis, labor is output,
suppose MP/w> MPdr. Then, on a pro-
better deal than
a
last-dollar-spent
minimize costs. Incapital,
more labor to and the firm should
use less
if the firm reduced its capital
and
on
capital by $1, it could particular,
expenditures
produce the same level of output if it increased
expenditures on labor by less than $1. Thus, its
by substituting away from capital
60
Th P'roduction Prorss and Costs 173
Principle Cost-Minimizing Input Rule

To minimize the cost of producing a given level of output, the marginal product per dollar
spent should be equal for all inputs:
MI MI
Equivalently. to minimize the cost of production, a firm should employ inputs such that the
marginal rate of technical substitution is equal to the ratio of input prices:
MIR
M
and toward labor, the firm could reduce its costs while producing the same level
of output. This substitution clearly would continue until the marginal product
per dollar spent on capital exactly equaled the marginal product per dollar spent
on labor.

Temporary Services uses four word processors and two typewriters to produce reports. The
marginal product of a typewriter is 50 pages per day, and the marginal product of a word
processor is 500 pages per day. The rental price of a typewriter is $1 per day, whereas the
rental price of a word processor is $50 per day. Is Temporary Services utilizing typeviriters
and word processors in a cost-minimizing manner?
Answer:
Let MP,be the marginal product of a typewriter and MPw be the marginai product of a word
processor. If we let Pw and Pr be the rental prices of a word processor and a typewriter,
respectively, cost-minimization requires that

MPMPw
Pr Pw
Substituting in the appropriate values, we see that
50 MP MP_500
50
Thus, the marginal product per dollar spent on typewriters exceeds the marginal product per
dollar spent on word processors. Word processors are 10 times more productive than type
writers, but 50 times more expensive. The firm clearly is not minimizing costs and thus
should use fewer word processors and more typewriters.
Optimal Input Substitution

A change in the price of an input will lead to a change in the cost-minimizing input
bundle. To see this, suppose the initial isocost line in Figure 5-9 is FG and the
6
174 Managerial Economes and Bustness Strategy
FIGURE 5-9 Substiluting Capilal for Labor, Due to Increaso in tha Vwag Rate
Isoquant
New cost-minimlzlng
to higher wage
point due
cost
Inltial polnt of
A minimlzatlon
- G
sup
Qo units or
Oupu nt On
proaucer iS cost-minimizing at input mix A, producing
the firm spent the sa
pose that the wage rate increases so that if to FH in Figure 5-9. Cea
clockwise
p s , S 1socost line would rotate
nrm spends the amount itspent prior to the increase in the wage rae
duce the same level of output.
relaiv P t
line, which reflects a higher
iven the new slope of the isocost the implied by the.inua s
abor, the cost-minimizing way to maintain tooutput the isoquant. Due to the incread
d pont5,labor relative to IJ the producer substitutes away from laDO
where isocost line is tangent
capital, dus
C price r a more capital-intensive mode
of production.
L nls
Oward capital and adopts

gests the following important result
Principle Optimal Input Substitution

minimize the cost of producing a given level of output, the firm
should use less ol
a
oinput and more of other inputs when that input's price rises.
Figure -10 shows the isocost line (AB) and isoquant for a firm that pro
minimization 1s a
and labor. The initial point of cost
duces rugs using computers
where the manager has chosen to use 40 units of capital (computers
ald ouM,
point units of labor when the wage rate is w = $20 and the rental rate of co
C
puters (capital) is =
$20. This implies that at point M, total costs are
0X 40) + ($20 x 80) $2,400. Notice also at point Mthat the MRTS equals
=
the ratio of the wage to the rental rate.

Now assume that due to a decrease in the supply of silicon chips, the rental rare
Since
Or capital increases tor= $40. What will the manager do to minimize costs?
the price of capital has increased, the isocost line will rotate counterclockwise from
62
175
The P'roduction Procrss and Costs
Prices
FIOUPE 5-10 Substitting lobor for Computers, Due to Higher Computer
Compulet
A
$2,400 120
20
$2S40
800= 70
D
C-$2S40
400 60
60
M Inltlal lnput mix
40
New input mix
due to higlher
computer prlces
10
Labor
()
30
120400_CO 14000-C
W $20
AB to DB. To produce the same amount of output, the manager will have to spend
the isocost line out
more than C $2,400. The additional expenditures will shift
=
minimization is at point N, where the

to EF in Figure 5-10. The new point of cost
to minimize the
firm now employs more labor (120 units) and less capital (10 units)
C ($40 X 10) +($20 x 120) =
$2,800,
production costs of rugs. Costs
=
are now
which are higher than CO.
THE COST FUNCTION
For given input prices, different isoquants will entail different production costs,
even allowing for optimal substitution between capital and labor. Each isoquant
corresponds to a different level of output, and the isocost line tangent to higher
isoquants will imply higher cosis of production; even assuming the firm uses
the cost-minimizing input mix. Since the cost of production increases as higher
isoquants are reached, it is useful to let C() denote the cost to the firm of pro-
ducing isoquant Q in the cost-minimizing fashion. The function, C, is called the
cost function.
63
176 Managrtil le onomics and Brsiness Strategy
INSIDE BUSINESS S-2

Fringe Benefits and Input Subsitution
riced
now
higiher-pr
Governent egulations ofton have unlntended con- from the
sequences, For instance, current fecderal tax law
fms shoud substituteaway
secretaries to minimize costs. Frank
Recently economists
requirrs that firms provide frlnge benefits in such a Scem far-fetched? the
rela-
examlned
way as not to discrimlnate against lower-income Black
Scou, Mark Berger,,and Dan and
employment
that
workers. Presumably, the purpose
of this regulation is
costs
tionship betwecn health care

carc
to ensiure that low-income workers wil have access to low-wage workers. They found cmployed
sig
health care, pension benefits, and other
fringe bene offered more generous
health careplans operat
keypunch
fits. Unfortunately, this itors, a n d
policy often limits the niflcantly fewer bookke janitors
enployment opportunities of low-incone workers. rcceptionists, secrctar
clerk-typists,
with Jower
To sce wl1y. consider a indus
orkers than did industries with higher
company that hires com- food service
puter bprogrammers
Wage and programmer
i l of a computer secretaries. Suppose theand
is $30,000 annual
that health of
levels care costs.
fringe Morcover
benefits hired part-time workers
since
of a secrctary is S150 fringe-benef.

The company is considering than did industries with lower
require firms
to offer pensi
oerng aamily health care plan worth $3,6O0 anually he goveriment docs not benefits to part-tim.
to part-
healtlh carc, and any other fringe

to its
employecs. 1gnoring the fringe-benefit bill, the rel-
ativeprice of a secrctary to a computer prograimer is workers.
care plan is added in,5. the
$15,000/$30,000 But rclalivc
when theprice
costofofathe health
sccretary Source: Frank Sco, Mark Berger, andntation,"
Dan Black,Jndls
"Effects O
increases to a litle over 55 of that of a computer pro- Fringe Benefis on Labor MarketSegner989), Dp.216-29
grammer lsoquant and isocost analysis suggests that and Labor Relattons Neview 1c a n
later cnaptco
will see in
is extremely valuable because, as we
COst runction the profit-maxiniz
tprovides essential informationa manager needs
to determine
Or Output. In the cost function summarizes
information
about
u P
V addition, information
ne
la
process. The cost function thus reduces
the amount of
auction
ager has to process to make optimal output decisions.
Short-Run Costs ne
or
fixed costs defined as the period over which
the amounts so
Kecall that the short run is
the use of varlao
Costs that do not is free to alter
inputs are fixed. In the short run, the manager
change with
with levels of fixed inputs. Because
inputs are cosuy
inputs but is "stuck" existing run c o n s i s t
changes in output; in the short
include the costs IIXed or variable, the total cost of producing output
wnether
of (1) the cost of fixed inputs and (2) the cost of variable inputs. These two co
of fixed inputs
nents of short-run total cost are called fixed costs and variable costs, respecu
used in
production. not vary with output. costs Fixed incude
FIxed costs, denoted FC, are costs that do Variable costs, denoted VCO, are
variable costs the costs of fixed inputs used in production. of inpuls
the costs
Costs that change costs include
that change when output is changed. Variable
with changes in Costs
that vary with output.
output; include the fixed and variable costs
costs of inputs that Since all costs fall into one or the other category, the sum of UIE
factors of production,
vary with output. 1s the firm's short-run cost function. In the presence of fixed
177
TABLE 5-3 The Cost function
() (2) (3) (4) (5) (6)

K FC C
Fixed Varlablo Output Fixed Variable Total
Cost
Input Input Cost Cost
I$400 x(2)]
olven olven Oiven I$1,000 x (1) 14)+(5)|
$2,000 $2,000
76 2,000 A00 2,400
248 2,000 800 2,800
492 2,000 1,200 3,200
784 2,000 1600 3,600
, 100 2,000 2,000 4,000
1,416 2,000 2,A00 A,A00
2,000 2,800 4,800
2 1,708
1,952 2,000 3,200 5,200
2,124 2,000 3,600 5,600
10 2,200 2,000 4,000 6,C00
short-run cost short-run cost function summarizes the minimum possible cost
of producing each
function level of output when variable factors are being used in the cost-minimizing way.
A function that of producingwith the technology used in Table
Table 5-3 illustrates the costs
defines the mini- 5-1. Notice that the first three columns comprise a short-run production.function
mum possible cost with
amount of output that can be produced
of producing each because they summarize the maximum factor
and alternative units of the variable
output level when two units of the fixed factor (capital)
unit and labor costs $400 per unit,
we
variable factors are (labor). Assuming capital costs $1,000 per summarized in
variable costs of production, which
are
employed in the can calculate the fixed and
cost-minimizing that irrespective of the amount of output pro-
columns 4 and 5 of Table 5-3. Notice
fashion. is $1,000 x 2 $2,000. Thus, every entry
=
duced, the cost of the capital equipment do not

the principle that fixed costs
in column 4 contains this number, illustrating
vary with output. For
of the variable factor must be employed.
To produce more output, more are needed; to produce
units of output, 5 units of labor
example, to produce 1,100 labor is the only variable
labor are required. Since
1,708 units of output, 7 units of units of output is
in this simple example, the variable cost of producing 1,100
input cost of
x 5 $2,000. Similarly, the variable
the cost of 5 units of labor, or $400
=
summarized in
units of output is $400 X 7 $2,800. Total costs,
producing 1,708 vari-
are simply the sum of
fixed costs (coBlumn 4) and
the last column of Table 5-3,
level of output.
able costs (column 5) at each vari-
relations among total costs (TO),
Figure 5-11 illustrates graphically the
fixed costs do not change with
out-
(VC), and fixed costs (F). Because
able costs
levels and must be paid even
if zero units of
constant for all output
put, they are are zero if no output
is pro-
are produced.
Variable costs, on the other hand,
output cost is the sum of
fixed
increases above zero. Total
duced but as
increase output
165
178 Manngrtal Feemni t aned Business Strategy
FIGURE 5-11 Tho Pelotionship omong Costs

lolal costs,
vAtialble
and fixed TC VC+ FC

9sls
VC
FC
FC
FC FC
0
VC curves Fr8
in
distance between
the 7TCand
variable costs. Thus, the
cOsts And
5-11 is simply fixed costs.
Costs than
Average and Marginal firms have
lower
costs
is that . large
One fundamental
One com misconception about costs

quantities of output.
indi-
What
smaller firms because they produce larger more must be
spent.
that to produce more output, advantages of producin8 lag
implication of scarcity is consider the
This
VIauals most likely
have in mind when they level of output.
over a larger
the overhead is spread out
xeu
Average
quantities of output is that of average
fixed cost.
related to the economic concept units of ouyput.
average fixed dea
is intricately divided by the number of
cOst (AFC) is defined
as fixed costs (FO)
cost
Fixed costs divided FC
by the number of
units of output.
AFC ue
is producea,
and more output
more
with output, as
Since fixed costs do not vary As a consequence, av
over a greater quantity
of output. 1s
fixed costs are allocated This princIple
as output is
expanded. decline as
fixed costs decline continuously fixed costs
age we see that average
Table 5-4, where
revealed in column 5 of
basis.
total output increases. costs on a per-unit
measure of variable
Average variable cost provides
a number
divided by the
as variable cost (VC)
average variable
cost Average variable cost (AVC)is defined
Variable costs of units of output:

divided by the
number of units of VC(O)
AVC-
output. Q
66
179
TABLE S-A Dorivalion of Averago Costs
(2) (3) (5) (6)

a FC TC AFC AVC ATC
Output Fixed Varlable Tofal Averogo Averago Average
Cost Cost Fixed Variablo Total
Co Cost Cost
Cost
Olven] 2)+ (2/(1)1 (4/(1)1
1Oven) Olven)
$2,000 0 $2,000
$26,32 $5.26 $31.58
2,000 A00 2,400
8,06 3.23 11.29
248 2,000 B00 2,800
2.4A 6.50
A92 2,000 200 ,200 4,07
2,55 2.04 A.59
784 2,000 1,600 3,600
3.64
4,000 82 182
, 100 2,000 2,000
1.41 69 3.11
1,416 2,000 2,A00 ,A00
.17 1.64 2.81
1,708 2,000 2,8000 A,800
1,02 1.64 2.66
1,952 2,000 3,200 5,200
2,124 2000 3,600 5,600 0.94 1.69 2.64
1.82 2.73
2,200 2,000 4,000 4,00 0.91
Column 6 of Table 5-4 provides the average variable cost for the production func-
tion in our example. Notice that as output increases, average variable cost initiallyy
declines, reaches a minimum between 1,708 and 1,952 units of output, and then
begins to increase.
Average total cost is analogous to average variable cost, except that it provides
a measure of total costs on a per-unit basis. Average total cost (ATC) is defined ass
total cost (7) divided by the number of units of output:
ATC Q
Column 7 of Table 5-4 provides the average total cost of various outputs in our
example. Notice that average total cost declines as output expands to 2,124 units and
then begins to rise. Furthermore, note that average total cost is the sum of average
fixed costs and average variable costs (the sum of columns 5 and 6) in Table 5-4.
The most important cost concept is marginal (or incremental) cost. Conceptu-
marginal ally, marginal cost (MC) is the cost of producing an additional unit of output, that
incremental) is, the change in cost attributable to the last unit of output:
COst
The cost of produc-
ing an additional MC=
unit of output. AQ
To understand this important concept, consider Table 5-5, which summarizes
the short-run cost function with which we have been working. Marginal cost,
depicted in column 7, is calculated as the change in costs arising from a given
change in output. For example, increasing output from 248 to 492 units (AQ= 244)
increases costs from 2,800 to 3,200 (AC = $400). Thus, the marginal cost of
increasing output to 492 units is ACAQ= 400/244 = $1.64.
67
180
TABLE S-5 Dorintion of

Menginel Cnt
(0) (2 (3) (7)
4 (6)
MC
VC A VC TC TC
Oiven] 1A(1 6/(2)or(4/2
olven) (a(O)] Olven
6 2,000
6 A00
A00/765.26
A00 2,400 A00 A00/172 2.33
248 172 800 AO) ,800 A00
A92 2AA A00/244 . 6 4
1,200 AO0 3,200 AO0 A00/292 1.37
78 292 1,600 AO0 3,600 A00 A0O/316 1.27
1,100 316 2,000 A00 4,000 A00
316
4 0 0 / 3 1 6 1 . 2 7
2,400 A00 ,AOO A0O A00/292 1.37

1,708 292 2,800 A00 A00
1,952 A,800 A00/244 1.64
24 3,200 A00 5,200 A00
,124 172 3,600 A00 A00
A00/172-2.33
5,600 400/76 5.26

2,200 76 4,000 A00 A00
6,000
input
When only
divided its
one input is marginal cost is the price
variable, the ot a
by marginal product. Remember that marginal produ ciorocal
ally, reaches a maximum, and then decreases. Since marginal cost is the rePdct
Or marginal product times the input's price, it decreases as margina
increases and increases when
marginal product is decreasing
Relations among Costs
and
Figure 5-12 graphically depicts average total, average variable, averag sot
divisible (the firm 15
dglna Costs under the assumption that output is infinitely
restricted to producing only the outputs listed in Tables 5-4 and 5-5 but can prouuce
the marguldu
any outputs). The shapes of the curves indicate the relation between
FIGURE 5-12 The Relationship among Average and Marginal Costs

MC
ATC
AVC
Minimum
of
TC
\ Minimum
of
AVC
AFC
68
181
nd avetage
also
presented in those tables. These relatíons among the cost curves,
costs
depheted in Figure 5-12, are very important. The first thing to notice is that the
margial cost curve intersects the ATC and AVC
curves at their minimun
This implies that when
marginal cost is below an average cost curve, average points.
teclining, and when marginal cost is above average cost, average cost is rising.cost is
There is a simpie
explanation for this relationship among the various cost
urves. Again consieder your prade in this course. If your grade on an exam is below
yor average grade, the
new grade lowers
sCore on an exam is
your average grade. If the grade you
above yotur average grade, the new
aye. In essence, the new grade is the
grade increases your aver-
When the marginal is above the
marginal contribution to your total grade.
is below the
average, the average increases; when the marginal
average, the average decreases. The same princlple applies to marginal
and average costs, and this is
why the curves in Figure 5-12 look the way they do.
The second thing to notice in
Figure 5--12 is that the ATC and AVC curves get
closer together as output increases. This Is
because the only difference in ATC and
AVCis AlPC. To see
wlhy, note that total costs consist of variable costs and fixed costs:
C0) = VC(O) + FC
If we divide both sides of this
equation by total output (Q, we get
COVCO). FC
Q
But C(/Q= ATC, VCO/Q= AVC, and FCIQ= AFC. Thus,
ATC= AVC+ AFC
average total costs and average variable costs is ATC
AVC= AFC. Since average fixed costs decline as
output is expanded, as in Figure
-12, this difference between average total and average variable costs diminishes
as fixed costs are
spread over levels of
increasing output.
Fixed and Sunk Costs
We now make an important distinction between fixed costs and sunk costs. Recall that
a fixed cost is a cost that does not
sunk cost
change when output changes. A related concept,
called sunk cost, is a cost that is lost forever once it has been paid. 'To be concrete,
A cost that is for-
imagine that you are the manager of a coal company and have just paid $10,000 to
ever lost after it
has been paid. lease a railcar for one month. This expense reflects a fixed cost to your firm-the cost
is $10,000 regardless of whether you use the railcar to transport 10 tons or 10,000 tons
of coal. How much of this $10,000 is a sunk cost depends on the terms of your lease. If
the lease does not permit you to
recoup any of the $10,000 once it has been paid, the
entire $10,000 is a sunk cost-you have
already incurred the cost, and there is nothing
you can do to change it. If the lease states that you will be refunded $6,000 in the event
you do not need the railcar, then only $4,000 of the $10,000 in fixed costs are a sunk
cost. Sunk costs are thus the amount of these fixed còsts that
cannot be recouped.
Since sunk costs are lost forever once they have been paid, they are irrelevant to
decision making. To illustrate, suppose you paid a nonrefundable amount of $10,000 to
69
182 Manaprrinl Pu owstne Ad Bsinct Stuate gy
that you
realize
lease, yo:1
lease a rallcar for one month, but immediately after sigviny; the A arner
expected. of
do not need itthe demand for coal is significantly lower than yon If the
terms
for $2,000.
approaches you and offers to suublease the rallcar from nu
er 's offer to
the farnne
you lease permlt you to sublease the railcar, slhonud you
aCcept w o u l d appear
firm i5
You might reason that the answer is no; after all, your
This
reasoning
$2,000.
lose $8,000 by subleasing a $10,000 railcar for a measly $10,000 is
W'7Ong. Your lease payment is nonrefundable, which neans tni do t o
can
you
there is noting
c a n d o s o m e -
navoidable cost that has already been lost, Since

you is to sub
Climinate this $10,000 cost, the only relevant issue is whether optimal
decision
that you
thing to enhance your inflow of cash. In this case your revenie:
$2,000 in your
lease the railcar because doing so provides you with making
irrelevant in sublease the
would not get otherwise. Notice that, while sunk costs are
do not su
they do affect calculation of total profits. If you
decision, your
railcar, you lose $10,000; if you sublease it, you lose only $8,00
Principle Irrelevancc of Sunk Costs

A decision maker should ignore sunk costs to maximlze profits or minimize losses.
10
Demonstration Problem 5-4 f the

ACME Coal paid $5,000 to lease a railcar from the Reading Railroad. Unae us of sign-
two
railcar is returned
within o
case, $1,000 of this payment is refundable if the
ing the lease. cosis:
ts
fixed
ACME's
the lease and paying $5,000, how large are
.pon signing
sunk costs? ar.
no use
for the railcar.
realizes that it has
.One day after signing the lease, ACME sublease the railcar Iron
offered to
has a bumper crop of corn and has
larmer the farmer's
ofter:
ACME at a price of $4,500. Should ACME accept
Answer:
its sunk costs are 3*,O
. ACME's fixed costs are $5,000. For the first two days, becones a
the entire $5,000

that cannot be recouped). After two days,
IS
the amount
sunk cost. if
Note that ACME's
total loss is $5U0 1t
2. Yes, ACME should sublease the railcar. $4,000 (assuming 1
its losses will equal
accepts the farmer's offer. If it does not,
returns the railcar by the end of the next business day).
cubic cost
function Algebraic Forms of Cost Functions
Ire
Costs are a cubic
cubic cost function is
function of output; take many forms, but the
in
practice, cost functions may cost function.
The Cubic cos
provides a reason- encountered and closely approximates any
able approximation guently
function is given by
to virtually any
cost function.
C() f+ aQ+ b + cQ
=
70
The Prodution Pioress and
Costs
183
where a, b, c, and l'are constants. Note
that
Given an algebraic form of the cubic frepresents fixed costs.
cost function, we
the marginal cost function. may directly calculate
Formula: Marginal Cost for Cubic Costs. For a cubic cost function,
C)= l+ aQ+ b + cQ
the marginal cost function is
MC() = a t 2hQ+ 3cQP
A Caleulus
Marginal cost is simply the derivative of the cost function with respect
Alternative to output
MCI)-
dQ
For exanple, the derivative of the cubic cost function with respect to Qis
dC +2bQ+ 3cQ
dQ
which is the formula for marginal cost given above.

The cost function for Managerial Enterprises is given by C(O) 20 + 30. Determine the
=
marginal cost, average fixed cost, average variable cost, and average total cost when Q= 10.
Answer:
Using the formula for marginal cost (here a = c = 0), we know that MC = 6Q. Thus, the
marginal cost when Q= 10 is $60.
lo find the various average costs, we must first calculate total costs. The total cost of
producing 10 units of output is
C(10) = 20 +3(10)2 = $320
Fixed costs are those costs that do not vary with output; thus fixed costs are $20. Variable
costs are the costs that vary with output, namely VC(Q) = 30.Thus, VC(10) = 3(10) = $300.
It follows that the average fixed cost of producing 10 units is $2, the average variable cost is
$30, and the average total cost is $32.
Long-Run Costs
In the long run all costs are variable, because the manager is free to adjust the levels of
all inputs. In Figure 5-13, the short-run average cost curve A7C) is drawn under the
assumption that there are some fixed factors of production. The average total cost of
I7
184
Masnprtial Fa manl ael anitiest Stratey
INSIDE BUSINESS S-3
Estimating Production Functions, Cost Functions, dn

Returns to Scalo
xplains a large
Whilr serving in the U.S. change expla1 that
Army, Matc Netlove con Ress hat technolagical

costs
ceived a eseareh projeci to mtlol the in

electricty
ccononie factons dtctions

that impat the
prodn tinn of electrlcity. The primary ocured Ietween 1999
urod
innovalion in Nerlove's moxlel of
cilysubn
techriiqeS
teo
e d to
the way it was rootcd n the th electricty siupply was loday, these pioneering needed too
approaches--
th theoty of ptotluction and econometric
ne
n p p r 1 . 1
cosis. His nppronch Was the f1st to Ore Alvanceel cost

functjons
f r o m
the "dual" emptrlcally utllize estimate the productiona

and
industries rangjn
approach to production and costs-that is, to decisions in
and T
horton sh
Cxploit the lact that a cost fiunction summarizes all of t e tnanagerialhealthcare as
Maloiey mbbe.com/bayc
the infor nation contained in a Clectricity to book at www.

you
give
and vice versa. production function, The Web site for this
filesoand
data
nonetric
that
techniques
Contains some:spreadsheet and
Iwo primary findings emerged from Nerlove's an opportunity to
ise 3 production
cmpirical analysis. irst, substantlal cconomles of scile Introduced in hapter

to estna
existed at the fim level in the nmarket lor

the 1950s. The clectricity in COst functions.
degree of the scale economies, however, Scale in Blectricity
varies inverscly with "Returns to
output and is consiclerably lower oCes: M. Nerlove, Christet
ed. C.
than previously estinated for individual
plant facilities. Upply, Mensurement
n Bconomics,Press, 1963)
University
This was especially rue for large firms. Second, ('alo Allo, CA: Stanford Creene, "iconOne
though Christensen and W.H.
Ceneration," Journa o
the size of an electricity 1.,R,
company's operations impacted P6-98;
U.S, Electrlc Power 655-76; M. Maloney
its economies of scale, it did not
impact its marginal rate Ocale in Vol. 84(1976), pp.
rOlical conomy,
Electriciy
of substitution between factors of Estimating
production. COnomies and Diseconomies:
Vol
Organization,
Advances in the theory of duality betwecn pro- Functlons,"-Review of Industrtal
duction and costs led Christensen and Greene. to dis- 19(2001) pp. 165-80: J.Thornto ew Evidence.
nguish between scale economies and cost reductions Production Function for the US: Some
that stem from technological change Their analysisApplied Economlcs, Vol. 34(2004) PP:
production, is
ATCo(C%. In u
output level . given the fixed factors of
producing cannot adjust the
fixed raCO a ed
Short run, if the firm increases output to 0, it
fim can adjust ne
In the long run. however, the the
average costs rise ATC%(Q).
to
firm adjusts the fixed Iacto the
factors. Let ATCG be the average cost curve after
the
cost curve Al
with average
manner. NOw the firm can produce O
Opamal its average costs be 0 the firm
would
long-run average firm produced Q with average cost curve ATC, scale of operation
Cost curve By adjusting the fixed factors in a way that optimizes the
average co
at a lower
A curve that units of output
production and can produce O, cost
cu
defines the mini- zes in itself a short-run average
Notice that the curve labeled ATC is minimize the cost
mum average cost AlC(QI. selected to
on the new levels inputs that have been
of fixed
of producing alter-
Dased output-say, to
Q-it would lo
native levels of If the firm wishes to further expand factors
proaucing8 . changed its fixed
output, allowing in the short to ATC(O) until it again
run
for optimal selec- low curve ATG units of output, namely ATQI).
incur lower average costs of producing Q 5-13, defines tne
tion of both fixed LRACin Figure
cost curve, denoted
he long-run a verage
tOr
alloWing
and variable factors levels of output,
alternative
of production. minimum average cost of producing
72
185
Th Prdtion Proee nhil Cets
FIGURE 5-13 Optimal Plont Sire ond long Run Average Cost
ATC% ATC A
ATC, 10)
ATC, (0) LRAC
ATC, (0) F:*
ATC, 9)
ATC, 0)t Output
fixed and variable factors).

selection of all variables of production (both
optimal the short-Tun a v e r -
curve is the lower envelope of all
The long-run average cost lies below
means that the long-run
average cost curve
This
age cost that it equals each short
curves.
cost curves, except
on the short-run average factors
every point c u r v e uses fixed
at the points where the short-run
run average cost curve cost curve in
think of each short-run average
optimally. In essence, we may of fixed size.
Different
5-13 as the average cost
of producing in a plant sizes. In the
Figure
are associated
with different plant
cost curves
economics of short-run average
is free to choose the optimal
plant size for produc-
the firm's manager cost of
scale long run, the long-run average
Exist when long- desired level of output, and this determines
ing the
run average costs
producing that output level.
decline as output
is increased.
Economies of Scale
diseconomies of is U shaped. This
in Figure 5-14(a)
average cost
curve
scale Notice that the long-run at lower
Exist when long- allows the firm to produce
that an expansion of output
run average costs implies initially between 0 and Q*. This
condition
as is shown for outputs
rise as output is long-run average cost, of scale, increasing
When there are economies
increased. is known as economies of scale. cost. After a point,
such
decreases the minimum average
constant returns the size of the operation lead to an increase in aver-
further increases in output
to scale as Q in Figure 5-14(a), Sometimes the
diseconomies of scale.
Exist when long- This condition is known as
age costs. different levels of output at
a firm to produce
run average costs in an industry allows is called
technology 5-14(6). This condition
minimum average cost, as in Figure
remain constant as
output is
the same
constant returns to
Scale.
increased.
73
B6
FIOURE 5-14 Sayle feomemit
1RAC
RAC
Bevonies Diseconotnies
o sCale seale
0
to scale
() Economles and diseconomies of scale (b) Constant
returns
A Accounting
Reminder: Economic Costs versus cos nic
In
concluding this section, it is important to recall the difference often
associated
cOsts and accounting costs. Accounting costs are the costs mos
with the costs of producing. For example, accounting costs inciuae a t a0pear on
to labor and capltal to produce output. Accounting costs are the costsu
the income statements of firms. The lirm
however.
a good,
These costs are not the only
c o u l d u s e the s a m e resources to
costs of
produce
producing
s o m e o t h e r good. b y C
t
0 Q d
p.r e
n r i r,e
one good, producers give up the opportunity for producing someo
UNSIDE BUSINESS 5-4

International Compariies Exploit Economies of Scale
Ltd.-
I n d i a - M a r u t i Udyog
In industries with economies of scale firms that in
pro An automaker scale
are
duce greater levels of output produce at lower average tangible evidence that economies of per
PrOduced
costs andthus gainapotentialcompetitiveadvantage important in business decisions: en9s. thanks
over rivals. Recently, two intermational busincsses cent increase in net profits in the mi ereaase was
such strategies to enhance their bottom line. its ability o exploitthese economie
Panel Com spawned by. a 30 percent increase in salesolume
pursued
Japan'sMatsushita Plasma Display vou
that
er
pany, Ltd:, invested S831 milion to build the world s permitted the firm to spread its sizable 1X in
largest.plant.1or producing plasma display panels The greater output Importantly, the company S
factorya joint venturebetween Panasonic andToray averagecostsduetoeconomieso ingfrom
Industries5expected to produce 250.000 panels per enough to offset the higher costs
month by the late 2000s This strategy was imple- increases in theprice of steel:
mented in response torising global demandfor plasma
display panels,and a desire on the partof the company Sources Matsushita Plans Big Expansion o ML
to gain a competitive advantage over ivalsin this Manufacturing DGNems Serviceay M18 2001
Sifylndia, May 18.
20043
increasingly competitive
eindustry industry.
. from CostSaving Measures,
Sains
I7
Te l'rodin tion Prorest and Costs
187
the costs of
production inchde
nities forgone by
not only the accounting costs but also the
producing given procduct
a
opportu-
MULTIPLE-OUTPUT coST FUNCTIONS

Until
analysis of the production process has focused on situations
now, our
im produces a single output. There are also numerous examples of firms thatwhere the
multiple outputs. Toyota produces cars, trucks, and SUVs (and produce
Dell produces varieties of
many each):
many diflerenttypes of computers and printers. While our analysis for
the case of a fim that
produces a single output also applies to a multiproduct firm, the
latter raises some additional issues.
This section will highlight these
In this scction, we will assume concepts.
that the cost function for a
given by C(Q.Q). where Q is the number of units multiproduct firm is
multiproduct cost is the number of units produced of product I and Q2
function
defines the
produced of product 2. The
multiproduct cost function thus
A function that cost of producing Q units of product 1 and Qunits of
product 2 assum-
defines the cost of ing all inputs used efficiently.
are
producing given
levels of two or
Notice that the multiproduct cost function has the same
basic interpretation as
more types of
a
single-output cost function. Unlike with a single-product cost function, however,
the costs of
outputs assuming production depend on how much of each type of output is produced.
all This gives rise to what economists call
inputs are used economies of scope and cost
complemen
efficiently. tarities, discussed next.
Economies of Scope
economics of Bconomies of scope exist when the total cost of producing Q and Q2 together is
SCope less than the total cost of
When the total producing Q and Q separately,
that is, when
cost of producing
two types of Ca.0) +CO. Q) > CQ. Q)
outputs together is n a restaurant, for example, to produce given quantities of steak and chicken din-
less than the total ners, it generally is cheaper to produce both products in the same restaurant than to
cost of producing
have two restaurants, one that sells only chicken and one that sells only steak. The
each type of
output separately. reason is,
of course, that
producing the dinners separately would require duplica-
tion of many common factors of production, such as ovens, refrigerators, tables, the
building, and so forth.
Cost Complementarity
cost Cost complementarities exist in a
complementarity multiproduct cost function when the marginal
cost of producing one output is reduced when the output of another product is increased.
When the mar-
ginal cost of pro- Let C(, Q) be the cost function for a multiproduct firm, and let MG(a. Q) be
ducing one type of the marginal cost of producing the first output. The cost function exhibits cost com-
output decreases plementarity if
when the output of
another good is
increased.
AMG(. 20
A
75
188 Managetnl Eonomiet andt lkusines Strategy
f pro
that Is, f anincrease In the output of product 2 decreases the marginal co
ducing
An example1. of cost complementarity is the production of dou
product u t and
the
doughnut holes. The firm can make these products separately or joinuy .
the
of makingadditional doughnut holes is lower when yorkers roll
out
cost g the
I mana
punch the holes, and fry both the doughnuts and the holes instead
holes separately. also be
The concepts of economies of scope and cost omplementarity can Ict cost
examined within the context of an algebratc functional form for mulupro

a
tunction. For example, suppose the multiproduct cost function is quadrau
CO. 0) ( t aQQ + (Q) + (0)
For this cost function,
MC aQ +20
cost of produc
When a < 0, an Increase in Q reduces the marginal o
product . Thus, if a < 0, this cost function exhibits cost complementarity.

there are no cost complementarities.
Formula: Quadratic Multiproduct Cost Function. The multiproduct cost funcuo
CO. Q) = ft aQ+ (Q) + (0)2
has corresponding marginal cost functions,
MCG(0. O) a+20
and
MC(0. Q) = aQ, +20%
cost
To examine whether economies of scope exist for a quadratic multiproduct
function, recall that there are economies of scopeif
CI.0)+C(0, Q)>CQ. Q)
or, rearranging,
C(a.0) + CO. Q) -
ClQ. ) >0
This condition may be rewrittenas

f+ (Q)2 + f+ (Q)2-[f+ a0Q + (Q)2+ (Q))>0
which may be simplified to
f-a0>0
levels and e if
Thus, economies of scope are realized in producing output
f>a2
176
189
The l'rodn tion l'oett and 1
Cost F'unction. The

the Quadratic Mulliproduct
Summary of the Properties of (0)'
a 0 (0)
multiproduct costfunetlon C(O. O)ft
0.
complementarity whenever
a<
1. Exhibltls cost
whenever O0.
2. Exhibts econmies of scope

produces two goods, is given by
Suppose the cost function of firm A, which
C- 100 50,,+ (0, +( ,
2.
The firm wishes to produce5 units of good 1 and 4 units of good
economics ofscope cxist?
1. Do cost complementarities exist? Do in
that produces good 2 to firm B,
2. Firm A is considering selling the subsidlary if it
to firm A's costs
which case it will produ only good 1. What will happen
continucs to produce 5 unlts of good 1?
Answer:
1. For this cost function, a
=
-1/2 <0, so Indeed there arc cost conplementarities.
determine whether f- aQ
> 0. This
To check for economles of scope, we must
economies of scope exist in pro-
is clearly true, since a<0 in this problem. Thus,
2.
ducing 5 units of good I and 4 unlts of good
if it sells the subsidiary that
2. To determine what will happen to firm A's costs
calculate costs under the alternative
scenar-
produces good 2 to firm B, we must
ios. By selling the subsidiary, firm A will
reduce its production of good from
2
this will increase the marginal
4 to 0 units; since there are cost complementarities,
of producing the
cost of producing good 1. Notice that the total costs to firm A
5 units of good 1 fall from
10 + 25 + 16 =
131
C(5, 4) =
100
to
C(5,0) =
100 + 25 125
But the costs to firm B of producing 4 units of good 2 will be

CO,4) = 100 + 16 = 116
and the costs to firm B of

Firm A's costs will fall by only $6 when it stops producing good 2,
producing 4 units of good 2 will be $116. The combined costs to the two firms of producing
the output originally produced by a single firm will be $110 more than the cost of producing
by a single firm.
The preceding problem illustrates some important aspects of mergers and sales
of subsidiaries. First, when there are economies of scope, two firms producing dis
tinct outputs could merge into a single firm and enjoy a reduction in costs. Second,
selling off an unprofitable subsidiary could lead to only minor reductions in costs.
77
190 Managerlnl Economics and husiness Strategy
When economies
of scope exist, it is difficult to "allocate costs acros
cect
product ines
ANSWERING THE HEADLINE

In the opening headline, the phrase "wins the battle" refers to the short-ru
catlons of the agreement between Boeing and the IAM, while "wins the w ment
that the ag
to the agreement's long-run implications. The analyst recognizes
also increased Do u
uníoin workers in the short run, but the agreement
Delielited
long-term value by giving it the lexibility to substitute away from mo
unionized inputs. ol
hort
union contract provided a number S

Ore specifically, Boeing's new urity
term" provisions (health and penslon benefits, higher wages,and. beneficial
Some of the union's more senior workers) that were costly to Boeing Dut h the
with
associated
to the union. In the long-run, however, the higher labor costs ensive
more exp
substitute away from
agreement provide Boeing with an incentive to ance,
the lexibility to do so. ror

union labor, and the agreement provide Boeing
the siubcontracting provisions Boeing won in the agreement may, i t i g e d
permit the company to substitute away from its costly and neaviy hoart
sh
areas.
Pacific Northwest toward assembly facilities in less costly
inputs
the analyst concluded that the long-run flexibility
imbedded in the agreement
that generate 1Ong
possibilities for Boeing
lates into cost-reducing substitution costs.
benefits that more than offset the short-run
probably
SUMMARY
ze
and cost functions,
which summai
n this chapter, we introduced the production
inputs into outputs
sold by a
rirm. ro
important information about converting provid
firms that use several inputs to produce output, isocosts and isoquants
convenient way to determine the optimal input mix.
total cost, average xe
We broke down the cost function into average build a founaau
and marginal cost. These concepts help will De
average variable cost, decisions that
the profit-maximizing input and output
for understanding
covered in greater detail in later chapters. the informatIo
and isocosts provide
a desired level of output, isoquants
Given level of inputs. The cost-minimizing ieve
needed to determine the cost-minimizing
at which the ratio of input
prices equai u
of inputs is determined by the point
ratio of marginal products for the various inputs.
economies of scope,
and
cost
showed how economies of scale,
Finally, we
by single- an
Complementarities influence the
level and mix of outputs produced of vve
inputs.
will look at the acquisition
multiproduct firms. In the next chapter
we to
contracts, or vertical integrauon

markets,
will see how managers can use spot
desired mix of outputS.
obtain the inputs needed to produce their
efficiently

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PGP COURSE MATERIAL

ITRIMESTER{PGDM, 1B, BIF, MM, HRM)

Economics for Managers

institute of Public Enterprise

Trimester: 1"t Term- 202 Credits 3

Course Code: 103

| Dr. Ch. Lakshmi Kumari, Dr. SaiSailaja, Modules: 3

Courses PGDM, PGDM-BIF,

Code: 103 Credits: 3

Proportions Returns to scale, Isoproducts; Theory of cost and Revenue- cost

Trimester:1" Term-2018 Credits 3

Course Code: 103

Faculty: Dr. Ch. Lakshmi Kumari, Dr. Sai Sessions:20

PGDM- IB, PGDM-

introduces managers to the essence of business econonics the theories, conceptsS

the microeconomic environment. It is

an understanding of the economic

wherein the students would be

choice, production, cost,

problems. Students who

T o apply economic theoryand analytical toolsto help managers make betterdecisions.

To demonstrate the relation of Economics to the other courses in business education

who have not.

Session Theme Portion of Textbook Case/Article/Activity

The problem of what, how and Chapter-l of Introduction to the Challenge of

Case: Xerox Vs Canon

Elasticity of Demand & Supply

and Promotional Assignment Submission

Theory of Individual/ Consumer | Chapter 5 Income and Substitution Effects

5 Measuring Elasticity of Demane Chapter-5,6 of Price Elasticity Estimation

the Demand for Chekkers Pizza.

Test: 1 Article Study and assignment on Elasticity estimation

Theory of Production: Chapter Table 8.1 Discussion

Proportions Law of variable proportions

Long Run: Returns to scale, Chapter-9 Case Discussion: Mittal Steel in

Video: Returns to scale in

Video: Fixed vs. Variable costs

Continuation of Mittal steel case

Continuation of Mittal steel case

10 Long run cost curves Chapter-8,9, 10 Cases: Continuation of Mittal steel

Video: Break-even analysis

Perfect Competition Chapter-11Thomas Cases: 1.Competition in the

3.Copper, pp- 150-151

Video: Types ofmarkets: Perfect

12 Monopoly: Causes, Price Chapter-12ThomasCase: Case on Monopoly in the

(Dominic Salvatore pp-369)

De Beers- The Diamond

Video: Monopoly market

13 Price Discrimination- causes, Chapter-12 Cases: 1.Disneyland Pricing

2. Price discrimination in the

Video: Price discrimination

Sectoral assignments on HHI

and Firm Concentration Ratios

Cases: 1.The OPEC Cariei

the Role of Competition

Video: Colusive oligopoly

End Semester Fxammauon

See session plan above_ 10%