ECO-307

MANAGERIAL ECONOMICS

● WHAT IS ECONOMICS?
Choices. Choices. Choices
● PRODUCTION
Decision. Decision. Decision
● The Circular Flow Model
Produce. Sell. Receive. Use.
● Introduction to Managerial Economics
Produce. Sell. Receive. Use.
● Key Measures and Relationships
Produce. Sell. Receive. Use.

1.) What is Economics?

It is how individuals and societies make
decisions about ways to use scarce resources to fulfill
wants and needs.
CONCLUSION
The Study of Economics Micro and Macro Economics are not
1. MACROECONOMICS contradictory in nature, in fact, they are
● The BIG picture complementary. As every coin has two aspects- micro
● Growth, employment, etc and macroeconomics are also the two aspects of the
same coin, where one’s demerit is others merit and in
this way they cover the whole economy. The only
important thing which makes them different is the area
of application.

Economics: Five Economic Questions

Society must figure it out
● WHAT to produce?
● HOW MUCH to produce?
● HOW to produce it?
● FOR WHOM to produce?
● WHO makes these decisions?

What are resources?

The things used to make other goods.
2. MICROECONOMICS
● How individuals make economic SCARCITY - FUNDAMENTAL PROBLEM
decisions - unlimited wants and needs but limited resources

Why do we have scarcity? Because ALL resources, goods

and services are limited- WE MUST MAKE CHOICES!

Why Choices?
We make choices about how we spend our money, time
and energy so we can fulfill our NEEDS and WANTS.

Needs - “stuff” we must have to survive. Generally:

Food, shelter, Clothing.
Wants - “stuff” we would really like to have (Fancy food,
a nice house, clothing, big screen TV’s, jewelry,
conveniences... also known as “LUXURIES”.
You can’t have it all, (remember, we have scarcity...) so
you have to choose how to spend your money, time and
energy. These decisions involve picking one thing over
all the other possibilities. and that is TRADE-OFF!
Three parts of the PRODUCTION Process
1. Factors of Production - what we need to make goods
and services.
2. Producers - company that makes goods and/or
delivers services.
3. Consumers - people who buy goods and services
(formerly known as “stuff”).

TRADE-OFFS
1. What you could have done instead of coming to
school or study?
2. Why did you make that trade-off?

A special kind of Trade-Off is an “OPPORTUNITY COST”.

OPPORTUNITY COST
- The value of the NEXT BEST CHOICE.
Ex: Sleeping is the oppotunity cost of studying for a test.

When you choose to do one thing, its value (how much

it is worth) is measured by the value of the NEXT BEST
CHOICE. This can be in time, energy, or even, MONEY.

2.) PRODUCTION
- is making something; is how many goods and services
a business makes.

GOODS - tangible (you can touch it) products we can

buy.
SERVICES - Work that is performed for others.

And what do we need to make all of this stuff???

FACTORS OF PRODUCTION
These are the parts necessary to produce the finished
product.
Production is a co-operative process and not a job of
any single factor.

4 FACTORS OF PRODUCTION
1. Land - Natural Resources (Water, natural gas, oil,
tree) All the stuff we find on, in, and under the land.
2. Labor - Physical and Intellectual (labor is manpower). 3.) THE CIRCULAR FLOW MODEL
3. Capital - Tools, Machinery, Factories (The things we The circular flow model is an economic model that
use to make things) Human Capital is brainpower, ideas presents how money, goods, and services move
and innovation. between sectors in an economic system.
4. Entrepreneurship - Investment (Investing time,
natural resources, labor and capital are all risks
associated with production.
 substance to those economic concepts which are
useful in deciding the business strategy of a unit of
management. Therefore, focuses on those tools
and techniques, which are useful in decision-
making.
Managerial economics is primarily concerned with the
application of economic principles and theories to five
types of resource decisions made by all types of
business organizations.
a. The selection of product or service to be produced.
b. The choice of production methods and resource
combinations.
c. The determination of the best price and quantity
combination
d. Promotional strategy and activities.
e. The selection of the location from which to produce
and sell goods or service to
consumer.
4.) INTRODUCTION TO MANAGERIAL ECONOMICS
The scope of managerial economics covers two areas of
The study of how to direct scarce resources in the way
decision making
that most efficiently achieves a managerial goal.
a. Operational or Internal issues
b. Environmental or External issues
Management is the science and art of getting things
done through people in formally organized groups. It
OPERATIONAL or INTERNAL ISSUES
includes a number of functions: Planning, Organizing,
Operational issues refer to those, which wise within the
Staffing, Directing, and Controlling.
business organization and they are
under the control of the management.
Manager
A person who directs resources to achieve a stated goal.
Those are:
The manager, while directing the efforts of his staff,
1. Theory of demand and Demand Forecasting
communicates to them the goals, objectives, policies,
2. Pricing and Competitive strategy
and procedures; coordinates their efforts; motivates
3. Production cost analysis
them to sustain their enthusiasm; and leads them to
4. Resource allocation
achieve the corporate goals.
5. Profit analysis
6. Capital or Investment analysis
MANAGERIAL ECONOMICS
7. Strategic planning
● Managerial Economics as a subject gained
popularity in USA after the publication of the
ENVIRONMENTAL or EXTERNAL ISSUES
book ``Managerial Economics” by Joel Dean in
An environmental issue in managerial economics refers
1951.
to the general business environment in which the firm
● Managerial Economics refers to the firm’s
operates. They refer to the general economic, social and
decision making process. It could be also
political atmosphere within which the firm operates. A
interpreted as “Economics of Management”.
study of economic environment should include:
Managerial Economics is also called “Industrial
Economics” or “Business Economics”.
a. The type of economic system in the country.
● In the words of E. F. Brigham and J. L. Pappas
b. The general trends in production, employment,
Managerial Economics is “the applications of
income, prices, saving and investment.
economics theory and methodology to business
c. Trends in the working of financial institutions like
administration practice”.
banks, financial corporations,
● Managerial economics be defined as a body of
insurance companies
knowledge, techniques and practices which give
d. Magnitude and trends in foreign trade;
e. Trends in labour and capital markets;
f. Government’s economic policies viz. industrial policy
monetary policy, fiscal policy, price
policy etc.
5.) KEY MEASURES AND RELATIONSHIPS
Managerial Economics Is Applicable to Different Types
of Organizations
The organization providing goods and services will often
be called a “business” or a “firm,” terms that connote a
for-profit organization. Wherein the underlying goal of
the organization is to create profit.
However, managerial economics is relevant to nonprofit
organizations and government agencies as well as
conventional, for-profit businesses. Although the
underlying objective may change based on the type of
organization, all these organizational types exist for the
purpose of creating goods or services for persons or
other organizations.
Economics provides a framework for analyzing
regulation, both the effect on decision making by the
regulated entities and the policy decisions of the
regulator.
REVENUE, COST AND PROFIT
❖ The total monetary value of the goods or
services sold is called revenue.
❖ The collective expenses incurred to generate
revenue over a period of time, expressed in
terms of monetary value, are the cost.
➢ Some cost elements are related to the
volume of sales; that is, as sales go up,
the expenses go up. These costs are
called variable costs.
➢ Other costs are largely invariant to the
volume of sales, at least within a certain
range of sales volumes. These costs are
called fixed costs.
❖ Businesses are viable on a sustained basis only
when the revenue generated by the business
generally exceeds the cost incurred in operating
the business. The difference between the
revenue and cost (found by subtracting the cost
from the revenue) is called the profit.
EXAMPLE:
The students realize they need to determine
whether they can make a profit from a summer ice
cream bar business. They met the person who operated
an ice cream bar business in the building the previous
summer. He told them last summer he charged $1.50
per ice cream bar and sold 36,000 ice cream bars. He
said the cost of the ice cream bars—wholesale
purchase, delivery, storage, and so on—comes to about
$0.30 per bar. He indicated his other main costs—
leasing the building, license, local business association
fee, and insurance—came to about $16,000.
***Determine a rough estimate of the revenue, costs,
and profit if they were to repeat the outcomes for the
prior operator.
Based on this analysis, the students are
confident the summer business venture can make
money. They approach the owner of the building and
learn that if they want to reserve the right of first option
to lease the building over the summer, they will need to
make a nonrefundable $6000 deposit that will be
applied to the lease. They proceeded to make that
deposit.
A few weeks later, all three students were
unexpectedly offered summer business internships at a
large corporation. Each student would earn $10,000.
However, the work site for the internships is far from
the beach and they would be in an office all day. They
now must decide whether to accept the internships and
terminate their plan to run a business at the beach or
turn down the internships.
If you were to decide? What will be your decision?
ECONOMIC PROFIT VS ACCOUNTING PROFIT
Accounting Profits
- Total revenue (sales) minus cost of producing goods or
services.
- Reported on the firm’s income statement.
Economic Profits
- Total revenue minus total opportunity cost.
OPPORTUNITY COST
Accounting Costs
- The explicit costs of the resources needed to produce
goods or services.
- Reported on the firm’s income statement.
Opportunity Cost
- The cost of the explicit and implicit resources that are
foregone when a decision is made.
Economic Profits
- Total revenue minus total opportunity cost.
REVENUE, COST AND PROFIT FUNCTION
There is a relationship between the volume or quantity
created and sold and the resulting impact on revenue,
cost, and profit. These relationships are called the
revenue function, cost function, and profit function.
These relationships can be expressed in terms of tables,
graphs, or algebraic equations.

In a case where a business sells one kind of product or

service, revenue is the product of the price per unit
times the number of units sold. If we assume ice cream
bars will be sold for $1.50 per piece, the equation for
the revenue function will be
R = $1.5 Q
(R= P x Q) BREAKEVEN ANALYSIS
where R is the revenue and Q is the number of units sold As the sales volume increases, revenue and cost
increase and profit becomes progressively less negative,
The cost function for the ice cream bar venture has two turns positive, and then becomes increasingly positive.
components: the fixed cost component of $40,000 that There is a zone of lower volume levels where economic
remains the same regardless of the volume of units and costs exceed revenues and a zone on the higher volume
the variable cost component of $0.30 times the number levels where revenues exceed economic costs.
of items. The equation for the cost function is:
The break-even point is the point at which total cost
C = $40,000 + $0.3 Q and total revenue are equal, meaning there is no loss or
(TC= FC + VC) gain for your small business. In other words, you've
where C is the total cost. reached the level of production at which the costs of
production equals the revenues for a product.
*Note we are measuring economic cost, not accounting
cost.

Since profit is the difference between revenue and cost,

the profit functions will be
π = R − C = $1.2 Q − $40,000
(P = R - C)
Here π is used as the symbol for profit. (The letter P is
reserved for use later as a symbol for price.)

AVERAGE COST
The average cost is another interesting measure to
track. This is calculated by dividing the total cost by the
quantity. The relationship between average cost and
quantity is the average cost function. For the ice cream
bar venture, the equation for this function would be

AC = C/Q = ($40,000 + $0.3 Q)/Q = $0.3 + $40,000/Q.
(AC = TC/Q)
When the price and unit contribution margins are close,
most of the revenue generated from additional sales
turns into profit once you get above the breakeven level.
However, if you fall below the breakeven level, the loss
will grow equally dramatically as the volume level drops.
Businesses like software providers, which tend have
mostly fixed costs, see a close correlation between
revenue and profit. Businesses of this type tend to be
high risk and high reward.
On the other hand, businesses that have
predominantly variable costs, such as a retail grocery
outlet, tend to have relatively modest changes in profit
relative to changes in revenue. If business level falls off,
they can scale down their variable costs and profit will
not decline so much. At the same time, large increases
in volume levels beyond the breakeven level can achieve
only modest profit gains because most of the additional
revenue is offset by additional variable costs.
IMPACT OF PRICE CHANGES
To examine the impact of price and determine a best
price, we need to estimate the relationship between the
price charged and the maximum unit quantity that could
be sold. This relationship is called a demand curve.
Demand curves generally follow a pattern called the law
of demand, whereby increases in price result in
decreases in the maximum quantity that can be sold.
The demand curve will move downward from the left to
the right, which expresses the law of demand—as the
price of a given commodity increases, the quantity
demanded decreases, ceteris paribus.
We will consider a simple demand curve for the ice
cream venture. We will assume that since the operator
of the business last year sold 36,000 units at a price of
$1.50 that we could sell up to 36,000 units at the same
price this coming summer. Next, suppose the students
had asked the prior operator how many ice cream bars
he believes he would have sold at a price of $2.00 and
the prior operator responds that he probably would
have sold 10,000 fewer ice cream bars. In other words,
he estimates his sales would have been 26,000 at a price
of $2.00 per ice cream bar.
P = 3.3 − 0.00005 Q
where P is price and Q is the maximum number of ice
cream bars that will sell at this price.
*compute for the prices with the given quantity and
make a graphical presentation
In a fixed price market, the seller decides a price and
the buyers respond with the volume of demand.
However, in economics, the common practice is to
describe the demand curve as the highest price that
could be charged and still sell a quantity Q.
We can use the stated relationship in the demand curve
to examine the impact of price changes on the revenue
and profit functions. (The cost function is unaffected by
the demand curve.) Again, with a single type of product
or service, revenue is equal to price times quantity. By
using the expression for price in terms of quantity rather
than a fixed price, we can find the resulting revenue
function.
R = P Q = (3.3 − 0.00005 Q) Q = 3.3 Q − 0.00005 Q2.
By subtracting the expression for the cost function from
the revenue function, we get the revised profit function:
π = (3.3 Q − 0.00005 Q2) − (40,000 + $0.3 Q) = –0.00005
Q2 + 3 Q − 40,000.
*Note that the revenue and profit functions are curved
since they are quadratic functions. From the graph of
the profit function, it can be seen that it is possible to
earn an economic profit with a quantity as low as 20,000
units; however, the price would need to be increased
according to the demand curve for this profit to
materialize. Additionally, it appears a higher profit is
possible than at the previously planned operation of
36,000 units at a price of $1.50. The highest profitability
appears to be at a volume of about 30,000 units. The
presumed price at this volume based on the demand
curve would be around $1.80.
The graph of a quadratic function is a curve called a
parabola. Parabolas may open upward or downward
and vary in "width" or "steepness", but they all have the
same basic "U" shape. *Compute for the prices with the
given quantity and make a graphical presentation.
 managerial control variable should be increased up to
MARGINAL ANALYSIS the point where MB = MC.
Marginal analysis is an examination of the associated
costs and potential benefits of specific business If marginal cost and marginal revenue are equal, your
activities or financial decisions. The goal is to determine business has reached its optimal production level. At
if the costs associated with the change in activity will this level, efficiency has reached its peak, and you've
result in a benefit that is sufficient enough to offset maximized profits.
them.
MR > MC means the last unit of the control variable
For example, if a company has room in its budget for increased benefits more than it increased costs.
another employee and is considering hiring another MR < MC means the last unit of the control variable
person to work in a factory, a marginal analysis increased costs more than it increased benefits.
indicates that hiring that person provides a net marginal
benefit. In other words, the ability to produce more If a company's marginal revenue is less than the
products outweighs the increase in labor costs. marginal cost of producing more units, it's an indication
that the company is producing too much. On the other
Marginal in economics means having a little more or a hand, if a company's marginal revenue is greater than
little less of something. It refers to the effects of its marginal cost, it indicates that the company is not
consuming and/or producing one extra unit of a good or producing enough units.
service.

Economists analyze relationships like revenue functions

from the perspective of how the function changes in
response to a small change in the quantity. These
marginal measurements not only provide a numerical
value to the responsiveness of the function to changes
in the quantity but also can indicate whether the
business would benefit from increasing or decreasing
the planned production volume and in some cases can
even help determine the optimal level of planned
production.

The marginal revenue measures the change in revenue

in response to a unit increase in production level or
quantity. The marginal cost measures the change in cost
corresponding to a unit increase in the production level.
The marginal profit measures the change in profit
resulting from a unit increase in the quantity. Marginal
measures for economic functions are related to the
operating volume and may change if assessed at a
different operating volume level.

MARGINAL REVENUE: Change in total benefits arising

from a change in the control variable, Q:

MARGINAL COST: Change in total costs arising from a THE SHUTDOWN RULE
change in the control variable, Q: You may recall earlier in this chapter that, before
deciding to disregard the $6000 nonrefundable down
payment (to hold the option to operate the ice cream
MARGINAL PRINCIPLE: To maximize net revenue, the business) as a relevant economic cost, the total cost of
operating the business under a plan to sell 36,000 ice
cream bars at a price of $1.50 per item would have
exceeded the expected revenue. Even after further
analysis indicated that the students could improve profit
by planning to sell 30,000 ice cream bars at a price of
$1.80 each, if the $6000 deposit had not been a sunk
cost, there would have been no planned production
level and associated price on the demand curve that
would have resulted in positive economic profit. So the
students would have determined the ice cream venture
to be not quite viable if they had known prior to making
the deposit that they could instead each have a summer
corporate internship. However, having committed the
$6000 deposit already, they will gain going forward by
proceeding to run the ice cream bar business.
Earlier in the chapter, we cited one condition for
reaching a breakeven production level where revenue
would equal or exceed costs as the point where average
cost per unit is equal to the price. However, if some of
the costs are already sunk, these should be disregarded
in determining the relevant average cost. In a
circumstance where a business regards all fixed costs as
effectively sunk for the next production period, this
condition becomes a statement of a principle known as
the shutdown rule: If the selling price per unit is at least
as large as the average variable cost per unit, the firm
should continue to operate for at least a while;
otherwise, the firm would be better to shut down
operations immediately.
In this diagram, the firm will be willing to produce at
prices greater than or equal to Pmin, since this is the
minimum value of the average variable cost curve. At
prices below Pmin, the firm will decide to shut down
and produce a quantity of zero instead.
Two observations about the shutdown rule are in order:
In a circumstance where a firm’s revenue is sufficient to
meet variable costs but not total costs (including the
sunk costs), although the firm may operate for a period
of time because the additional revenue generated will
cover the additional costs, eventually the fixed costs will
need to be refreshed and those will be relevant
economic costs prior to commitment to continue
operating beyond the near term. If a business does not
see circumstances changing whereby revenue will be
getting better or costs will be going down, although it
may be a net gain to operate for some additional time,
such a firm should eventually decide to close down its
business. Sometimes, it is appropriate to shut down a
business for a period of time, but not to close the
business permanently. This may happen if temporary
unfavorable circumstances mean even uncommitted
costs cannot be covered by revenue in the near term,
but the business expects favorable conditions to resume
later.
Chapter 3
Demand and Pricing
3.1 Theory of the Consumer
The theory of demand has its foundations in the
theory of consumer choice. Analysis of consumer
behavior is a prerequisite to deal with the theory of
demand. The Theory of Consumer Choice relies on the
assumption that the consumer is rational, he is
equipped with the knowledge regarding his income,
commodities available and their prices, to make a
decision as to what to buy. Trade-offs faced by the
consumers while making a choice, assume an important
role in the theory of consumer choice. Amount to be
spent on different commodities, given the income and
the price, amount of time to be devoted to leisure and
work, whether to consume more in the present or to
save more for the future are a few important questions
that a consumer encounters in his day to day life. In the
due course, we will see how the theory of consumer
choice caters to these questions.
Budget Constraint
A budget constraint is defined as the limit on
the consumption bundles that a consumer can afford.
That means it describes all possible combinations of
goods and services a consumer can afford given their Consumer Preferences and Indifference Curves
current income. A consumer would prefer having
greater quantity or better quality of the goods he Just like the budget constraint, consumer
consumes, however, his income acts as a limit on the preferences are also an important part of the theory of
amount of money he can spend on consumption of consumer choice. To continue with the example of
those goods. burgers and milkshake, it is the consumer preferences
To take a simple example, lets study the case of that help the consumer to choose from different
a consumer who consumes only two commodities: combinations of these two goods. To show the
Burger and Milkshake. Suppose that the consumer earns consumer preferences graphically, we often use
a monthly income of Php 1000, the price of a burger is indifference curves.
Php 20 and that of a glass of milkshake is Php 10.
Table No. 1 lists several combinations of Indifference Curves
milkshake and burger that the consumer can choose An indifference curve is a graphical
from given his income and prices of the two goods. representation of various combinations or consumption
bundles of two commodities. It provides equivalent
Table 1 Combinations of Burger and Milkshake that the satisfaction and utility levels for the consumer. It is a
consumer can afford to consume downward sloping convex line connecting the quantity
of one good consumed with the amount of another
Glasses of Numbe Spending Spendin Total
good consumed.
Milkshake r of on g on Spendin
Figure 2 shows indifference curves for the
s Burgers Milkshak Burgers g
consumer who consumes burgers and milkshake. Points
e
A, B and C on the indifference curve I1 show various
0 50 0 1000 1000 combinations of burgers and milkshake that make the
consumer equally happy. Moving from point A to B, the
10 45 100 900 1000 consumption of milkshake increases while that of
burger, falls. Same is the case when the consumer
20 40 200 800 1000 moves from B to C. The slope of the indifference curve is
termed as the marginal rate of substitution which equals
30 35 300 700 1000
the rate at which the consumer is ready to substitute
40 30 400 600 1000 one good for the other. In this case the marginal rate of
substitution is the measure of the number of glasses of
50 25 500 500 1000 milkshake that need to be given to the consumer for a
unit reduction in consumption of burger. Indifference
60 20 600 400 1000 curve I2 , shows greater level of satisfaction relative to
the indifference curve I1.
70 15 700 300 1000
Important Properties of Indifference Curve
80 10 800 200 1000
Higher indifference curves carry a greater level of
90 5 900 100 1000 satisfaction compared to the lower ones: The
preference of the consumers for greater quantities gets
100 0 1000 0 1000 exhibited in the indifference curve approach also.
Higher indifference curves depict bundles with larger
quantities of goods relative to the lower ones and the
consumer prefers higher indifference curves to the
lower ones.
Indifference curves slope downwards: In the case where
a consumer likes both the goods, when the quantity of
one good is raised, the quantity of the other good has to
fall for the consumer to stay at the same level of
satisfaction. This is what makes the indifference curves For example, a good return on an investment or
slope downwards. other monetary gains may prompt a consumer to
Indifference curves do not intersect: The set of curves replace the older model of an expensive item for a
will never intersect each other. The higher level and newer one.
lower level of curves show different levels of The inverse is true when incomes decrease.
satisfaction. Hence, they do not meet at the point of Substitution In the direction of buying lower-priced
intersection. items has a generally negative consequence on retailers
because it means lower profits. It also may mean that
INCOME EFFECT AND SUBSTITUTION EFFECT there are fewer options for the consumer.
While the substitution effect changes
Income Effect consumption patterns in favor of the more affordable
alternative, even a modest reduction in price may make
The income effect is the change in the a more expensive product more attractive to
consumption of goods based on income. This means consumers.
consumers will generally spend more if they experience For instance, if private college tuition is more
an increase in income. They may spend less if their expensive than public college tuition—and money is a
income drops. concern—consumers will naturally be attracted to
The effect doesn't dictate the kinds of goods consumers public colleges. But a small decrease in private tuition
will buy. They may opt to purchase more expensive costs may be enough to motivate more students to
goods in lesser quantities or cheaper goods in higher begin attending private schools.
quantities, depending on their circumstances and The substitution effect is not limited to
preferences. consumers. When companies outsource part of their
The income effect can be both direct or indirect. When a operations, they are demonstrating the substitution
consumer chooses to make changes to the way they effect. Using cheaper labor in a different country or by
spend because of a change in income, the income effect hiring a third-party result in a drop in costs. This nets a
is said to be direct. For example, a consumer may positive result for the corporation, but a negative effect
choose to spend less on clothing because their income for the employees who may be replaced.
has dropped.
An income effect becomes indirect when a consumer is INCOME EFFECT VS. SUBSTITUTION EFFECT
faced with making buying choices because of factors not
related to their income. For instance, food prices may go
up, leaving the consumer with less income to spend on BASIS FOR INCOME SUBSTITUTION
other items. This may force them to cut back on dining COMPARISON EFFECT EFFECT
out, resulting in an indirect income effect.
The marginal propensity to consume explains how
consumers spend based on income. It is a concept based Meaning Income effect Substitution effect
on the balance between the spending and saving habits refers to the means an effect
of consumers. change in the due to the change
The marginal propensity to consume is included in a demand of a in price of a good
larger theory of macroeconomics known as Keynesian commodity or service, leading
economics. The theory draws comparisons between caused by the consumer to
production, individual income, and the tendency to change in replace higher
spend more of it. consumer's real priced items with
income. lower prices ones
Substitution Effect
The substitution effect may occur when, due to a
change in relative prices and finances, a consumer Reflected by Movement Movement along
replaces one product with another. That might mean along income- price-consumption
switching out cheaper or moderately priced items for consumption curve
ones that are more expensive. curve
 Although some have attempted to claim that we
approximate the idea of the consumer, our
consumption choices may not entirely match it. Simon
discusses bounded rationality and satisficing. Herbert
Effect of Income being Relative price Simon proposed a theory of bounded rationality (1997).
freed up. changes that asserts that when given few choices, people
actually act logically. Therefore, consumers may be able
to reach something near to the theoretical maximum in
terms of overall utility if they concentrate on a small
number of key goods and services. Simon also noted
Expresses Impact of rise Change in quantity
that, rather than pursuing the optimal pattern of
or fall in demanded of a
consumption, humans may "satisfice,"or seek to achieve
purchasing good due to
a specific level of consumer satisfaction. Once more, if
power on change in prices.
the level of acceptability is reasonably close to the
consumption
optimal level, the outcomes of purchasing decisions may
resemble what would happen if the consumers
Rise in price of Reduces As alternative functioned in accordance with this idea.
a good disposable goods are We notice how other people behave, which is another
income, which comparatively point that suggests that discrepancies between the
in turn cheaper and so theory and actual conduct may not lead to drastically
decrease customers will different consumption. If someone else, through
quantity switch to other deliberate effort or unintentional discovery, is enjoying
demanded goods. more fulfillment under comparable wealth and income
conditions, their neighbors and acquaintances will
notice this and begin to imitate their consumption
Fall in price of a Increases real Will make it habits. Our consumption may therefore change to
good spending power cheaper than its follow the ideal pattern.
of a consumer, substitutes, which The fact that the theory of the consumer lacks face
that allows will attract more validity means that it is not effective at modeling
customers to customers and customer behavior, which is perhaps the most
buy more, with result in higher significant factor. Whether owing to changes in their
the given demand. actual discretionary income or indirect effects on wealth
budget. brought on by price changes, we do anticipate
3.2 Is The Theory of Consumer Realistic? consumers to react to price changes and changes in
It would be challenging to argue that the theory of the their wealth.
consumer is consistent with our personal experiences 3.3 Determinants of Demand
making purchasing decisions or with what we see in
other consumers. We don't consciously consider how The determinants of demand refer to the
many of the tens of thousands of potential goods and quantities of a product or service consumers are ready
services we might use and their respective marginal and able to purchase.
utility. We are unaware of numerous goods and Economic demand depends on a number of
services' existence as well as their various current costs. different variables. For instance, price is a key driver of
Even if we did, the computational complexity required demand, as there are very few consumers that don't
to solve for optimal consumption would likely be too care about money. Equally, a consumer's purchasing
much for our brains and even the fastest computers. habits may change if they get a pay rise. In order to
Frequently, both we and others only consider what is measure these fluctuations, economists have identified
necessary to survive rather than what will bring us the five key determinants of demand that influence
most satisfaction when we consume. Poor or seriously ill purchase patterns associated with a product or service.
consumers are probably unable to make even a small In turn, manufacturers and suppliers can study these
attempt at consumption optimization. Some individuals metrics to manage inventory. Below, we look at these
might just drink out of habit rather than on purpose. factors in more detail.
Price of the Product
The law of demand states that when
prices rise, the quantity of demand falls. That
also means that when prices drop, demand will
grow. People base their purchasing decisions on
price if all other things are equal. The exact
quantity bought for each price level is described
in the demand schedule. It's then plotted on a
graph to show the demand curve.
If the quantity demanded responds a lot
to price, then it's known as elastic demand. If
demand doesn't change much, regardless of
price, that's inelastic demand.
Note: The demand curve shows just the
relationship between price and quantity. If one
of the other determinants changes, the entire
demand curve shifts.
Income of the Consumers
When income rises, so will the quantity
demanded. When income falls, so will demand.
But if your income doubles, you won't always
buy twice as much of a particular good or
service. There are only so many pints of ice
cream you'd want to buy, no matter how
wealthy you are, and this is an example of
"marginal utility."
The first pint of ice cream tastes
delicious. You might have another. But after
that, the marginal utility starts to decrease to
the point where you don't want any more.
Important: Marginal utility is the concept that
each unit of a good or service is a little less
useful to you than the first. At some point, you
wont want it anymore, and the marginal utility
drops to zero.
Prices Related Goods and Services
Complementary products – An increase
in the price of one product will cause a decrease
in the quantity demanded of a complementary
product. Example: Rise in the price of bread will
reduce the demand for butter. This arises
because the products are complementary in
nature.
Substitute Product – An increase in the
price of one product will cause an increase in
the demand for a substitute product. Example:
Rise in the price of tea will increase the demand
for coffee and decrease the demand for tea.
The price of complementary goods or
services raises the cost of using the product you
demand, so you'll want less. For example, when
gas prices rose to $4 a gallon in 2008, the
demand for gas-guzzling trucks and SUVs fell.
Gas is a complementary good to these vehicles.
The cost of driving a truck rose along with gas
prices.
The opposite reaction occurs when the
price of a substitute rises. When that happens,
people will want more of the good or service
and less of its substitute. That's why Apple
continually innovates with its iPhones and iPods.
As soon as a substitute, such as a new Android
phone, appears at a lower price, Apple comes
out with a better product. Then the Android is
no longer a substitute.
Consumer Expectations and Taste
Expectations of a higher income or
expecting an increase in prices of goods will lead
to an increase in the quantity demanded.
Similarly, expectations of a reduced income or a
lowering in prices of goods will decrease the
quantity demanded.
If consumers suspect that the price of a
product will rise in future, the demand for said
product will increase in the present. For
example, if there is a rise in petrol prices
forecast for the coming week, motorists will fill
up today. Equally, customers attitudes, tastes,
and preferences can impact demand in ways
less directly associated with cost. For instance, if
a popular celebrity is involved in marketing a
product, demand may increase. Conversely, if a
scientific study reports a product is detrimental
to your health, demand will drop.
When the publics desires, emotions, or
preferences change in favor of a product, so
does the quantity demanded. Likewise, when
tastes go against it, that depresses the amount
demanded. Brand advertising tries to increase
the desire for consumer goods.
Number of Buyers in the Market
One of the most important
determinants of demand is the size of the
market. The more consumers want to purchase
a product, the faster demand will rise. Although
a rise in population is an obvious way this can
happen, there are other factors that influence
the size of a customer base. For example, a
company may produce a highly effective
 marketing campaign that introduces their
product or service to a new segment.
The number of consumers affects
overall, or aggregate,demand. As more buyers
enter the market, demand rises. That's true
even if prices don't change, and the U.S. saw
this during the housing bubble of 2005. Low-
cost and sub-prime mortgages increased the
number of people who could afford a house.
The total number of buyers in the market
expanded. This increased demand for housing.
When housing prices started to fall, many
realized they couldn't afford their mortgages. At
that point, they foreclosed. That reduced the
number of buyers and drove down demand.
How Each Determinant Affects Demand
Each factor's impact on demand is unique.
When the income of the buyer increases, for example,
that could also increase demand. The buyer has more
money and is more likely to spend it. But when other
factors increase—like the price of related goods, for
example—demand could decrease.
Before breaking down the effect of each
determinant, it's important to note that these factors
don't change in a vacuum. All the factors are in flux all
the time. To understand how one determinant affects
demand, you must first hypothetically assume that all
the other determinants don't change.
Important: That principle is called ceteris paribus or all
other things being equal.
3.4 Modeling Consumer Demand
Consumer demand is an economic measure of a
groups desire for a product or service based on
availability. It represents consumers' buying habits and
helps determine the purchasing trends of specific
populations. Knowing how consumer demand works are
vital for interpreting market trends, developing business
models, and creating marketing strategies.
To develop a formal model of consumer
demand, the first step is to identify the most important
determinants of demand and define variables that
measure those determinants. Ideally, we should use
variables for which data exist so that statistical
estimation techniques can be applied to develop an
algebraic relationship between the units of a good
consumed and the values of the key determinants.
Techniques to derive these algebraic relationships from
historical data are outside the scope of this text, but an
interested reader may want to consult a text on
econometrics.
Four key determinants of demand:
● the price they charge for the service
● their advertising expenditure
● the price charged by the competition
● the disposable income of their potential
customers.
Four variables to measure determinants:
P = the price per month of their service, in dollars.
A = advertising expenditure per month, in dollars,
CP = the price per month of the competitors service, in
dollars,
DIPC = the disposable income per capita, in dollars, as
measured by the U.S. Department of Commerce for that
month.
Q= 25,800-800P + 4A+ 200 CP + 0.4DIPC
This relationship is called a demand function. One
application of the demand function is to estimate the
consumption quantity Q for specific values of P, A, CP,
and DIPC.
Example:
Suppose a business is selling broadband services in a
community.
Suppose P = $30, A = $5000, CP = $25, and DIPC =
$33,000:
Q= 25,800-800P + 4A+ 200 CP + 0.4DIPC.
Q = 25,800 - 800(30) + 4(5000) + 200(25) +
0.4(33,000) = 40,000 subscribers
In Chapter 2 "Key Measures and Relationships",
we introduced a demand curve to describe the
relationship between the quantity of items sold and the
price of the item. When there are multiple
determinants of demand, the demand curve can be
interpreted as a reduced view of the demand function
where only the price of the product is allowed to vary.
Any other variables are assumed to remain at a fixed
level
For the previous demand function for
broadband service, suppose we assume A is fixed at
$5000, CP is fixed at $25, and DIPC is fixed at $33,000. If
you substitute these values into the demand function
and aggregate constant terms, the demand function
becomes:
Q= 25,800-800P + 4A+ 200 CP + 0.4DIPC
Q = 25,800 - 800P + 4(5,000) + 200(25) +
0.4(33,000)
 Q = 25,800 - 800P + 20,000 + 5,000 + 13,200 No business owner has a crystal ball showing
what the customers will want during the upcoming year
38,200 and how much of it they will buy. Running a business is
Q = 25,800 + 38,200 - 800P hard. Knowing and meeting customers' preferences are
much harder. Firms are unable to decide how much
64,000 money to spend on marketing, how much to produce,
how many employees to hire, and other matters
Q = 64,000 - 800 P
without a solid understanding of demand. And without
Recall that demand curves are usually expressed with
demand, there would be no business. Fortunately, you
price as a function of quantity.
can forecast these demands using tools and information
With some basic algebra, the equation of the demand
available in your business.
curve can be written as:
But what is forecasting in the first place? It is
Q = 64,000 - 800 P
important to note that forecasting is different from
800 P = 64,000 Q
estimation. Estimation focuses more on the links
800 800
between datas and operations, finding the reasons
P = $80 - $0.00125 Q behind the numbers and using this information to plan
for the future. Forecasting on the other hand is driven
Suppose the competitor decides to increase its price to by numbers rather than stories.Forecasting basically is
$35. Repeating the preceding steps, the demand the process of using variables that are known to
function simplifies to: anticipate outcomes that are unknown. When it comes
to business, we must anticipate the what, when, where,
Q= 25,800-800P + 4A+ 200 CP + 0.4DIPC why, and how of client demand.

Q = 25,800 - 800P + 4(5,000) + 200(35) +

0.4(33,000)

Q = 25,800 - 800P + 20,000 + 7,000 + 13,200

40,200
Q = 25,800 + 40,200 - 800P

66,000

Q = 66,000 - 800 P

Q = 66,000 - 800 P
800 P = 66,000 Q
800 800 Figure 1.1 Forecasting

P = $82.50 - 0.00125 Q.
Demand Forecasting on the other hand is
Figure 3.1 Shift in Demand Curve for Broadband
different from demand estimation. The goal of demand
Service Caused by Increase of Competitor Price From
estimation is to quantify the connections or
$25/month to $35/month shows a graph of the demand
relationships between the amount of demand and the
curve before and after the shift. Effectively, the result is
factors that influence it are commonly employed in
that the broadband firm would see its demand increase
developing price strategies of the company. This is
by 2000 customers per month, or alternatively, the firm
usually done for a short period of time. Demand
could raise its price to $32.50 and still maintain 40,000
forecasting on the other hand is the technique of
customers per month
estimating and predicting future consumer demand for
a good or service using predictive analysis of previous
FORECASTING DEMAND data. The goal of demand forecasting is to enable
managers to plan for the most likely future demand for
a product's necessary preparation of personnel, raw
materials, equipment, finances, and other production
factors. By estimating future sales and revenue, demand
forecasting assists the company in making more
educated supply decisions. However, both the two
approaches have the main objective to avoid under and
over production.
Generally, there are three (3) laws that govern
the demand. Price and the demanded quantity are
inversely proportional, customers budget and the law of
diminishing marginal utility. In short note, change in
customers income, change in number of consumers,
change in price of a substitute good, change in
customers expectations, change in price of a
complementary good and change in consumers tastes
and preferences all have an impact on the demand.
When you have a large product, a huge customer
demographic, predicting demand becomes a nightmare.
Without demand forecasting, you may underproduced
or overproduced or even set unrealistic sales targets.
However, reality check, a majority of the important
demand factors are not under the control of businesses.
The company cannot influence how the general
economy and consumer earnings will develop. The
company could anticipate, but not influence, the
behavior of other businesses that supply substitute and
complementary products services and products. It is
crucial to consider how these external pressures will
affect things which use the different methods of
demand forecasting.
The most common is the survey method which
is divided into four types: (1) opinion survey method, (2)
expert survey method, (3) delphi method and (4)
consumer interview method.
All these sum up to the idea that one of the best
ways to forecast is to know the demands of your
customers. The next aspect that we can look at is the
traditional statistical method.Here, the company usually
uses what they call a time series of data. These include
datas that are recorded at equally spaced intervals. This
allows them to see the trend and seasonality of a
product.
However, historical datas sometimes alone is
not enough. The pandemic shows that the demand
changes may be illogical and unpredictable- no country
predicted that there will be a huge increase in demand
for toilet paper, masks, sanitizers and all. Here historical
data alone didn't help- especially if you have a new
product. Demand projection for a new product is very
different from demand projection for an established
one. Because there is no previous data available for new
products, statistical approaches cannot be used. So how
will you forecast? As a business owner, what would you
do? You make an advance prediction. How? According
to Joel Dean, there are six approaches for forecasting
the demand of a new product which includes: (1)
evolutionary approach, (2) substitute approach, (3)
growth curve approach, (4) opinion polling approach, (5)
sales experience approach (6) vicarious approach. The
growth curve approach has limited applicability and is
most helpful when demand projection is advanced. It
has long been common practice to investigate consumer
demand for new items by conducting opinion research
or intention surveys. When the experiment is well
controlled, sales experience with a new product on a
sample basis gives predictions of demand a stronger
basis.
The difficulty comes in figuring out how much
room to leave for the sample market's peculiarities and
immaturity. The Vicarious technique is incredibly simple
and agonizingly difficult to quantify. It can typically only
be used as an inexpensive horseback sally.
To sum it up, businesses can't decide how much
money to spend on marketing, how much product to
produce, how many people to hire, and other issues
unless they have a thorough grasp of demand. Demand
forecasting can help you shorten production lead times,
boost operational effectiveness, save money, introduce
new items, and generally give customers a better
experience. However, it will never be completely
correct. You'll just be able to make wise decisions
regarding corporate growth plans, pricing, and market
potential. If not done properly, all the ill-informed
choices that might possibly occur can have a significant
impact on profitability, supply chain management,
inventory holding costs, and most importantly,
customer happiness.
ELASTICITY OF DEMAND
In the earlier discussion we were able to
understand the relationship between demand and price.
Reiterating the discussion briefly, The Law of Demand
states that as the price of a good decreases, the
quantity demanded of those goods increases. Thus,
according to the law of demand there is an inverse
relationship between price and quantity demanded.
Those other things which are assumed to be constant
are taste or preference of the consumer, income of the
consumer, prices of related goods etc. If these factors
undergo a change, then the inverse relationship may not
hold good. However, we also observe that for
commodities like salt or rice we do not notice much of a
change in demand whereas in case of goods like Air
conditioners, Cars etc. even with a small change there is
substantial increase in demand. The Law of demand
while stating the relationship between demand and
price mentions only the direction of change in demand
but does not mention anything about the magnitude of
the change which is very essential in the decision-
making process for the producer and Government.
Suppose we would like to assess whether the
demand for broadband service will change much in
response to a change in its price. One indicator of the
level of response to a price change is the coefficient of
the price term in the demand function equation, –800 P.
The interpretation of the coefficient –800 is that for
each increase of $1 in the monthly subscriber price, the
number of monthly subscribers will decrease by 800
subscribers. This observation provides some insight,
particularly if the broadband firm is considering a price
change and would like to know the impact on the
number of subscribers. However, for someone who
measures price in terms of a different currency, say
Japanese yen, a conversion to U.S. dollars would be
needed to appreciate whether the demand change
implied by the coefficient value is large or modest.
Another limitation of this approach to
measuring the responsiveness of demand to a
determinant of demand is that the observation may not
apply readily to other communities that may have a
larger or smaller population of potential customers. An
alternative approach to measuring the sensitivity of
demand to its determinant factors is to assess the ratio
of percentage change in demand to the percentage
change in its determinant factor.
Types of Elasticity of Demand
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross-Price Elasticity
Price Elasticity of Demand
Assessing the elasticity of demand relative to
changes in the price of the good or service being
consumed is called the own-price elasticity or usually
just the price elasticity. As an illustration of this,
suppose we want to measure the sensitivity of demand
for broadband services corresponding to a modest
change in its price. First, to determine the price
elasticity, you need to clearly understand the settings
for all the determinant factors because elasticity
changes if you look at a different configuration of factor
levels. Suppose we decide to find the price elasticity
when P = $30, A = $5000, CP = $25, and DIPC = $33,000.
Earlier we determined that the demand quantity at this
setting was Q = 40,000 monthly subscribers.
Q = 25,800 − 800 P + 4 A + 200 CP + 0.4 DIPC. This
relationship is called a demand function.
Where:
P = the price per month of their service, in dollars
A = advertising expenditure per month, in dollars,
CP = the price per month of the competitors service, in
dollars,
DIPC = the disposable income per capita, in dollars, as
measured by the U.S. Department of Commerce for that
month.
Q = 25,800 − 800 ($30) + 4 ($5000) + 200 ($25) + 0.4
(33,000)
Q= 25,800 -24,000 + 20,000 + 5,000 + 13,200
Q= 64,000 – 24,000
Q= 40,000
If we let the price increase by 10% from $30 to
$33 and repeat the calculation of Q in the demand
function, the value of Q will decline to 37,600
subscribers, which is a decline of 2400 customers. As a
percentage of 40,000 monthly customers, this would be
a 6% decrease (2400/40000). So the price elasticity here
would be:
Q = 25,800 − 800 P + 4 A + 200 CP + 0.4 DIPC.
Q = 25,800 − 800 ($33) + 4 ($5000) + 200 ($25) + 0.4
(33,000)
Q= 25,800 -26,400 + 20,000 + 5,000 + 13,200
Q= 64,000 – 26,400
Q= 37,600
Since the law of demand states that quantity
demanded will drop when its price increases and
quantity demanded will increase when its price
decreases, price elasticities are usually negative If Price Elasticity of Demand >1, then it is an
numbers (other than special cases like Giffen goods, Elastic Demand.
described earlier in this chapter). In those rare instances An example of products with an elastic demand is
where price elasticities are positive, the product violates consumer durables. These are items that are purchased
the law of demand. infrequently, like a washing machine or an automobile,
Goods and services are categorized as being and can be postponed if price rises. For example,
price elastic whenever the price elasticity is more automobile rebates have been very successful in
negative than –1. In this category, the percentage increasing automobile sales by reducing prices.
change in quantity will be greater than the percentage
change in price if you ignore the negative sign.
When the computed price elasticity is between
0 and –1, the good or service is considered to be price
inelastic. This does not mean that demand does not
respond to changes in price, but only that the response
on a percentage basis is lower than the percentage
change in price when the negative sign is ignored. Figure 2. Elastic Demand
By assessing sensitivity to changes on a
percentage basis, it does not matter what units are used
in the variable measurements. We could have
constructed our demand function with a price
measurement in cents or euros, and the price elasticity
would have been the same. Also, if we wanted to
compare the price elasticity of broadband service in this
community with the price elasticity of broadband
service in a larger community, we could compare the
price elasticities directly without any need for further
adjustment.
Furthermore, demand can be classified as
elastic, inelastic, unitary, perfectly elastic, and perfectly
inelastic. An elastic demand is one in which the change
in quantity demanded due to a change in price is large.
An inelastic demand is one in which the change in
quantity demanded due to a change in price is small.

To calculate elasticity, instead of using simple

Inelastic Demand
percentage changes in quantity and price, economists
If Price Elasticity of Demand <1, then it is
sometimes use the average percent change in both
Inelastic Demand.
quantity and price. This is called the Midpoint Method
Inelastic demand is shown in Figure 2. Note that
for Elasticity:
a change in price results in only a small change in
quantity demanded. In other words, the quantity
(Q1 – Q2) / (Q1 + Q2)
demanded is not very responsive to changes in price.
(P1 – P2) / (P1 + P2)
Examples of this are necessities like food and fuel.
Where:
Consumers will not reduce their food purchases if food
Q1– Initial demand of product; prices rise, although there may be shifts in the types of
Q2– Final demand of product B; food they purchase. Also, consumers will not greatly
P1– Initial price of product; and change their driving behavior if gasoline prices rise.
P2– Final price of product

Elastic Demand

Figure 3. Inelastic Demand
An example of computing inelasticity of demand
using the formula above is shown in Example 2. When
the price decreases from $12 to $6 (50%), the quantity
of demand increases from 40 to only 50 (25%). The
elasticity coefficient is .33. However, this does not mean
that the demand for an individual producer is inelastic.
For example, a rise in the price of gasoline at all stations
may not reduce gasoline sales significantly. However, a
rise of an individual stations price will significantly affect
that stations sales.
Unitary Elasticity
If Price Elasticity of Demand = 1, then it is
Unitary Demand.
For example, a 10% quantity change divided by
a 10% price change is one. This means that a 1% change
in quantity occurs for every 1% change in price.
Figure 4. Unitary Elasticity
Perfectly Elastic Demand
If Price Elasticity of Demand = ∞, then it is a
Perfectly Elastic Demand.
A perfectly elastic demand curve is represented
by a straight horizontal line and shows that the market
demand for a product is directly tied to the price. When
the percentage of change in quantity demanded is
infinite even if the percentage of change in price is zero,
the demand is said to be perfectly elastic.
Figure 5. Perfectly Elastic Demand
It can also be interpreted that at price P
consumers are ready to buy as much quantity of the
product as they want. However, a small rise in price
would resist consumers to buy the product. Perfect
elastic demand is considered a theoretical extreme case
and there is not really any real-life product that could be
considered perfectly elastic. Though, the idea is
beneficial in economic analysis.
Perfectly Inelastic Demand
If Price Elasticity of Demand = 0, then it is a
Perfectly Inelastic Demand.
A perfectly inelastic demand curve is
represented by a straight vertical line and it is where the
quantity demanded does not respond to price. An
example of this is life-saving drugs like insulin. The
implication of a perfectly inelastic demand curve is that
price does not matter; the consumer would purchase
the same amount of a good or service no matter its
price. A person with diabetes must have a specific
amount of insulin. Without it, the diabetic dies, but if
the person with diabetes takes more insulin than
necessary, he or she risks overdosing.
Figure 6. Perfectly Inelastic Demand

Income Elasticity of Demand
Another important class of elasticities is
the response of demand to changes in income,
or the income elasticity.
(Q1 – Q2) / (Q1 + Q2)
(I1 – I2) / (I1 + I2)
Where:
Q1– Initial demand of product;
Q2– Final demand of product B;
I1– Initial income of customers; and
I2– Final income of customers
When income elasticity of a product is greater than
one, we call the product a cyclic good. The adjective
cyclicsuggests that this demand is sensitive to changes
in the business cycle and will generally change more on
a percentage basis than income levels. Luxury goods
that customers can do without in hard economic times
often fall in this category.
When income elasticity is between zero and one, we
call the product a noncyclic good. The demand for
noncyclic goods tends to move up and down with
income levels, but not as strongly on a percentage basis.
Most of the staple goods and services we need are
noncyclic.
Normally we would expect demand for a good or
service to increase when incomes increase and decrease
when incomes decrease, other things being equal.
However, there are arguably some exceptions that do
not behave this way. Low-cost liquor, which might see
increased use in hard economic times, is one of these
possible exceptions. When income elasticity is negative,
we call the product a countercyclic good.
a) Let us take the example of some exotic cuisine.
Let us assume that recently the average income level
has gone up by 75% that resulted in extra money which
eventually resulted in an increase in consumption of
exotic cuisines by 25%. Calculate the income elasticity of
demand based on the given information.
Therefore, the income elasticity of demand for the
exotic cuisine is 0.33. It is a noncyclic good.
b) Consider a local car dealership that gathers data on
changes in demand and consumer income for its cars for
a particular year. When the average real income of its
customers falls from $50,000 to $40,000, the demand
for its cars plummets from 10,000 to 5,000 units sold, all
other things unchanged.
Using the income elasticity of demand formula,
(Q1 – Q2) / (Q1 + Q2)
(I1 – I2) / (I1 + I2
Q1– Initial demand of product;
Q2– Final demand of product B;
I1– Initial income of customers; and
I2– Final income of customers
(10,000 – 5,000) / (10,000 + 5,000) = 0.33 = 2.97
($50,000 – $40,000) / ($50,000 + $40,000) 0.11
Therefore, the income elasticity of demand is
2.97. It is a cyclic good and indicates that local
customers are particularly sensitive to changes in their
income when it comes to buying cars.
c) Lets take another example of cheap
garments. The weekly demand for cheap garments went
down from 4,000 pieces to 2,500 pieces as the level of
real income in the economy increased from $75 per day
to $125 per day. The reason is the shift in preference
due to the availability of extra money on the back of
increased income level. Calculate the income elasticity
of demand based on the given information.
(Q1 – Q2) / (Q1 + Q2)
(I1 – I2) / (I1 + I2)
Q1– Initial demand of product;
Q2– Final demand of product B;
I1– Initial income of customers; and
I2– Final income of customers
(4,000 – 2,500) / (4,000 + 2,500) = 0.23 = -0.92
($75 – $125) / ($75 + $125) -0.25
Therefore, the income elasticity of demand for
cheap garments is -0.92. It is a counter cyclic good.
Cross-Price Elasticity
When elasticities are calculated to measure the
response of demand to price changes for a different
good or service, say either a substitute product or
complementary product, we call the calculated value a
cross-price elasticity. Cross-price elasticities tend to be
positive for substitute goods and negative for
complementary goods. If the elasticity is equal or very
close to zero, it means that the two products are
uncorrelated. The change in the price of product A does
not influence the demand for product B. Elasticities can
be calculated for any factor on demand that can be
expressed quantitatively.
(Q2A – Q1A) / (Q2A + Q1A)
(P2B – P2A) / (P2B + P2A)
Where;
Q1A– Initial demand of product A;
Q2A– Final demand of product B;
P2A– Initial price of product B; and
P2B– Final price of product B
a. Let us take the simple example of gasoline and
passenger vehicles. Now let us assume that a
surge of 50% in gasoline prices resulted in a
decline in the purchase of passenger vehicles by
10%. Calculate the cross-price elasticity of
demand in this case.
Since we can see a negative value for cross
elasticity of demand, it vindicates the
complementary relationship between gasoline
and passenger vehicles.
Let us assume that two companies are selling soft
drinks. At present, company no. 2 sells soft drinks Y at
$3.50 per bottle, while company no. 1 can sell 4,000
bottles of soft drinks Y per week. To bump the sales of
company 1, company 2 decided to decrease the price to
$2.50, which resulted in reduced sales of 3,000 bottles
of soft drinks Y per week. Calculate the cross-price
elasticity of demand in the case.
Given: Q2A = 3,000 bottles, Q1A = 4,000 bottles, P2A =
$3.50 and P2B= $2.50
(Q2A – Q1A) / (Q2A + Q1A)
(P2B – P2A) / (P2B + P2A)
Where:
Q1A– Initial demand of product A;
Q2A– Final demand of product B;
P2A– Initial price of product B; and
P2B– Final price of product B
(3,000 – 4,000) / (3,000 + 4,000)=-0.14 = 0.84
($2.50 – $3.50) / ($2.50 + $3.50) -0.17
Since we can see a positive value for cross
elasticity of demand, it vindicates the
competitive/substitute relationship between soft drink X
and soft drink Y.
In interpreting and comparing elasticities, it is
important to be clear whether the elasticity applies to a
single business in a market or to all sellers in a market.
Some elasticities, like price elasticities and advertising
elasticities, tend to reflect greater sensitivity to changes
in the factor when an elasticity is calculated for a single
business than when assessed for the total demand for
all sellers in a market. For example, we noted earlier
that gasoline is very price inelastic. However, this
observation really applies to the gasoline industry as a
whole. Suppose there was a street intersection in a city
that has a gasoline station on every corner selling
effectively the same product at about the same price,
until one station increases its price dramatically
(believing gasoline was highly inelastic to changes in
price, so why not), but the other three stations leave
their price where it was. If prices were clearly displayed,
most customers would avoid the station that tried to
increase the price and that station would see nearly all
of its business disappear. In this situation where the
competitors goods are highly substitutable, the price
elasticity for a single gasoline station would be very
price elastic.
CONSUMPTION DECISION IN THE LONG RUN AND
SHORT RUN
Consumption, in economics, the use of goods and
services by households that has an exchangeable value.
While on the other hand, consumers don't just decide to
buy. Their buying behavior is determined by many
different factors. And too many businesses focus on
optimizing certain steps and that is called consumption
decision. Since there is no reliable alternative to driving
a car, most customers find it difficult to react to
increases in petrol costs right away. However, if
customers believed that gas prices would rise for the
foreseeable future, they would gradually adjust their
lives to enable them to significantly reduce their
gasoline consumption. They may buy more fuel-efficient
or alternative fuel vehicles, or they could switch
occupations or houses to be closer to their places of
employment, shopping, and other amenities.
Many individuals believe that the moment a buyer
pays is the most significant one in the sale. But in reality,
each stage of the customer decision-making process
matters when it comes to how to affect consumer
behavior. Businesses must carefully consider each step
of the process if they want to optimize their decisions in
the future.
Consumer Decision-Making Process
Problem Recognition - recognizes the need for a service
or product.
Information Search - gathers information.
Alternatives Evaluation. - compare their potential
decisions to similar
Purchase Decision - makes the actual decision
Post - Purchase Evaluation - reflects about the decision
they made.
Short-run decisions and long-run decisions are
distinguished by economists. When a consumer chooses
something that will be consumed soon enough to be
impacted by her current household resources,
commitments, and knowledge, such a decision is
considered short run. The consumer can change her
consuming habits and increase the utility of
consumption further if given enough time to remove
these restrictions. Long-run decisions are those that will
have an impact on consumption long enough in the
future for any necessary changes to be made.
It is possible to create demand curves and functions
for both short- and long-term time horizons. Because
they predict demand for the immediate future and
typically do not require a long history of data on
consumption and its determining elements, short-run
demand curves are simpler to construct. Longer data
histories and higher levels of sophistication are needed
for long-run demand since it must take changes in
consumption habits into account.
PRICE DISCRIMINATION
I have been commuting for the past month due
to the face-to-face-classes and I am aware of the
discount that I am having as a student. It definitely saves
me more money and is beneficial for me because of my
limited finances. With this, I know all of us are aware of
the fact that not all of the passengers inside a bus or a
jeepney or any transportation services pay the same
amount of transportation fare. In my case, instead of
paying the normal fare of 107 pesos from Candelaria to
Batangas, I only pay 87 pesos for my bus fare and 12
pesos for my jeepney fare. Some of us get a discount
including those who have disabilities, those senior
citizens, and students like me. We can understand in
this situation the difference of prices paid while
receiving the same service being offered.  
The example above is what we called Price
Discrimination. This entails the pricing strategy that
charges the consumers different prices for goods or
services that are identical. It reflects the competitive
behavior of many different types of market make it
online, or offline. To maximize profits, many companies
practice price discrimination. This enables businesses to
charge more to those customers with more purchasing
power while offering lower pricing to those who are
more price-sensitive. Price Discriminationis great for
situations where specific groups are involved.
Consumers (such as students or older citizens) benefit
from discounted rates, or pricing that is nonlinear and
based on the quantity of units purchased. In many
situations, students are charged less than adults. Price
discrimination is frequently used with market
segmentation, where the various buyer categories can
be easily differentiated. After that, a different pricing
strategy is used to target each sector and by offering
lower rates in areas with lower average incomes, some
companies may geographically segregate their
customers.
Let's take a look at the following graphs:
Figure 7
Figure 7.1
The graphs above show the difference between
a single product offering a single pricing and another
one with multiple pricing. For the figure 7, lets say that
the firm is selling a ballpen for $5 each. We can see that
the demand for the ballpen with that amount of pricing
is only one. Now look at figure 7.1, the firm decided to
offer different pricing for each of the consumer and in
this situation, the demand increases as well as the
revenue through selling to customers who were
originally not going to purchase by offering them the
prices that each of the customer is willing to pay.
To better understand why firms discriminate,
here are some of their reasons. Just like the graphs
shown, there are some of potential benefits in price
discrimination, first is that it allows companies to
increase their revenues and to sell their products, which
therefore leads to a higher profit and another one is the
occurrence of economy of scale from increased of
output. In a similar vein, price discrimination may also
help manufacturing and retail businesses to quickly sell
off their existing inventories when necessary, making
greater use of their store or manufacturing facility
space. For the point of view of a consumer, although not
all them can benefit from lower costs, those that are
highly elastic may do so thanks to price discrimination.
Alongside with its benefits, price discrimination has
disadvantages too. Customers who pay more are at the
disadvantage. Another one is the consumer surplus
(economic measure of a customer's excess benefit) is
decreased by the pricing strategy, which also transfers
money from consumers to producers, creating
inequality. Ultimately, the ability to price discriminate
may be limited because the conditions necessary are
not fully met. In other words, there are limits on the
extent to which different prices can be applied.
Price Discrimination have multiple types. The
first-degree, second-degree, and third-degree price
discrimination.  The first-degree price discrimination is
when every unit is purchased at the price the consumer
is most willing to pay.
This is sometimes referred to as perfect price
discrimination. This type of price discrimination, if
perfectly executed, could give the highest revenue a
business could have. According to Pigou, first-degree
price discrimination does not have a great practice
relevance. This type of discrimination will transfer all the
consumer surplus to its producers. This is commonly
practice in auctions and is popularly used by online
sellers who sells ukay-ukayswhere the highest paying
customer will get the product offered.
Figure 8. First Degree Price Discrimination

As for the figure above, we can see the
relationship between the business and its consumers. As
the price increase to 60, the demand is equal to zero,
however, the demand curve shows an increase when
the price changes to 50 which is equivalent to 200
quantities. Thus, demand begins to change which
therefore shows that the consumers are willing to pay
the following prices. In essence, this is called
personalized pricing, where each buyer receives a
different selling price. The term"perfect price
discrimination"is another name for this strategy. For
some reasons, personalized pricing is particularly
challenging to put into effect. First, it can be challenging
to pinpoint each consumer's individual willingness-to-
pay. Second, people frequently become upset when
they learn that another customer paid less for a good or
service than they did. The ability of perfect price
discrimination can result in arbitrage, where
opportunistic buyers buy the product at a reduced price
in one market and then sell it at a profit in another.
Figure 9. Second Degree Price Discrimination
For the second-degree price discrimination, the
producers offered prices to segmented group of
consumers and unlike first-degree discrimination,
consumers are broken into groups where consumers
pay prices base on the quantity they availed. As we can
see on the graph above, the blue shaded part
represents the revenue of the consumer when the
selling price is $5 each, however, it is evident that the
quantity purchase is smaller in comparison when the
price is changed in $3.50, as the price go down, the
quantity purchased increases which therefore results to
an increase of revenue from $500 to $700. A great
example of this will be those buyers who buy in bulk
whereas they were offered less price per unit unlike
those who buys individually. In connection with this, we
call pricing Linear when the charge for multiple items is
the price times the number of items and non-linear
entails the opposite where the total charges payable by
customers are not proportional to the quantity of their
consumed services.
Figure 10. Third Degree Price Discrimination
Last one is thethird-degree price discrimination.
This occurs when a business prices its products
differently for various consumer groups. As from what is
shown on the figure above, different prices are offered
to the students and for the adult segment on the market
of museum XYZ. For the graph on the left, the price
offered is lower than the price offered for adults which
is the graph in the middle, the right graph on the other
hand, is the whole market that Museum XYZ faces for
tickets to the museum. This is made up from the student
market and the adult market added together. Another
example of this would be the student discounts and
travel tickets which are more expensive when it is peak
season. By charging a lower price to the group that is
more price elastic and a higher price to the group that is
more price inelastic, retailers can increase economic
profit in third degree price discrimination. Different
rates are set for various groups or customer segments
when the idea of group pricingis used. The groups are
often divided because one group is price-sensitive and
its members have a lower willingness to pay function.
For a price discrimination to be successful, the firm
must employ the following pricing strategy: first, the
firm must operate in a market with imperfect
competition in order to influence prices. If a firm is
operating in a market with perfect competition, price
discrimination would not be possible. Firms in
monopoly, monopolistically competitive, or oligopolistic
markets may engage in price discrimination.Another
thing to consider is to prevent resale. Market segments
must be separated from one another in order to prevent
customer who receive a cheaper price to sell from
customers who are charged a higher price. Price
discrimination is unlikely to be successful if consumers
can easily resell a product. Lastly, the market must
demonstrate elasticities of demand in order to separate
those customers who have different elasticities and they
will be treated differently.  Since the total fixed cost is fixed, the more you
In conclusion, price discrimination occurs when
businesses have an incentive to lower prices for certain
categories of customers who are price sensitive (elastic
demand). These individuals frequently earn less money
that they can spend than the typical consumer. The
drawback of it is that some customers will pay more. It
can also manage demand and enable a company to turn
a loss into a little profit or to keep a business activity
running instead of shutting it down. Customers will
undoubtedly benefit from this since it broadens their
selection of products and services.
Chapter 4 Cost and Production
4.1 Average Cost Curves
Types of Costs For Production
FIXED COSTS.Fixed costs typically stay the same for a
specific period and they are often time related.
Examples: Rental lease payments, salaries,
insurance, property taxes, interest expenses,
and depreciation.
VARIABLE COSTS.As variable costs change directly in
relation to the output of a business, so when there is no
output, there are no variable costs.
Examples: Labor fees, commissions, raw
materials, and utility expenses.
TOTAL COST. The sum of all costs, including the fixed
and variable costs.
Average Cost definition
Average cost reflects the cost on a per unit
basis. A portion of the average cost is the amount of
variable costs that can be assigned to the production
unit. The other portion is the allocation of fixed costs
(specifically those fixed costs that are not sunk),
apportioned to each production unit. The average cost
generally varies as a function of the production volume
per period. Average Cost is also often called the total
cost per unit or the average total cost.
Average Cost formula
The average cost is important for firms since it
shows them how much each unit of output costs them.
We can calculate the average cost using the following
equations:
AC = C/Q = (FC + VC Q)/Q = VC + FC/Q
AC=Total CostQuantity
AC = AFC + AVC
The Average Fixed Cost and the Spreading Effect
The average fixed cost decreases with increasing
quantity produced because the fixed cost is a fixed
amount. This means it does not change with the
produced amount of units.
produce, the average fixed cost per unit will decrease
further. This effect is called the spreading effect since
the fixed cost is spread over the produced quantity.
Given a certain amount of fixed cost, the average fixed
cost decreases as the output increases.
The Average Variable Cost and the Diminishing Returns
Effect
On the other hand, we see a rising average
variable cost. Each unit of output that the firm produced
additionally adds more to the variable cost since a rising
amount of variable input would be necessary to produce
the additional unit. This effect is also known as
diminishing returns to the variable input
This effect is called the diminishing returns
effect. Since a greater amount of variable input would
be necessary as the output increases, we have higher
average variable costs for higher levels of produced
outputs.
Average Cost examples
It is very important to understand how to
calculate the Average Cost using the total fixed cost and
average variable cost. Let's practice calculating the
Average Cost and have a closer look at the example of
the Willy Wonka chocolate firm. In the below table, we
have columns for the produced quantity, the total cost
as well as the average variable cost, average fixed cost,
and average total cost.
It is important to distinguish between the total
cost and the average total cost since the former always
increases with additional quantity. However, the
average total cost function has a U-shape and first falls
and then rises as the quantity increases.
The U-shaped Average Total Cost Curve
The average total cost function has a U-shape,
which means it is decreasing for low levels of output
and increases for larger output quantities.
The figure illustrates how the average cost
changes with different levels of quantity. The quantity is
shown on the x-axis, whereas the cost in dollars is given
on the y-axis.
The U-shape structure of the Average Cost
Function is formed by two effects: the spreading effect
and the diminishing returns effect. The average fixed
cost and average variable cost are responsible for these
effects.
4.2 Long-Run Average Cost and Scale
Short-Run Demand - consumers were limited in their
choices by their current circumstances of lifestyles,
consumption technologies, and understanding.
Long-Run Demand - A long-run time frame was of
sufficient length that the consumer had the ability to
alter her lifestyle and technology and to improve her
understanding, so as to result in improved utility of
consumption
Short-Run Production Decisions – businesses are
somewhat limited by their facilities, skill sets, and
technology
Long- Run Production Decisions - businesses have
sufficient time to expand, contract, or modify facilities.
How long a period is needed until decisions are long
term varies by the kind of organization or industry. A
retail outlet might easily totally redefine itself in a
matter of months, so for them any decisions going out a
year or longer are effectively long-term decisions. For
electricity power generators, it can take 20 years to
plan, get approvals, and construct a new power
generation facility, and their long-term period can be in
terms of decades.
Distinctions Between Short-Run and Long-Run
Production Decisions
Nature of Costs
Short Run. There are fixed costs and variable
costs.
Long Run. All costs in long-run production
decisions can be regarded as variable costs.
Firms ability to alter its capacity.
Short Run. The firms capacity or point of lowest
average cost is effectively fixed.
Long Run. The firm is able to make decisions
that alter its capacity point by resizing
operations to where the firm expects to have
the best stream of profits over time.
Because a business has the ability to redesign all
of its operations to suit a targeted level of production,
average cost curves for long-run planning are flatter
than short-run average cost curves. If it appears that a
low-volume operation would yield the best returns, the
firm can be downsized to remove the cost of excess
capacity and arrive at a lower average cost than would
be achievable in the short run. By expanding its
capacity, a firm would be able to perhaps even lower
average cost, but certainly avoid the inefficiencies of
being overcapacity, should higher production levels
appear to be better. One way to think of a long-run
average cost curve is that each point on the curve
reflects the lowest possible average cost of an operation
resized to be optimal for that level of production.
The long-run average cost (LRAC) curve is actually
based on a group of short-run average cost (SRAC)
curves, each of which represents one specific level of
fixed costs. More precisely, the long-run average cost
curve will be the least expensive average cost curve for
any level of output. The figure shows how the long-run
average cost curve is built from a group of short-run
average cost curves. Five short-run-average cost curves
appear on the diagram. Each SRAC curve represents a
different level of fixed costs. For example, you can
imagine SRAC1 as a small factory, SRAC2 as a medium
factory, SRAC3 as a large factory, and SRAC4 and SRAC5
as very large and ultra-large. Although this diagram
shows only five SRAC curves, presumably there are an
infinite number of other SRAC curves between the ones
that are shown. This family of short-run average cost
curves can be thought of as representing different
choices for a firm that is planning its level of investment
in fixed cost physical capital—knowing that different
choices about capital investment in the present will
cause it to end up with different short-run average cost
curves in the future.
 The long-run average cost curve shows the cost of
producing each quantity in the long run, when the firm
can choose its level of fixed costs and thus choose which
short-run average costs it desires. If the firm plans to
produce in the long run at an output of Q3, it should
make the set of investments that will lead it to locate on
SRAC3, which allows producing q3 at the lowest cost.
The left-hand portion of the long-run average cost
curve, where it is downward- sloping from output levels
Q1 to Q2 to Q3, illustrates the case of economies of
scale. In this portion of the long-run average cost curve,
larger scale leads to lower average costs. In the middle
portion of the long-run average cost curve, the flat
portion of the curve around Q3, economies of scale
have been exhausted. In this situation, allowing all
inputs to expand does not much change the average
cost of production, and it is called constant returns to
scale. In this range of the LRAC curve, the average cost
of production does not change much as scale rises or
falls. Finally, the right-hand portion of the long-run
average cost curve, running from output level Q4 to Q5,
shows a situation where, as the level of output and the
scale rises, average costs rise as well. This situation is
called diseconomies of scale. A firm or a factory can
grow so large that it becomes very difficult to manage,
resulting in unnecessarily high costs as many layers of
management try to communicate with workers and with
each other, and as failures to communicate lead to
disruptions in the flow of work and materials.
The production level at which the long-run average cost
curve flattens out is called the minimum efficient scale.
(Since the business is able to adjust all factors of
production in the long run, it can effectively rescale the
entire operation, so the target production level is
sometimes called the scale of the business.)
Businesses that are able to lower their average
costs by increasing the scale of their operation are said
to have economies of scale. Economy of scale is a
proportionate saving in costs gained by an increased
level of production. On the other hand, firms that will
see their average costs increase if they further increase
their scale will experience diseconomies of scale.
Diseconomies of scale occur when a business grows so
large that the costs per unit increase. Businesses that
have achieved at least their minimum efficient scale and
would see the long-run average cost remain about the
same with continued increases in scale may be
described as having constant economies of scale.
The impact of an increase of scale on production
is sometimes interpreted in terms of returns to
scale.The assessment of returns to scale is based on the
response to the following question: If all factors of
production (raw materials, labor, energy, equipment
time, etc.) where increased by a set percentage (say all
increased by 10%), would the percent increase in
potential quantity of output created be greater, the
same, or less than the percent increase in all factors of
production?
Returns to Scale – the rate by which output changes
due to some change in input.
If potential output increases by a greater proportion
than the increase in inputs, operations are said to have
increasing returns to scale.
Example: If a soap manufacturer
increases its input by 70% and ends up
doubling the output (increase of 100%),
then the manufacturing company has
experienced increasing returns to scale.
If output increases by the same percent as the increase
in input, the operations show constant returns to scale.
Example: If a soap manufacturer
doubles its total input, and ends up also
doubling its total output, it has achieved
constant returns to scale.
If the potential output increases by a smaller proportion
than the increase in inputs there are decreasing returns
to scale.
Example: If a soap manufacturer
doubles its total input but gets only a
40% increase in total output, it can be
said to have experienced decreasing
returns to scale.
4.3 Economies of Scope and Joint Products
ECONOMIES OF SCOPE
Most businesses provide multiple goods and
services; in some cases, the number of goods and
services is quite large. Whereas the motivation for
providing multiple products may be driven by consumer
expectations, a common attraction is the opportunity to
reduce per unit costs. When a venture can appreciate
such cost savings, the opportunity is called an economy
of scope.
Cost Reduction
The ability to share fixed costs across the
product and service lines so that the total fixed costs are
less than if the operations were organized separately.
For example, suppose we have a company that expands
from selling one product to two similar products. The
administrative functions for procurement, receiving,
accounts payable, inventory management, shipping, and
accounts receivable in place for the first product can
usually support the second product with just a modest
increase in cost.
Occurs from doing similar activities in larger
volume and reducing per unit variable costs. If multiple
goods and services require the same raw materials, the
firm may be able to acquire the raw materials at a
smaller per-unit cost by purchasing in a larger volume.
ECONOMIES OF SCALE
As with economies of scale, the opportunities for
economies of scope generally dissipate after exploiting
the obvious combinations of goods and services. At
some point, the complexity of trying to administer a firm
with too many goods and services will offset any cost
savings, particularly if the goods and services share little
in terms of production resources or processes. However,
sometimes firms discover scope economies that are not
so obvious and can realize increased economic profits,
at least for a time until the competition copies their
discovery.
JOINT PRODUCTS
When two or more products are produced
simultaneously in natural proportions from the same
material in the same process is called as Joint Products
having almost equal importance. Its has been defined as
two or more products separated in processing, each
having a sufficiently high saleable value to merit
recognition as a main product.
Features
Joint products are of almost equal importance meaning
each product is in such proportion that no single
product can be termed as main product.
They are produced simultaneously by a common
process.
They are produced from the same basic raw materials.
They are produced in natural proportions. Proportion of
such products cannot be changed at the will of
management.
4.4. Cost Approach Versus Resource Approach to
Production Planning
PRODUCTION PLANNING
It is without a doubt that it is necessary for a business
to have some sort of framework or guide on how the
business will be able to utilize its resources effectively
and be able to perform the production process of its
product or service with the utmost efficiency and make
the best out of it. Thus, production planning comes in.
By definition, production planning is the administrative
process that occurs within a manufacturing organization
and entails making sure that enough raw materials,
personnel, and other essential resources are bought and
available to produce completed goods in accordance
with the schedule established. It is an act of developing
a guide for the design and production of a given product
or service. Simply put, it is planning the production of
the organization.
Importance of Production Planning
Production planning helps the organization make the
production process as efficient as possible to the extent
of the organizations capabilities as it creates an efficient
process of production that is in accordance with the
needs of the customers and the organization itself. That
is, with the purpose of catering to various customers in
mind, it makes use of the resource allocation of staff
activities, materials, and production capacity. Besides
that fact, plans may also need to be modified in
response to unforeseen occurrences, thus production
planning is dynamic in nature and remains in a constant
state of change. That is to say that, in order to maintain
plant performance at its highest level, optimal
production planning necessitates continuous, real-time
updates to production schedules. However, frequent
changes to manufacturing plans or scheduling
compromise the overall supply-chain efficiency. In order
to attain this ideal production strategy, the organization
must strike the perfect balance.
COST APPROACH AND RESOURCE APPROACH
In production planning, we have two
approaches: (1) Cost Approach to Production Planning;
and (2) Resource Approach to Production Planning. The
comparison of these two shall be the focus of our
discussion.
Cost Approach to Production Planning
The most general approach to how organizations plan
their productions starts with what goods and/or services
the organization intends to offer. Now, when the
organization approaches this by determining and
deciding what production configuration or which
production arrangement shall deliver the organizations
desired output at the lowest cost possible after which
they had already settled on the goods and/or services
they intended, such an approach is the cost approach to
production planning. Furthermore, any remaining
chance for profit involves cutting costs as much as
feasible because, once output goals are established, the
projected revenue is essentially fixed.
Cost Minimization
Any remaining chance for profit involves cutting
costs as much as feasible because, once output goals
are established, the projected revenue is essentially
fixed.That is easier said than done.
As defined, cost minimization is the process of
reducing spendings on pointless or ineffective activities.
Any degree of cost reduction will probably have a
significant impact on maximizing earnings, regardless of
how significant the changes in spending are.
Take this for an example, if the firm with the
office warehouse rents 30 forklifts, they will need to hire
1 machine operator to oversee 5 forklifts, requiring a
total of 6 operators. In another scenario, more
experienced operators may be more efficient by using
other tools to help them move large quantities of
product across the warehouse floor. The warehouse can
move around the same amount of products with 15
automated forklifts and 15 machine operators.
Suppose that the cost to rent a forklift is ₱5,000
per month and hiring a machine operator costs ₱4,500
per month. The cost of these inputs would look like the
following:
Scenario 1 Scenario 2
Cost of Capital: Cost of Capital:
30 forklifts x ₱5,000 = 15 forklifts x ₱5,000 =
₱150,000 ₱75,000
Cost of Labor: Cost of Labor:
6 operators x ₱4,500 = 15 operators x ₱4,500 =
₱27,000 ₱67,500
Total Cost = ₱177,000 Total Cost = ₱142,500
From this example, we can clearly see that it is a
more cost-effective scenario in the second one where
the warehouse rents 15 automated forklifts and hires 15
machine operators.
Although the cost minimization principle may
seem simple in concept, achieving this in actuality in
practice is not that feasible, especially for most ventures
of any complexity. That is for the reason that there are
so many different production alternatives, that is why it
is difficult to achieve the goal of cost reduction because
the actual costs that are incurred may be more or lower
than anticipated during the planning stage.
Resource Approach to Production Planning
There will always be a situation where a company may
be more skilled or knowledgeable among those
procurement and production operations it uses to
produce its goods and services, at least in comparison to
its rivals. For an instance, a company might have world-
class manufacturing capabilities but merely average
marketing cost-effectiveness.
Having said that, in cases where a company
excels in some areas of its operations, there may be a
chance for increased profitability by identifying these
crucial areas, which are sometimes referred to as core
competencies in the business strategy literature. And,
when the company approached this by figuring out what
kinds of products or services would best exploit these
capabilities, this is what we call the resource approach
to production planning. This is based from one of the
key initial papers Wernerfelt (1984) wrote which is
about the resource-based view of management.

Resource-based View of Management
Resource-based view of management is said to be an
approach or a strategy to attaining a long-term
competitive advantage. By this, it suggests that by
repurposing the existing resources or using the current
resources in a new way, it is simpler and more practical
to take advantage of external opportunities; which
contrasts with acquiring new skills or developing new
capabilities for each different opportunity.
In accordance with the RBV model, resources are a
crucial component to an organization's ability to
perform better. From this, there are two (2) types of
resources: (1) Tangible; and (2) Intangible.
Tangible resources.Physical objects make up
tangible resources that are readily available for
purchase by organizations including land, buildings,
machinery, equipment, and capital.
Intangible resources. Things that do not exist
physically, such as brand reputation, trademarks,
intellectual property, and the likes.
Moreover, there are two critical assumptions in
RBV. That is, resources must be heterogeneous and
immobile.
Heterogenous. The first assumption suggests
that the capabilities and other resources of the
organization are different from that of others.
Immobile. The second assumption suggests that,
at least in the short-run, resources are immobile and do
not move from an organization to another.
Importance of Resource-based View
The aims of the resource-based view is to achieve a
sustainable competitive advantage. Such sustainable
competitive advantage can be achieved by doing a
thorough resource analysis, allocating resources, and
utilizing resources across functional boundaries. The
same is true for a company's ability to innovate more
effectively and differentiate itself from the competition.
An RBV strategy helps organizations achieve the
following:
Visibility for efficient resource allocation. Managers are
enabled to learn more about resource skills and
competencies thanks to the comprehensive view of all
the resource pools. Managers are thus able to allocate
resources in accordance with the range and market
demand of the company's products and services. They
can also make data-driven decisions, fully use talents to
its maximum potential, and maximize profitability with
the aid of real-time information.
Maintain competitive advantage. The increase in
market volatility customer demands. The ability of a
corporation to adapt to shifting market conditions
frequently becomes the determining element for its
development and success. In these circumstances,
managers can implement crucial strategic responses by
utilizing both their tangible and intangible assets.
Demand fulfillment is made possible by an RBV of
strategy, which helps a business maintain its
competitive edge.
Cross-functional resource usage. The resource-based
strategy model makes it easier for the workforce and its
expertise to be visible across the entire business in a
matrix structure. It aids in forming a cross-functional
team to carry out the project and allocating the proper
resources from other departments. It also lowers hiring
cycle costs and also aids in utilizing a diverse workforce.
In addition, workers are assigned multifaceted tasks to
work on to build their professional portfolios.
Ultimately, both the cost approach and resource
approach to planning productions will theoretically
result in similar decisions about what products and
services to offer and how to organize the production in
order to do so. However, corporations are unlikely to
achieve really optimal organization, especially after the
fact, given the large range of viable outputs and
organizations of production to deliver them. Between
the two, the cost approach is often simpler to
implement, especially for a company that is currently
operating in a specific industry and has the ability to
make small, cost-saving improvements.
Anyhow, there is some risk of narrow focus that
ignores opportunities to make the most use of core
competencies while trying to find a solution to the issue
of how to provide the goods and services at the lowest
possible cost. This is where the resource approach is
best utilized as this promotes more out-of-the-box
thinking that could result in a significant business
restructure.
4.5 Marginal Revenue Product and Derived Demand
What is Derived Demand?
In economics, derived demand is the demand for a good
or service that results from the demand for a different,
or related, good or service. It is a demand for some
physical or intangible thing where a market exists for
both related goods and services in question. It was first
introduced by Alfred Marshall in 1890 in his book,
Principle of Economics.For example, the demand for
large-screen televisions creates a derived demand for
home theater products such as audio speakers,
amplifiers, and installation services.
Only when there is a separate market for both related
goods or services involved does derived demand exist.
The market price of a product or service is significantly
influenced by the level of derived demand for that
specific product or service.
Derived demand differs from regular demand, which is
simply the quantity of a certain good or service that
consumers are willing to buy at a given price at a certain
point in time. Under the theory of regular demand, a
products price is based on whatever the market—
meaning consumers—will bear.
Understanding Derived Demand
Derived demand is related solely to the demand placed
on a good or service for its ability to acquire or produce
another good or service. Derived demand can be
spurred by what is required to complete the production
of a particular good, including the capital, land, labor,
and necessary raw materials. In these instances, the
demand for raw material is directly tied to the demand
for products that require the raw material for their
production.
The demand that is derived from the demand for
another product can be an excellent investing strategy
when used to anticipate the potential market for goods
outside of the original product desired. In addition, if
activity in one sector increases, then any sector that's
responsible for the first sectors success may also see
gains.
NOTE:The principles of derived demand work in both
directions. If the demand for a product decreases, then
the demand for the goods required to produce that
product will also decrease.
The Chain of Derived Demand
Derived demand comprises three components – raw
materials, processed materials, and labor. The three
elements are called the chain of derived demand.
1. Raw materials
They are resources that are used in the production of a
product. For example, lithium batteries are raw
materials for cell phones. The level of derived demand
for a certain raw material is directly related to and
dependent on the level of demand for the final good to
be produced. The level of demand for lithium batteries
is directly related to the level of demand for cell phones
(final product).
2. Processed materials
They are products that have been built from assembling
raw materials; steel, gas, and paper are examples of
processed materials.
3. Labor
Labor consists of the workers who facilitate the
production of goods and the provision of services. The
demand for labor depends on the demand for the final
good or service– there is no demand for labor when
there is no demand for the final product. Labor is a
component of derived demand.
The chain of derived demand is the flow of raw
materials to processed goods to finished products with
the help of labor. An increase in the demand for the end
goods by the customer will trickle down to the
beginning of the chain. For example, an increase in
demand for stainless steel utensils will increase the
demand for steel (processed goods), and in turn,
increase the demand for iron ore (raw material).
The Economic Effects of Derived Demand
Far beyond the industries, workers, and consumers
directly involved, the chain of derived demand can have
a ripple effect on local and even national economies. For
example, custom clothing sewn by small local tailor may
create a new local market for shoes, jewelry, and other
high-end fashion accessories.
On the national level, an increase in demand for raw
materials like crude oil, lumber, or cotton, can create
vast new international demand trading markets for
countries that enjoy an abundance of those materials.
We can better understand how the markets for
inputs function and how these markets relate to the
markets for final goods by understanding derived
demand and the supply of inputs. Understanding these
concepts enable us to determine whether it is worth
paying someone $20 per hour or how much a company
would be willing to pay for that specific material on the
margin. These answers are based on the value or
revenue generated by using an additional amount of the
relevant input compared to what it costs to employ that
additional amount of input. Similar to the concept of
marginal revenue and marginal cost, which measures
the additional benefits and costs of producing another
unit of output, we use the concept of marginal revenue
product and marginal resource cost which measures
the additional revenue and additional cost from using
one more input.
What is Marginal Product?
The marginal product of a production input is the
amount of additional output that would be created if
one more unit of the input were obtained and
processed. It is also referred to as marginal physical
product, or MPP. In practical terms, this might mean the
additional donuts produced at a donut shop once they
hire an extra employee. Or it might mean the additional
number of strawberries harvested by a farmer who
plants additional seeds. Or the additional revenue a
bowling alley receives if it builds extra lanes.
What is Marginal Revenue Product?
The marginal revenue product of a production input is
the marginal revenue created from the marginal
product resulting from one additional unit of the input.
The marginal revenue product is calculated by
multiplying the marginal product of the input by the
marginal revenue generated.
There are two variables needed in order to determine
the marginal revenue product:
1. Number of units that an additional employee or
machine will add to the total production, also
referred to as marginal product
2. Amount gained from the sale of an additional
unit or the price that the units sell for on the
market, also referred to as marginal revenue
Calculating the Marginal Revenue Product
The formula to determine Marginal Revenue Product is:
MRP = MP x MR
Where:
· MRPis the Marginal Revenue Product
· MP is the Marginal Product
· MRis the Marginal Revenue
Example: John is the manager of a shoe manufacturing
plant, and he is considering hiring another employee to
meet the increasing demand. Assumes that each unit
sells for $10, and John knows that a new employee will
produce an extra 200 pairs of shoes every week, the
marginal revenue product is calculated as follows:
MRP = 200 x $10
MRP = $2,000
Therefore, if John hires a new employee, the
employee will generate an additional $2,000 in
weekly revenue for the manufacturing plant.
Understanding Marginal Revenue Product
Marginal revenue product is used to make critical
decisions on business production and determine the
optimal level of a resource. The MRP also assumes that
the expenditures on other factors remain unchanged.
For example, a farmer wants to know whether to
purchase another specialized tractor to seed and
harvest wheat. If the extra tractor can eventually
produce 3,000 additional bushels of wheat (the MP),
and each additional bushel sells at the market for $5
(MR), the MRP of the tractor is $15,000.
Holding other considerations constant, the farmer is
only willing to pay less than or equal to $15,000 for the
tractor. Otherwise, he will take a loss. Estimating costs
and revenues is difficult, but businesses that can
estimate MRP accurately tend to survive and profit
more than their competitors.
In determining if a firm is using the optimal level on an
input, the marginal revenue product for an additional
unit of input can be compared to the marginal cost of a
unit of the input. If the marginal revenue product
exceeds the marginal input cost, the firm can improve
profitability by increasing the use of that input and the
resulting increase in output. If the marginal cost of the
input exceeds the marginal revenue product, profit will
improve by decreasing the use of that input and the
corresponding decrease in output. At the optimal level,
the marginal revenue product and marginal cost of the
input would be equal.
Example:An accounting firm sells accountant time as a
service and each hired accountant is typically billed to
clients 1500 hours per year. The marginal revenue from
an additional billed hour of accountant service is $100.
The marginal revenue product of an additional
accountant would be 1500 times $100, or $150,000.
Suppose the marginal cost to hire an additional
accountant was $120,000. The firm would improve its
profit by $30,000 by hiring one more accountant.
What Is the Law of Diminishing Marginal Returns?
The law of diminishing marginal returns is a theory in
economics that predicts that after some optimal level of
capacity is reached, adding an additional factor of
production will actually result in smaller increases in
output. Correspondingly, the marginal revenue product
will generally decrease as the input and corresponding
output continue to be increased.
So, for the accounting firm, although they may realize
an additional $30,000 in profit by hiring one more
accountant, that does not imply they would realize
$3,000,000 more in profits by hiring 100 more
accountants.
If the marginal revenue product is measured at several
possible input levels and graphed, the pattern suggests
a relationship between quantity of input and marginal
revenue product, as shown in Figure 1 "Typical Pattern
of a Derived Demand Curve Relating the Marginal
Revenue Product to Quantity of Input Employed in
Production". Due to the law of diminishing marginal
returns, this relationship will generally be negative.
Thus, the relationship looks much like the demand curve
corresponding to output levels. In fact, this relationship
is a transformation of the firms demand curve,
expressed in terms of the equivalent marginal revenue
product relative to the number of units of input used.
Due to the connection to the demand curve for output,
the relationship depicted in the figure is called a derived
demand curve.
Figure 1
Typical Pattern of a Derived Demand Curve Relating
the Marginal Revenue Product to Quantity of Input
Employed in Production
One difficulty in comparing marginal revenue product to
the marginal cost of an input is that the mere increase in
any single input is usually not enough in itself to create
more units of output. For example, simply acquiring
more bicycle frames will not result in the ability to make
more bicycles, unless the manufacturer acquires more
wheels, tires, brakes, seats, and such to turn those
frames into bicycles. In cases like this, sometimes the
principle needs to be applied to a fixed mix of inputs
rather than a single input.
For the accounting firm in the earlier example, the cost
to acquire an additional accountant is not merely the
salary he is paid. The firm will pay for benefits like
retirement contributions and health care for the new
employee. Further, additional inputs in the form of an
office, computer, secretarial support, and such will be
incurred. So the fact that the marginal revenue product
of an accountant is $150,000 does not mean that the
firm would benefit if the accountant were hired at any
salary less than $150,000. Rather, it would profit if the
additional cost of salary, benefits, office expense,
secretarial support, and so on is less than $150,000.
4.6 Marginal Cost of Input and Economic Rent
When inputs are in high supply at the current market
rate and there is competition in the market of inputs, an
input's marginal cost is essentially the same as its actual
cost of acquisition. In this case, the earlier-discussed
idea can be stated by contrasting the price to buy the
input to the marginal revenue product (s). Marginal cost
refers to the increase or decrease in the cost of
producing one more unit or serving one more customer.
It is also known as incremental cost. For example, say
that to make 100 branded bags, it costs $100. To make
one more bag would cost $80. The cost to produce one
extra unit of a good or service is then known as the
marginal cost.
If less competition is happening in the market for inputs,
a company may have to pay a little more than the
current market rate to get more units since they will
have to be taken from another company. Because the
price increase caused by the extra unit may carry over
to an increase in the price of all the units being
purchased, in this case, the marginal cost of inputs may
be higher than the cost to purchase an additional unit.
Consider the scenario where the salary needed to hire a
new accountant is higher than what the company is
currently paying accountants with the same skill. The
company may need to increase the salaries of the other
accountants that they had recruited in order to keep
them since they pay a higher salary to keep the new
accountant. In this situation, the marginal cost of adding
one more accountant could be far higher than the direct
cost of doing so. The company may conclude that, even
though the resulting marginal revenue product is
substantially greater., the greatest wage for a new
accountant that the firm can justify is $50,000.
The price of an additional unit of input typically reflects
either the opportunity cost related to the value of the
next best use of that input or the minimum amount
necessary to induce a new unit to become available if
inputs are available in a ready supply or there are close
substitutes that are available that are in a ready supply.
However, some production inputs can be in such short
supply that even further price hikes won't prompt the
availability of new units, at least not right away. In these
circumstances, even after all available inputs have been
used, the marginal revenue product for an input may
still be significantly higher than its marginal cost.
Because of this imbalance, the vendors of these goods
and services could demand a price rise for the input up
to the point when marginal cost and marginal revenue
output are equal. Economic rent is the difference
between what the supplier of the finite input supply can
charge and what it would have taken to persuade the
supplier to sell the unit to the firm.
Assume that a large bridge needed urgent repairs, so a
contracting company was brought in. The company will
need to engage additional construction workers who are
local because of the time constraint. Typically, these
employees could have agreed to labor for $70 an hour.
The employees, however, can demand to be paid as
much as $200 per hour for the work if they perceive
that the contracting company is being paid a premium
for the repairs, indicating that the marginal revenue
product of labor is high and there are few qualified
workers available. The $130 shortfall would represent
economic rent brought on by the lack of suitable
workers who could be hired quickly.
Economic rent can occur in industries like agriculture
when there is a shortage of highly productive land or in
some labor markets like professional sports or
commercial entertainment when there is a shortage of
people with the knowledge or brand recognition
necessary to make the activity successful.
4.7 Productivity and Learning Curve
In production management, it is very important
that we know how to use the available resources
effectively and efficiently.
Effectiveness is defined as the degree to which
something is successful in producing a desired result;
success. Efficiency is defined as the ability to accomplish
something with the least amount of wasted time,
money, and effort or competency in performance. But
here in our topic, we will focus on how we are going to
use our resources efficiently.
In economics, productivity refers to how much
output can be produced with a given set of inputs.
Productivity increases when more output is produced
with the same amount of inputs or when the same
amount of output is produced with less inputs.
In measuring the level of productivity, we can
use this formula. This is the ratio of the total number of
units of output divided by the total units of an input. An
alternative measure of average productivity would be
the total dollars in revenue or profit divided by the total
units of an input.
The productivity of firms may change over time.
In the case of labor, the productivity of individual
workers will rise as they gain experience and new
workers can be trained more effectively. There is also an
improvement in overall productivity from the increased
knowledge of management in how to employ
productive resources better. These productivity gains
from experience and improved knowledge are
sometimes called learning by doing. The economics of
learning by doing was introduced by Arrow (1962).
Measure of Average Productivity = Total Number of
Units of OutputTotal Units of an Input
Measure of Average Productivity = Total Dollars/Pesos
in Revenue or ProfitTotal Units of an Input
Illustrative Examples
Suppose a person is employed for 40 hours a week in a
toy factory. In a given week, the worker produces 120
dolls. The productivity of the worker in that week is 3
dolls per hour.
Labor Productivity = Output/Hours worked
= 120 dolls/40 hours
= 3 dolls per hour
Illustrative Examples
Suppose the factory produces a range of toys,
including dolls, miniature cars, card games and board
games. In a given week, the gross value added of these
goods is $5 million, using 125,000 hours of labour.
Labour productivity for the toy factory in that week is
$40 per hour.
Labor Productivity = Output/Hours worked
= $5 million/125,000 hours
=$40 per hour
Learning Curve Theory Learning Curve Formula

Learning is essentially the acquisition of In geometrical equation:

understanding, skills and knowledge through experience
or study. In the business world, tasks are completed by Y = aX b
the workers in job description and experience is the
essential part to gain knowledge and skill from actually · Y is the cumulative average time or cost per unit
performing a job. Some tasks need to be done
repetitively especially on a large business. With · a is the time or cost to produce the initial
repetition, if the time it takes to finish the task quantity
diminishes, and so performance improves. Through
· X is the cumulative units of production
experiences, a business can drive significant
improvements in quality, work processes and routines.
· b is the learning curve coefficient
As a business acquires learning about how to
· b = log(LR)/log2
better make and provide a product or service over a
greater quantity of output, it can support that Note: The learning curve formula is usually used in
accumulated experience helps reduce unit costs. calculating cost or time for other quantities of units
Learning curve theory reflects the increased rate at produced that are not part of the doubling series, such
which people perform tasks as they gain experience. It as three, five, six, etc.
demonstrates that over a period of time, there is an
increase in productivity but with diminishing rate as Illustrative examples:
production increases. Learning curves are also known as
experience curve, cost curves, efficiency curves and Calculate the cost of forth production if
productivity curves. In addition, the learning curve production doubles on an 80% learning curve, and the
shows the relationship between cumulative production initial cost is $100.
experience and average cost. Improvements due to
productivity gains will usually result in decreased
average costs. This translates to lower input costs and
higher overall output.

Learning Curve Percentage

One numerical measure of the impact of learning

on average cost is called the doubling rate of reduction.
The doubling rate is the reduction in average cost that 1. Tabular Presentation
occurs each time cumulative production doubles. In
learning curve theory, the learning rate or the learning Unit Solution Average Cost Reduction
curve percentage is the percentage subtracted from one Produce Per Unit
hundred percent to get the reduction percentage. The d
reduction percentage denotes the percentage decrease
in unit time or cost with every doubling of units 1 $100 $ 100
produced.

For example, an 85% learning curve means a 15% 2 $100 x $ 80 20%

decrease in unit time with every doubling of units 80%
produced. An 80% learning curve means a 20%
4 $ 80 x 80% $ 64 20%
reduction percentage. A 90% learning curve denotes a
10% reduction percentage. The basic formula for this is 8 $ 64 x 80% $ 51.20 20%
as follows: percent of reduction + percent of learning
curve = 100% 16 $ 51.20 x $ 40.96 20%
 80%

2. Graphical Presentation

3. Geometrical/Equation Presentation

Suppose we need to calculate the cost to produce

after making four doubling series of production.

Y = aXb

b = log (LR)/log2 = log (0.80/)log2 = -0.321928

Y = 100(8-0.321928)

Y = $ 51.20