Economic Analysis for Management

Lecture 2

IME, IIT Kanpur

Trade-offs

Consumers:
Consumers have limited incomes, which can be spent on a wide
variety of goods and services, or saved for the future.
Workers:
Workers also face constraints and make trade-offs. First, people must
decide whether and when to enter the workforce. Second, workers
face trade-offs in their choice of employment. Finally, workers must
sometimes decide how many hours per week they wish to work,
thereby trading off labor for leisure.
Firms:
Firms also face limits in terms of the kinds of products that they can
produce, and the resources available to produce them.
Prices and Markets

▶ Microeconomics describes how prices are determined.

▶ In a centrally planned economy, prices are set by the
government.
▶ In a market economy, prices are determined by the interactions
of consumers, workers, and firms. These interactions occur in
markets—collections of buyers and sellers that together
determine the price of a good.
Theories and Models

▶ In economics, explanation and prediction are based on theories.

Theories are developed to explain observed phenomena in
terms of a set of basic rules and assumptions.
▶ A model is a mathematical representation, based on economic
theory, of a firm, a market, or some other entity.
Positive and Normative Analysis

▶ Positive analysis means explaining the present situation, and

predicting based on that.
Example: Indian government plans to discontinue import of
defense items. What impact will it have on the Indian
manufacturing industry that caters to the defense? The
statements that describe cause and effect.
▶ Normative analysis questions what should be. Answering a
question such as, should there be less economic inequality in
the world?
Question

Which of the following two statements involves positive economic

analysis and which normative? How do the two kinds of analysis
differ?
1. Gasoline rationing (allocating to each individual a maximum
amount of gasoline that can be purchased each year) is poor
social policy because it interferes with the workings of the
competitive market system.
2. Gasoline rationing is a policy under which more people are made
worse off than are made better off.
What is a Market?

▶ In a Microeconomics course like this, markets are a central focus

of analysis.
▶ Easiest way to understand - divide the economic units into two
groups - buyers and sellers
▶ Buyers and sellers ‘interact’ in the market
▶ Most economic units play the role of buyers and sellers in
different markets
▶ Arbitrage: Exist when prices are different in different markets for
the same commodity.
Competitive vs noncompetitive markets

▶ Perfectly competitive market: has many buyers and sellers, so

that no single buyer or seller has any impact on price.
– Example: Market for vegetables
▶ Note: There is no one number of buyers and sellers to call a
market a perfectly competitive market.
▶ The world oil market can be termed a noncompetitive market.
▶ Indian Railways is another example of a noncompetitive market.
Market price

▶ In a perfectly competitive market, usually one single price will

prevail (think of prices of potatoes in a vegetable market).
▶ In not-perfectly competitive markets, the market prices can vary.
This can happen due to brand loyalty (think of prices of soap).
In such cases, the average of the prices for the products in
different market can be thought as the market price.
▶ Market price of most ‘goods’ fluctuate over time(think of the stock
market).
Market definition - the extent of market
▶ The extent of a market, or the boundary of a market can be both
geographical as well as the range of products included in it.
- For example, the market for fossil fuel. Should we consider the
market for Delhi, for UP, or for whole of India? Secondly, should
we consider separate markets for petrol and diesel? Within
petrol there can be several markets as well.
▶ The boundaries depend upon the type of product. For market for
land, geography is important. But a commodity like rice has a
world market.
But a market for computers can be segmented in various ways.

▶ Understanding the boundaries are important for two reasons:

1. A company wants to have this information for setting price,
making investment decisions etc.
2. The government wants to know if there is enough competition
in the market. Should it allow an M&A to happen?
Question

Is an Industry a Market?
Real vs Nominal prices

▶ Nominal price, or the current price is the rupee value of the price
quoted in the market. It is unadjusted for inflation. Price of the
same variety of rice was Rs. 5 a kg in 1970, Rs. 20 in 2000 and
Rs. 70 in 2020 (let’s say).
▶ The real price, on the other hand, is the price adjusted for
inflation. The nominal price is adjusted by an aggregate measure
of prices to arrive at the real price. Example, in real terms, price
of the rice variety in 2020 is Rs. 4 per kg in 1970 prices.
▶ The two major price indices in India are: consumer price index
(CPI), and the wholesale price index (WPI). Why?
Example from your book

▶ For calculating real price from current price, we need the

following information: price index in both base year and current
year, and nominal price of the commodity in current year.
▶ For our example, real price of eggs in 2010 is $0.27 in 1970
dollars (or prices).
▶ Real price of college education in 2010 is $3,835 in 1970 prices.
▶ Note how we mention real price. It changes if the base year
changes.
Exogenous and endogenous variables

▶ Exogenous variable: A variables whose value is taken as given

in the analysis of an economic system.
▶ Endogenous variable: A variable whose value is determined
within the economic system being studied.
▶ Example 1: You want to measure the time a ball will take to fall
from a rooftop to the base level.
▶ Example 2: You want to measure how education affects wage.
▶ Example 3: You want to examine, how falling ill affect buying
health insurance decision.
Demand and Supply
Introduction

Supply and demand analysis is a fundamental and powerful tool that

can be applied to a wide variety of interesting and important
problems.
Helps us understand why and how prices change, what happens
when an external entity intervenes in it.

Why should you study supply and demand analysis?

– Understanding and predicting how changing world economic
conditions affect market price and production.
– Evaluating the impact of government price controls, minimum
wages, price supports, and production incentives.
– Determining how taxes, subsidies, tariffs, and import quotas affect
consumers and producers.
The supply curve
The supply curve shows the quantity of a good that producers are
willing to sell at a given price, holding constant any other factors that
might affect the quantity supplied.
We can write this relationship as an equation: Q = Qs (P).
The supply curve
The supply curve shows the quantity of a good that producers are
willing to sell at a given price, holding constant any other factors that
might affect the quantity supplied.
We can write this relationship as an equation: Q = Qs (P).

Source: Microeconomics 8e, by Pindyck and Rubinfeld

The supply curve, labeled S in the figure, shows how the quantity of a
good offered for sale changes as the price of the good changes.
The supply curve is (generally) upward sloping. Why?
The higher the price, the more firms are able and willing to produce
and sell, ceteris paribus.
If production costs fall, firms can produce the same quantity at a
lower price or a larger quantity at the same price. The supply curve
then shifts to the right (from S to S’).
Other variables that affect supply

▶ The quantity that producers are willing to sell depends not only
on the price they receive but also on their production costs,
including wages, interest charges, and the costs of raw materials.
▶ When production costs decrease, output increases no matter
what the market price happens to be. The entire supply curve
thus shifts to the right.
▶ Economists often use the phrase change in supply to refer to
shifts in the supply curve, while reserving the phrase change in
the quantity supplied to apply to movements along the supply
curve.
The demand curve
The demand curve shows how much of a good consumers are willing
to buy as the price per unit changes.
We can write this relationship between quantity demanded and price
as an equation: Q = Qd (P)
The demand curve
The demand curve shows how much of a good consumers are willing
to buy as the price per unit changes.
We can write this relationship between quantity demanded and price
as an equation: Q = Qd (P)

Source: Microeconomics 8e, by Pindyck and Rubinfeld

The demand curve, labeled D, shows how the quantity of a good
demanded by consumers depends on its price.
The demand curve is downward sloping. Holding other things equal,
consumers will want to purchase more of a good as its price goes
down.

The quantity demanded may also depend on other variables, such as

income, the weather, and the prices of other goods. For most
products, the quantity demanded increases when income rises. A
higher income level shifts the demand curve to the right (from D to
D ′ ).
Movement along the curves, and shift of the curves

▶ Qd = a − bP + cI, or Qs = a + bP − cR
▶ Movement along the curves, when P changes.
▶ Shift of the curves when other variables change.
▶ It is possible that both happening at the same time.
Substitutes and complements

▶ Changes in the prices of related goods also affect demand.

▶ Goods are substitutes when an increase in the price of one
leads to an increase in the quantity demanded of the other.
▶ Example: Coke and Pepsi.

▶ Goods are complements when an increase in the price of one

leads to a decrease in the quantity demanded of the other.
▶ Example: Computer and printer.
▶ How will the demand curve behave, if there is a change in the
prices of a substitute or complementary good?
Question

▶ Coke and Pepse are substitutes. Therefore, there is no single

market for colas. True or False?