MANAGERIAL ECONOMICS
3. How an individual firm/industry attains
MODULE 1: INTRODUCTION AND RELATED
TOPICS
Economics
- The study of allocation of scarce resources,
among alternative uses
- A social science that studies the behavior of
individuals, households, and organizations
(economic actors, players, or agents),
when they manage or use scarce resources,
which have alternative uses, to achieve
desired ends
- Concerned with man’s problem of using
scarce resources to satisfy human wants
THE ECONOMIC PROBLEM: Scarce
Resources, Unlimited Wants
 Economics is the study of how people use
their scarce resources to satisfy their
unlimited wants
- About making choices
- Studies how people use their scarce
resources in an attempt to satisfy their
unlimited wants
 A resource is scarce when it is not freely
available, when its price exceeds zero
- Everything you see including natural
resources are scarce, there is a value
to it
SCARCITY
- Occurs when the amount of people’s desire
exceeds the amount available at a price of
zero
 Goods and services that are truly free are not
the subject matter of economics. Without
scarcity, there would be no economic
problem and no need for prices
1. Resources are always scarce
2. They are not only scarce, but also have
alternative uses
3. Optimum allocation is required
4. It is about making of choices or decision-
making
 Allocation problems are faced by individuals,
organizations and nations also
Economics deals with:
1. How an individual consumer allocates his scarce
resources among alternative uses?
 Customer tries to get maximum satisfaction
(most rational decision)
 Maximization of satisfaction/utility is the
goal of individual customer
2. An individual producer aims at least cost
combination of inputs to get a given quantities
of output
 Efficiency – getting more out of less
 Inputs – raw materials put into process to
develop a certain product or good
 must maximize resources put into
process to maximize output
equilibrium
 A firm is said to be an equilibrium (state of
balance), if it attains profit maximizing level
of output. It tries to maximize revenue or
minimize cost
 Equilibrium – point where buyers and
sellers are equally satisfied
4. How a country reach equilibrium:
 Allocating limited resources in such a way
that the desired goals are reached – goal
may be overall welfare of its people
- Have to allocated these limited
resources that everyone would be
happy but not everyone is going to
be satisfied. We are talking about
the general welfare.
Individuals/organizations nations attain their goals,
by optimum use of limited resources
RESOURCES
- Inputs, or factors of production used to
produce the goods and services that human
wants
Four categories:
1. Labor – the physical and mental effort used
to produce goods and services
2. Capital
- Physical Capital: manufactured items
used to produce goods and services
- Human Capital: knowledge and skills
people acquire to increase their labor
productivity
3. Natural resources – used to produce goods
and services; can be renewable or
exhaustible
- They are limited
4. Entrepreneurial ability – managerial and
organizational skills needed to start a firm.
The talent, combined with the willingness to
take risk of profit or loss
- Entrepreneur – profit seeking
decision maker who starts an idea,
organizes an enterprise to bring the
idea to life, and assumes the risk of the
operation
Payment for Resources
1. Wages – payment to resource owners for
their labor
2. Interest – payment to resource owners for
the use of their capital
3. Rent – payment to resource owners for the
use of their natural resources
4. Profit – reward for entrepreneurial ability,
sales revenue minus resource cost
GOODS AND SERVICES
 Resources are combined to produce goods
and services
Goods – tangible product used to satisfy human
wants
- Requires scarce resources to produce and is
used to satisfy human wants
Service – an activity, or intangible product used to
satisfy human wants
 - Not tangible but requires scarce resources to
produce and satisfy human wants
ECONOMIC DECISION MAKERS
1. Households/Consumers – families
- Consumers – demand goods and services
- Resource owners – supply resources
2. Firms – the one producing the goods and
services
3. Government – part of the system that regulate
the economy, impose taxes and steps in if
there is problem happening in the economy
4. Rest of the world – interact with the other
decision makers
- Demand resources
- Produce goods and services
 Interaction determines how an economy’s
resources
MARKETS – set of arrangements by which buyers
and sellers carry out exchange of mutually agreeable
terms
- Means by which buyers and sellers carry out
exchanges in markets
- Determine price and quantity
- Interaction between buyers and sellers for
trading or exchange
Product market – market where goods and services
are sold or exchanged
Resource market – a market in which a resource is
bought
- Labor, capital, natural resources, and
entrepreneurial ability are exchanged in
resource markets
Common types
1. Goods market – wet and dry markets
2. Labor market – where workers offer their
services, and employers look for workers to
hire
3. Stock market – where commodities traded
consist of securities of corporations
SIMPLE CIRCULAR FLOW MODEL
- A diagram that traces the flow of resources,
product income, and revenue among
economic decision makers
 Flow of resources, products, income, and
revenue among economic decision makers and
interact with households and firms
RATIONAL SELF INTEREST
 Economics assumes that individuals are
being rational in making choices and
rationally select alternatives they perceive to
be in their best interests
Rational – people trying to make the best choices
they can, given the available information
 People try to minimize the expected cost of
achieving a given benefit or to maximize
the expected benefit achieved with a given
cost
Rational Self-Interest – individuals try to maximize
the expected benefit achieved with a given cost or
maximize the expected cost of achieving a given
benefit
 Individuals are rational: make the best
choice, given the available information,
maximize expected benefit, minimize
expected cost
 the lower the personal cost of helping others,
the more help we offer
CHOICE REQUIRES TIME AND
INFORMATION
- scarce and therefore valuable
 Rational decision makers acquire
information as long as the expected
additional benefit from the information is
greater than its expected additional cost
Rational decision makers
- Willing to pay for information
- Improve choices
- Acquire information
- Additional benefit expected exceeds
the additional cost
 Willing to spend more if they think that the
benefit of acquiring the information will
outweigh the cost
ECONOMIC ANALYSIS IS MARGINAL
ANALYSIS
 Economic choice is based on a comparison
of the expected marginal cost and the
expected marginal benefit of the action
under consideration
Marginal – incremental, additional, or extra
 Rational decision maker changes the status
quo if the expected marginal benefit is
greater than the expected marginal cost
MICROECONOMICS AND
MACROECONOMICS
Microeconomics – the study of economic behavior
in particular markets
- Individual economic choices, markets
coordinate the choices of economic decision
makers, individual pieces of the puzzle
Macroeconomics – the study of the economic
behavior of entire economics
- Performance of the economy as a whole and
big picture
THE ROLE OF THEORY
Economic Theory – simplification of reality used to
make predictions about cause and effect in the real
world
- Captures the important elements under study
 Simplification of economic reality
 Important elements of the problem
 Make predictions about the real world
Good theory – guide and sort, save, understand
information
NORMATIVE VS POSITIVE
Positive Economic Statement – concerns what is
and supported or rejected by reference to facts
Normative Economic Statement – concerns what
should be and reflects an opinion and cannot be
shown to be true or false by reference to the facts
- More on prescriptive in nature
- Very related or subjective
POSITIVE NORMATIVE
Assertion about opinion
economic reality
Supported or rejected What should be
by evidence
True or false
What is
PREDICTING AVERAGE BEHAVIOR
 Task of an economic theory is to predict
the impact of an economic event on
economic choices and in turn the effect of
these choices on particular markets or on
the economy as a whole
 Economists focus on the average or typical
behavior of people in groups
Individual behavior: difficult to predict and random
actions of individuals offset one another
Average behavior of groups: predicted more
accurately
PITFALLS OF FAULTY ECONOMIC
ANALYSIS
1. Fallacy that association is causation – one
event precedes another or that two events
occur simultaneously does not mean that one
caused the other
 Event A caused event B- associated in time
2. Fallacy of composition: the incorrect belief
that what is true for the individual, or the
part, is true for the group, or the whole
 Generalizes behavior of an individual,
making it seem that behavior is same of the
group
3. Mistake of ignoring secondary effects:
unintended consequences of policy
Goals of a Business Firm
 Can be a single goal or multiple goals
a. Profit maximization – revenue
maximization and cost minimization
b. Wealth maximization – value
maximization
MANAGERIAL ECONOMICS
- Economics applied in decision making and
branch of economics bridging the gap
between abstract theory and managerial
practice
- Application of the theories, concepts and
principles you’ve learned
- Price theory in the service of business
executives
 Integration of economic theory with
business practice for the purpose of
facilitating decision-making and forward
planning
DIFFERENT APPROACHES COVERED BY
MANAGERIAL ECONOMICS
1. Analysis based on the theory of the firm
2. Analysis based upon managerial services
3. Analysis based upon industrial economics
What Is A “Good” Model?
 Allows us to make predictions and set
hypothesis
 The predictions can be tested against the
empirical evidence
 The predictions are supported by the
empirical evidence
Use of Economic Models
Positive Economics – derives useful theories with
testable propositions about what is
Normative Economics – provides the basis for value
judgments on economic outcomes
 Economics is scientific in nature and in
general takes a positive and predictive
approach, not prescriptive or normative
 Not concerned about the descriptive realism
of assumptions: “I assume X’ is different
from “I believe X to be true”
ECONOMIC ANALYSIS

Comparative Statistics
- Begin with initial equilibrium position
(starting point to change something)
- Main purpose of model – what it was
designed to do
Example of normative prescriptions
It will cost me $30 per unit to supply
something which will me $20 per unit in revenue –
should I do it?
I must pay $20 billion to set up in my
industry. Should I charge higher prices to get that
money back?
 Positive and normative are linked by “if”- If
the aim of the firm is to maximize profit,
what will it do/what should I do?
Purpose of economic analysis
For academic economics: to understand, to make
predictions about firm’s behavior
- Positive approach to theory
For the businessperson: to assist decision-making,
to provide decision-rules which can be applied
- Normative approach to theory
 Purposes are different = interpretations are
different = can lead to misunderstanding
 Economists are not always honest about the
limitations of their approach for practical
purposes
Limitations:
 If aim is prediction, unrealistic assumptions
are acceptable and may be needed;
- Talk about data, the approach is
scientific, some unrealistic approach
or assumptions are accepted in the
study
Example, the firm may be assumed to behave “as if”
its managers had perfect knowledge of its
environment
- In reality no one has the perfect knowledge
 If aim is to produce decision-rules which
can be applied by practicing managers,
unrealistic assumptions will produce
decision-rules which are not operational
Example, set output and price by MC = MR
- Standpoint from a business, the unrealistic
assumption is not considered as operational
on his side
How Can Managerial Economics Assist Decision-
Making?
1. Adopt a general perspective, not a sample of
one
- Easier to make analysis to the overall
behavior, not the individual
2. Simple models provide stepping stone to
more complexity and realism
- we sometimes deal with simple models
but these models cannot be applied to
complex realism because it tends to get
complex when we consider more
variable
3. Thinking logically has value itself and can
expose sloppy thinking
- Open minded need
STRUCTURE-CONDUCT-PERFORMANCE
PARADIGM
Basic Conditions – factors which shape the market
of the industry
Structure – attributes which give definition to the
supply side of the market
Conduct – the behavior of firms in the market
Performance – a judgment about the results of the
market behavior
MODULE 2: INTRODUCTION: WHAT THE
BOOK IS ABOUT
Problems Solving in Economics requires two
steps:
1. Figure out what is causing the problem
2. Figure out how to fix it
 Predicting the behavior of people is required for
both steps
CASE 1:
A junior geologist was preparing a bid
recommendation for an oil tract in the Gulf of
Mexico. She suspected that the tract contained a large
accumulated of oil because her company, Oil
Ventures International, had an adjacent tract with
several productive wells. No competitors had
neighboring tracts, none of them suspected the large
accumulation of oil. Hence, she thought that the tract
would be won at a cheaper price and recommended a
bid of $5 million.
Surprisingly, OVI’s senior management
ignored the recommendation and submitted a bid of
$21 million. OVI won the bid over the next highest
bid of $750,000.
1. What is causing the problem? –
Overbidding of $21,000,000. Why
overbidding happened
Additional information:
 After her company won the auction, the
geologist increase the company’s oil reserves by the
amount of oil estimated to be in the tract but the well
was essentially dry when drilled up. The acquisition
of the tract did little to increase the size of the oil
reserves. Geologist reduced the estimated reserves
before OVI won the tract.
Senior management rejected the lower
estimate and directed the geologist to do what she
could to increase the size of the estimated reserves.
Months later, senior management resigned, collecting
bonuses tied to the increase in oil reserves that had
accumulated during their tenure.
Why did the senior management overbid?
- Senior management overbid because the
more they acquired oil reserves, the more
bonuses they will get
 One thing that unites economists -> use of
rational-actor paradigm – people act rationally,
optimally, and self-interestedly
Rational actor paradigm – helps you figure out why
people behave the way they do but also suggests
ways to get them to change
Change behavior = change self-interest = change
incentives
Incentives – created by rewarding good performance
- thing that motivates or encourages you to do
something
 good incentives come from rewarding good
performance
 well-designed organizations aligns employee
incentives with organizational goals
- employees have enough information
to make a good decision and the
incentive to do so
PROBLEM SOLVING PRINCIPLES
Three questions to find the source of the problem:
1. Who made the bad decision?
2. Did the decision maker have enough
information to make a good decision?
3. Did the decision maker have the incentive to
make a good decision?
Three answers to the three questions:
1. Letting someone with better information or
incentive to make the decision
2. Giving the decision maker more information
3. Changing the decision maker’s incentive
OVI Overbidding Problem
1. Who made the bad decision? Senior
management by overbidding
2. Did the decision maker have enough
information to make a good decision? Yes,
geologist recommended a bid of $5M
because it was only suspected that the
tract had a large amount of oil and no
competitors had neighboring oil tracts
3. Did the decision maker have the incentive to
make a good decision? No, because their
incentive was the more oil reserves they
acquire, the more bonuses they get
disregarding dried up acquired oil tract
to fill the oil reserves. They are not
rewarded by the profitability.
 Bonuses created incentive to manipulate the
reserve estimate and placed the blame on the
geologists
Answers to the three questions:
1. Should we Letting someone with better
information or incentive to make the
decision? No
2. Should we give the decision maker more
information? No
3. Should we change the decision maker’s
incentive? Yes
Recommended solution:
 Change performance evaluation metric:
- Increase profitability as cause of reward
instead of increase acquired reserves
 Reward scheme
- Bonuses tied to profitability, not acquired
reserves
CASE 2:
Investigative news program sent a TV
reported with a perfectly good car into a garage
owned by National Auto Repair (NAR). The reporter
left with new muffler and transmission and paid
$8,000. Consumers avoided NAR which hurt NAR’s
profit after the story was aired on national TV.
What is causing the problem? Why did mechanic
make unnecessary repairs?
Three questions to find the source of the problem:
1. Who made the bad decision? The mechanic
for the unnecessary repairs
2. Did the decision maker have enough
information to make a good decision? Yes,
the mechanic should know given it is his
field of expertise
3. Did the decision maker have the incentive to
make a good decision? No, mechanic
receives bonuses tied to the amount of
work done
Additional information:
NAR’s first solution: reorganize two
divisions, one responsible for recommending repairs
and one responsible for doing the repairs.
Recommending the repairs were paid flat salary
while doing the repairs were paid based on the
amount of work they did.
Note: Failed, unnecessary repairs still continued
because the mechanic doing the repairs was still paid
based on the amount of work they did. Still the same
incentive
Flat pay – compensates all workers at the same rate - Maximum amount of compensation that may
for each task performed or hour worked regardless of be taken into account
performance
 Performance compensation caps might be
NAR’s second solution: single mechanic to bad because compensation caps can
do the recommendations and repairs but replaced discourage employees from being
incentive pay with flat salary or fixed pay. productive after the cap

Note: Failed, although removed the incentive to do Bonus cap

unnecessary repairs, it removed the incentive to work
hard which resulted to shirking (avoidance/neglect a
duty or responsibility). Flat salary resulted to the
mechanic to ignore all except for the most obvious
problems.
Recommended solution:
 Add additional performance evaluation
metric. Adopt the secret shopper method.
Sporadically send in secret shoppers to
evaluate the performance of the mechanic.
INDIVIDUAL PROBLEMS
ETHICS AND ECONOMICS
Rational actor paradigm – model of behavior that
which assumes that people act rationally, optimally,
and self-interestedly, that is, they respond to
incentives
 Can make students uncomfortable because it
denies the personal ethics that motivates
most people
 Everyone has his own value system
- Maximum amount of bonuses that may be
taken into account
 Bonus cap for executives might be a bad
policy for the company because it could
encourage shirking after the executives
reached the cap
 Possible consequence of a performance
compensation reward scheme is it creates
productive incentives and harmful
incentives
1. The owners of a small manufacturing
concern have hired a vice president to run
the company with the expectation that he
will buy the company after five years. For
the first $150,000 of profit, the vice
president’s compensation is a flat salary of
$50,000 plus 75% of the profit and 10%
profit over $150,000. Purchase price for the
company is set at 4.5 times earnings
(profits), computed as average annual
profitability over the next five years

VALUE SYSTEM a. Plot the annual compensation of the vice

president as a function of annual profit.
a. Deontologists – actions are good or ethical Profit level of $0, $50,000, $100,000,
if they conform to a set of principles $150,000, $200,000, $250,000 and $300,000

b. Consequentialists – actions judged based Annual Company Profit Percentage VP Earned

on whether they lead to a good consequence $0 75%
- if the consequence of the action is $50,000 75%
good, then the action is deemed to be $100,000 75%
good or moral $150,000 75%
$200,000 10%
 Economics is more consequentialists $250,000 10%
- Uses analysis to understand the $300,000 10%
consequence of different solutions
Base Salary Total Vice President
Compensation
CASE FOR THE VALUE SYSTEM: $50,000 $50,000
$50,000 $87,500
Notre Dame entered the 2006 season as one $50,000 $125,000
of the top-ranked football teams in the country, $50,000 $162,000
demand or local hotels during home games increased, $50,000 $70,000
leading to the price of hotel rooms to also increase. $50,000 $75,000
$50,000 $80,000
Deontologists point of view: It Is viewed wrong and
that businesses should not increase their prices b. Assume the company will be worth
because it is viewed as opportunistic and unethical $10,000,000 in five years. Plot the profit of
because people just want to watch the game. If we buying the company as a function of annual
apply the POV of deontologists, there will be no profit. Profit levels of $0, $250,000,
incentive from the standpoint of the businesses. $500,000, $750,000 and $1,000,000

Consequentialists point of view: It is viewed as an Annual Company Profit Company Purchase

opportunity to make more profit due to the high Price
demand of hotel rooms for the home game. More $0 $0
people or tourists would come in. Maximizing the $250,000 $1,125,000
asset (hotel room) to earn more profit. $500,000 $2,250,000
$750,000 $3,375,000
Compensation caps $1,000,000 $4,500,000
Company Value Profit of Buying the Company
$10,000,000 $10,000,000
$10,000,000 $8,875,000
$10,000,000 $7,750,000
$10,000,000 $6,625,000
$10,000,000 $5,500,000

1-A. Does this contract align the incentives of

the new vice president with the profitability
goals of the owners?

No, it does not align with the profitability goals of the

owners. The new vice president wasn’t given the
incentive to increase the profit of the company. If he
would increase the profit to more than $150,000, he
would only receive 10%. If he earns up to $150,000
only, he would receive 75%. The vice president does
increase the profit because the percentage of profit is
less as profit gets higher. It is also harder to earn a
profit and it requires more effort to earn more than
$150,000.

1-B. Redesign the contract to better align the

incentives of the new vice president with the
profitability of the owners.

I would redesign the contract to the compensation of

the vice president. If profit exceeds $150,000, his
compensation would be compensation at $150,000
plus 10% of the company’s profit.

2. A total of 1,800 New York City teachers

who lost their jobs earlier this year have yet
to apply for another job despite the fact there
are 1,200. Why not?

A program where unemployed teachers get the same

salary as fully employed teachers. Unemployed
teachers would only fill in as substitutes would get
the same salary as fully employed teachers would
push teachers not to apply for a full-time teaching
job.

3. In 2008, the Labor Party in Britain promised

that patients would have to wait for no more
than four hours to be seen in the emergency
room. The National Health Services started
rewarding hospitals that met this goal. What
do you think happened? (Hint: not good)

Seriously ill patients were kept in ambulances instead

of being brought to the ER so that the waiting time
would not be inside the emergency room. People kept
waiting outside and in ambulances until they could be
treated within four hours. These also reduced the
ambulances able to respond to other emergency calls.
MODULE 3: ONE LESSON OF BUSINESS
 Goal is to show how to exploit inefficiency
as an opportunity to make money
CAPITALISM AND WEALTH
 Wealth is created when assets move from
lower to higher-valued uses
 An individual’s value for a good or a service
is measured as the amount of money he or
she is willing to pay for it
 Capitalism – voluntary transactions create
wealth
- Biggest advantage: creates wealth by
letting people follow their self interest
- Both buyer and seller should gain; they
would not transact
Desire + Income = You want something + you can
pay for it
EXAMPLE:
Buyer values a house at $240,000 and a seller at
$200,000. If they can agree on a price, $210,000 –
they both gain. In this case, the seller sells at a price
that is $10,000 higher than her bottom line and the
buyer buys at a price that is below his top dollar
 $240,000 buyer’s top dollar – willingness to
pay
 $200,000 seller’s bottom dollar – won’t
accept less
SURPLUS
 Both buyer and seller benefit from this
transaction
Buyer surplus = buyer’s value – price
$240,000 - $210,000 = $30,000
Seller surplus = price – seller’s value
$210,000 - $200,000 = $10,000
Total Surplus = buyer + seller surplus = difference
in values
$30,000 + $10,000 = $40,000 -> gains from trade
Zero-Sum Fallacy – fallacy because the voluntary
nature of trade requires that both parties gain;
otherwise, the transaction would not occur
 Against the idea that if one person makes
money, someone else must be losing out
DOES THE GOVERNMENT CREATE
WEALTH?
Government’s Role in Wealth Creation
 Enforcing property rights and contracts legal
tools that facilitate wealth creating
transactions
 Ensures that buyers and sellers keep gains
from trade
 Countries are poor because there is no
property rights and no rule of law
HOW ECONOMICS IS USEFUL TO
BUSINESS?
 Economists can be used by business people
to spot money-making opportunities
(assets in lower valued)
 An economy is efficient if all assets are
employed in their higher-valued assets
- Unattainable but useful
benchmark
 Economists are obsessed with efficiency
A good policy – facilitates the movement of assets to
higher-valued uses
A bad policy – prevents assets from moving or,
worse, moves assets to lower valued uses
One lesson of economics: the art of economics
consists in looking not merely at the immediate but at
the longer effects of any act or policy; it consists of
tracing the consequences of that policy not merely for
one group but for all groups
 Must look at the intended and unintended
effects of policies to understand their
efficiency
 The economist’s solution to inefficient
outcomes is to argue for a change in public
policy
 Business person’s solution is to try to make
money on the inefficiency
One lesson of business: the art of business consists
of identifying assets in low-valued uses and devising
ways to profitably move them to higher-valued assets
 Inefficiency implies the existence of
unconsummated, wealth-creating
transactions
 Each underemployed asset represents a
potential wealth-creating transactions and
the art of business is to identify these
transactions and find ways to profitably
consummate them
DESTROYING WEALTH
 Anything that impedes asset movement
destroys potential wealth
 Anything that moves assets from moving to
higher valued uses is destroying wealth
Taxes Destroy Wealth
Taxes
- Impede the movement of assets to higher
valued uses
- Reduce incentives to work
- Decrease the number of wealth creating
transactions
 When tax is larger than the surplus for a
transaction
One lesson of economics: intended effects of a tax is
to raise revenue for the government but the
unintended consequences of a tax is that it deters
some wealth-creating transactions
One lesson of business: unconsummated
transactions represent money-making opportunities
Subsidies Destroy Wealth
 by encouraging low-value consumers to buy
or high-value sellers to sell, subsidies
destroy wealth by moving assets from
higher to lower valued uses – WRONG
DIRECTION
  Example: flood insurance encourages
people to build in areas that they otherwise
wouldn’t

Price Controls Destroy Wealth

Price control – regulation that allows trade only at
certain prices
 Example: rent control (price ceiling) in
New York City deters transactions between
owners and renters

Price Ceiling – outlaw trade at prices above the

ceiling
- Implicit tax on producers and an implicit
subsidy to consumers
Price Floors – outlaw trade at prices below the floor

 Price floors above the buyer’s top dollar or

price ceilings below a seller’s bottom line
deter wealth-creating transactions

WEALTH CREATION IN ORGANIZATIONS

 Companies can be thought of as collections

of transactions, from buyer raw materials
like capital and labor to selling finished
goods and services
- Transactions like these move
assets from higher-valued uses
and thus, make money for the
company

 Organizations impose “taxes”, “subsidies”

and “price controls” within their
companies that either deter profitable
transactions or encourage unprofitable
ones

INDIVIDUAL PROBLEMS

A consumer values a car at $20,000 and it costs a

producer $15,000 to make the same car. If the
transaction is completed at $18,000, the transaction
will generate…

Buyer surplus = buyer’s value – price

$20,000 - $18,000 = $2,000

Seller surplus = price – seller’s value

$18,000 - $15,000 = $3,000

Total surplus = buyer + seller’s value

$2,000 + $3,000 = $5,000
MODULE 4: BENEFITS, COSTS AND
DECISIONS

CASE PROBLEM:
CASE PROBLEM:
Big Coal Power Company burns two types
of coal: high energy 8,800 coal and low energy 8,400 You are a manager of a new candy factory. Suppose
coal. Number refers to the amount of energy your company’s capital costs are $1 million/year.
contained in one pound of coal. The 8,400 coal Employees can be hired for $50,000 each and
generates 5% less electricity per ton than 8,800 coal. ingredients cost $0.50/candy bar. If you decide to
The price of the 8,400 fell 20% below the price of produce 1,000 candy bars a year, you need to hire 10
8,800 coal. The plant manager switched to the lower- employees but if you decide to produce 2,000 bars,
price coal (8,400). It reduced the average cost of you need 20 employees
electricity but also increased the manager’s
compensation because his performance evaluation is Output Fixed Variable Total
based on the average cost of electricity. The shift also 0 1,000,000 0
reduced the company’s profit. 1,000,000
1,000 1,000,000 500,5001,500,500
Electricity output fell by 5%, the difference 2,000 1,000,000 1,001,000
between the amount of electricity produced by two 2,001,000
different coals, and the parent company had to 3,000 1,000,000 1,501,500
replace the lost electricity with higher-cost natural 2,501,500
gas. Company profit fell by $5 million, computed as 4,000 1,000,000 2,002,000
the cost of replacing the lost electricity with 3,002,000
natural gas, minus the savings from using lower- 5,000 1,000,000 2,502,500
price 8,400 coal. 3,502,500

Three questions to come up with a solution:
1. Who made the bad decision? Plant
manager
2. Did decision maker have enough
information to make a good decision? Yes,
he knew that the 8,400 coal would
produce 5% less energy than 8,800 coal.
3. Did the decision maker have the incentive to
make a good decision? No, his
performance is evaluated based on the
average cost of electricity. The more he
could cut cost, the higher the incentive.
Solution:
Plant manager should’ve considered all the
costs of switcher to lower-energy and less electricity
generating coal. Average costs can be a poor measure
of the power plant performance. The company needs
to align the incentives of the business with the goals
of the parent company.
TYPES OF COST
Fixed cost – costs do not vary with the amount of
output
Variable cost – costs that change as output changes
TOTAL COST = FIXED COST + VARIABLE
COST
Fixed Cost
 Payments to your accountants to prepare
your tax returns
 Fees to design the packaging of your candy
bar
Variable Cost
 Electricity to run the candy making
machines
 Costs of material for packaging
 Variable cost are relevant in making
decisions
BASED ON THE CASE STUDY OF CADBURY:
Accounting vs Economic Profit
 Accounting profit recognizes only explicit
costs
 Typical income statements include explicit
costs
Explicit costs – those that are cashed out or recorded
through accounting entries
- Costs paid to suppliers for product inputs
- General operating expenses
- Depreciation expenses related to
investments in buildings and equipment
- Interest payments on borrowed funds

Note: Firm’s goal is to maximize profit

Profit = Total Revenue – Total Cost

Total revenue – the amount a firm receives from the

sale of its output
Total cost – the market value of the inputs a firm
uses in production

COSTS: EXPLICIT VS IMPLICIT

Explicit costs – requires an outlay of money

Implicit costs – do not require cash outlay
  The cost of something is what you give to
get it – true whether the costs are implicit or
explicit
Example
You need $100,000 to start your business. The
interest rate is 5%
Case 1: borrow $100,000
- Explicit cost = $5,000 interest on loan
Case 2: use $40,000 of your savings, borrow the
other $60,000
- Explicit cost = $3,000 interest on the loan
- Implicit cost = $2,000 foregone interest you
could have earned on your $40,000
Foregone – to give up
Total costs for both cases (explicit + implicit) =
$5,000
Accounting profit = total revenue – total explicit
costs
Economic profit = total revenue – total cost (explicit
+ implicit)
 Accounting profit is higher than economic
profit because economic profit has two
component while accounting profit has only
one
 Accounting profit ignores implicit costs,
so it’s higher than economic profit
Example:
The equilibrium rent on office space has just increase
by $500/month. Compare effects on accounting profit
and economic profit if:
a. You rent your own office space
Explicit costs increase by $500/month
Accounting profit and explicit cost fall
$500/month
b. You own your office space
Explicit cost and accounting profit does not
change but implicit costs increases to $500/month
as a result of foregoing to rent your office space
and results to economic profit falls by $500/month.
 Economic profit recognizes these implicit
costs; accounting profit recognizes only
explicit costs
OPPORTUNITY COSTS: COSTS ARE WHAT
YOU GIVE UP
Opportunity cost: one of the alternatives
as the foregone opportunity to earn profit from the
other
- Of an action is what you give up to pursue it
- Arise due to resource scarcity
 Costs imply decision-making rules and vice
versa
 The goal is to make decision that increase
profit
 If the profit of an action is greater than the
alternative, pursue it
RELEVANCE AND COSTS
Relevant costs & relevant benefits
 When making decisions, you should
consider all costs and benefits that vary with
the consequence of a decision and only costs
and benefits that vary with the decision
Two mistakes made:
1. Consider irrelevant costs
2. Ignore relevant costs
Fixed-cost/sunk-cost fallacy – you make decisions
using irrelevant costs and benefits
- Example, let overhead or depreciation costs
influence short-run decisions
CASE:
You pay $20 for a ticket. At halftime, your team is
losing by 56 points. You say you’ll stay to get your
money’s worth but you can’t. The ticket price does
not vary whether you stay or leave.
$20 ticket is already considered a sunk cost. You
already incurred the cost and you can’t get that back.
Whether you win or lose or let the game finish, it is
already sunk cost and irrelevant to your decision
making.
Hidden cost fallacy – you ignore the relevant costs
like ignoring opportunity cost
CASE:
You buy a ticket to a football game for $20 but at the
time, scalpers are selling tickets for $50 because you
team is playing its cross-state rival who has legions
of fans willing to pay over $50 to go to the game.
You value the ticket for much less and think “These
tickets only cost me $20.”
You give up the opportunity to scalp the tickets and
earn $50 by not going. The opportunity cost Is $50.
Unless you place a value on going to the game that is
at least $50, then yours is not a highest valued use for
the ticket.
EXAMPLE:
Should you fire an employee? The revenue he
provides to the company is $2,500 per month. His
wages are $1,900 per month. His is office is rented
out $800 per month.
Answer: Yes, the profit you are getting from the
employee is only $600 ($2,500 - $1,900), You could
also rent out his office and earn $800.
HIDDEN COST OF CAPITAL
 Recall that accounting profit does not
necessarily correspond to economic profit
Economic Value Added (EVA)
= net operating profit after taxes – cost of capital x
amount of capital utilized
- Helps firms avoid the hidden-cost fallacy by
taking all capital costs into account,
including the cost of equity
- Benefit of EVA is to identify costs
 If you cannot measure something, you
cannot control it
 Those who control costs should be
responsible for them
Psychological Biases
- Economics study of human behavior. Often
psychological biases get in the way of
rational decision making

1. Endowment effect – taking ownership of
items causes owner to increase
2. Loss aversion – individuals would pay more
to avoid loss than to realize gains
3. Confirmation bias – tendency to gather
information that confirms your prior beliefs,
and to ignore information that contradicts
4. Anchoring bias – relates the effects of how
information is presented or “framed”
5. Overconfidence bias – tendency to place
too much confidence in the accuracy of the
analysis
CLASS PROBLEM:
You won a free ticket to see an Eric Clapton
concert (which had no resale value). Bob Dylan is
performing on the same night and is your next-best
alternative activity. Tickets to see Dylan cost $40. On
any given day, you would be willing to pay up to $50
to see Dylan. Assume there are no other costs of
seeing either performer. Based on this information,
what is the opportunity cost of seeing Eric Clapton?
Based on this information, what is the minimum
amount (in dollars) you would have to value seeing
Eric Clapton for you to choose his concert?
Answer: The opportunity cost of seeing Eric Clapton
and the minimum amount you would value seeing
Eric Clapton is $10 because your next alternative is
Bob Dylan and opportunity is the benefit you forgone
seeing Dylan by seeing Clapton.
(1) A business owner makes 1,000 items a day.
Each day she contributes eight hours to
produce those items. If hired, elsewhere she
could have earned $250 an hour. The item
sells for $15 each. Production does not stop
during weekends. If the explicit costs total
$150,000 for 30 days, the firm’s accounting
profit for the month equals:
Total revenue – total explicit costs
(1,000 items x $15 each x 30 days) – $150,000
450,000 – 150,000
Accounting profit = 300,000
(2) Mr. D’s Barbeque of Pickwick, TN,
produces 10,000 dry-rubbed rib slabs per
year. Annually Mr. D’s fixed costs are
$50,000. The average variable cost per slab
is a constant $2. What is the average total
cost per slab?
Fixed cost = $50,000
Variable cost = $2 x 10,000 = $20,000
Total cost = $70,000
Average total cost = total cost/output
$70,000/10,000 = $7 average total cost
(2-A) Suppose that Mr.D smoked 10% more
ribs
10000 x 10% = 1000
10000 +100 = 11000
Average fixed cost = $50,000
Average Variable cost = $2 x (110% x 10,000) =
$22,000
Total cost = $72,000
$72,000/11,000 = $6.55 average total cost
Smoking 10% more ribs would lower the
average total cost.
(3) A business incurs the following costs per
unit: labor $125/unit, materials $45/unit, and
rent $250,000/month. If the firm produces
1,000,000 units a month. Calculate total
variable costs, total fixed costs and total cost
Total Variable cost = ($125 + $45) x 1,000,000 =
$170,000,000
Total Fixed cost = $250,000 of rent
Total cost = $170,250,000
(4) You were able to purchase two tickets to an
upcoming concert for $100 a piece when the
concert was first announced three months
ago. Recently, you saw that StubHub was
listing similar seats for $225 a piece. What
does it cost you to attend the concert?
Answer: Opportunity cost of attending the concert is
$450. You forgo the opportunity to sell the two
tickets for $450.
MODULE 4: EXTENT (HOW MUCH)
DECISIONS
MARGINAL ANALYSIS
Average cost (AC) = total cost (fixed and
variable)/total units produced
- Simply the total cost (TC) of
production/number of units produced (Q)
Average Total Cost = Average fixed cost + average
variable cost
 Average costs often decrease as quantity
increase due to presence of fixed costs (FC)
- FC does not change as Q increases
 Average costs are not relevant to extent
decisions
 Fixed cost portion of AC is irrelevant to
an extent decision
Marginal cost (MC) = additional cost incurred by
producing and selling on more unit
MC = TCQ + 1 -TCQ
MC = change in total cost/change in quantity
TCQ = total cost of quantity produced
  Marginal cost is often lower than average
cost (due to fixed cost) but not always
 Marginal costs are what matter in extent
decisions
EXAMPLE 1:
Business A produces 100 motor vehicles that $10,000
each. If the firm then goes to produce 120 more
motor vehicles. We need to work out the difference
between the total cost after and the initial cost to get
change in total cost.
= 1,200,000 – 1,000,000 / 120 – 100
= 200,000 / 20
MC = $10,000
EXAMPLE 2:
John Monroe owns a privately owned business called
Monroes Motorbikes. In his first year of business, he
produces and sells 10 motorbikes for $100,000,
which cost him $50,000 to make. In his second year,
he goes on to produce and sell 15 motorbikes for
$150,000, which cost $75,000 to make
= 75,000 – 50,000 / 15-10
= 25,000 / 5
MC = $5,000
Marginal revenue (MR) = additional revenue gained
from selling one more unit
MR = change in revenue / change in quantity
 You sell more if MR > MC
 You sell less if MC > MR
 You are selling at right amount if MR = MC
maximizing profit point
Marginal cost and marginal revenue – relevant cost
and benefits of an extent decision
CASE:
CEO’s mistake: CEO looked at the cost first rather
than the decision to increase the number of babies. In
economics, we look at the decision first rather
than the cost. Cost would just follow after we
made the decision.
 CEO committed fixed cost fallacy by
looking at average cost, which include cost
that do not change with the decision
 If he had ignored the fixed cost, he would
have seen that increasing the number of
deliveries would increase profit
Additional information:
Initially, Memorial made 500 deliveries
Fixed cost is $1,000,000
Variable cost $3,000/delivery
Total cost = fixed cost + variable cost
Average cost is total costs/ # of deliveries
Marginal revenue is $5,000
Hospital increased output from 500 to 501 deliveries.
MC = change in total cost / change in quantity
500 deliveries
- Fixed cost is $1,000,000
- Variable cost is $1,500,000
- Total cost is $2,500,000
- Average cost is $5,000
501 deliveries
- Fixed cost is $1,000,000
- Variable cost is $1,503,000
- Total cost is $2,503,000
- Average cost is $4,996
MC = 2,503,000 – 2,500,000 / 501 – 500
MC = 3,000 / 1
MC = $3,000
 CEO is wrong because MR > MC and
should be delivering more babies
INCENTIVE PAY
- Financial reward for performance rather than
pay for the number of hours worked
 How hard to work is an extent decision so
you can design incentive to encourage hard
work by using marginal analysis
Royalty rates vs fixed fee contracts
Example:
You receive two bids to harvest 100 trees on your
land. $150/tree or $15,000 for the right to harvest all
the trees. On your tract there are pines (worth $200)
and fir (worth $100). Which offer should you accept?
Bids have the same face value, but are very different
in terms of logger’s incentives
Fixed fee: $15,000
The logger will ignore the $15,000 because it doesn’t
vary with the decision to cut down trees (sunk cost
because logger ignored)
 The logger will end up cutting down all trees
that are profitable to cut down, MR > MC
Royalty rate: $150/tree
The logger will only cut down trees that generate
profit of $150, MR > MC + 150
 Mix of $200 and $100 trees, logger will only
harvest $200
 Landowner receives less money since the
logger only harvests one type of tree
Royalties – deter some wealth creating transactions
as fir trees are not harvested
INCENTIVE PAY
 Incentive compensation scheme that
increase MR or reduces MC will increase
effort. Fixed fees have no effects on efforts.
 A good incentive compensative scheme
links pay to performance measures that
reflect effort
CASE:
A consulting firm COO received a flat salary of
$75,000. After learning about the benefits of
incentive pay in class, the CEO changed COO
compensation to $50K + (1/3) x (profit - $150K)
Profits increase 74% to $1.2M
Compensation increased $75K -> $177K
Question: What are the disadvantages to incentive
pay?
Answer: Incentive pay creates a gap between
employees because you are not allocating the
incentive fairly to all.
 (7) You run a game day shuttle service for
People respond to incentive and people should still be parking services for the local ball club. Your
rewarded in terms of performance, give recognition costs for different loads are 1:$30, 2:$32,
other than the money. 3:$35, 4:$38, 5:$42, 6:$48, 7:$57 and 8:$68.
What are your MCs for each load level?
PRACTICE PROBLEMS: What is the AC? If you are compensated $10
per ride, what customer load would you
(1) A firm produces 500 units per week. It hires want?
20 full time workers (40 hours/week) at an
hourly wage of $15. Raw materials are Load Costs MC MR Profit
ordered weekly, and they cost $10 for every 1 $30 0 $10 -20
unit produced. The weekly cost of the rent 2 $32 2 $20 -12
payment for the factory is $2,250. How do 3 $35 3 $30 -5
the overall costs break down? 4 $38 3 $40 2
5 $42 4 $50 8
Fixed cost = $2,250 rent 6 $48 6 $60 12
Variable = $17,000 materials and labor 7 $57 9 $70 13
Materials: $10 x 500 = $5,000 8 $68 11 $80 12
Labor: 20 workers x 40 hours x $15 = $12,000
Total cost: 17,000 + 2,250 = $19,250

(2) A retailer has to pay $9 per hour to hire 13

workers. If the retailer only needs to hire 12
workers, a wage rate of $7 per hour is
sufficient. What is the MC of the 13th
worker?

$9 = 13 workers = $117
$7 = 12 workers = $84
$117 - $84 = $33 MC

(3) A firm is thinking of hiring an additional

worker to their organization who can
increase total productivity by 100 units a
week. The cost of hiring him is $1,500 per
week. If the price of each unit is $12.

100 units x $12 = $1,200 –> MR

Hiring him = $1,500 -> MC
Firm should not hire as MR < MC

(4) Total costs increase from $1,500 to $1,800

when a firm increase output from 40 to 50
units. If marginal costs is constant, what is
the variable costs?

MC = total cost / units produced

= 1,800 – 1,500 / 50 – 40
= 300 / 10
MC = 30

TC = FC + VC(q)TC = FC + VC(q)
1,500 = FC + 30(40) 1,800 = FC + 30(50)
1,500 = FC + 1,200 1,800 = FC + 1,500
FC = 1,500 – 1,200 FC = 1,800 – 1,500
FC = 300 FC = 300

(5) A company is producing 15,000 units. At

this output level, MR is $22 and the MC is
$18. The firm sells each unit for $48 and
average total cost is $40.

Answer: The company needs to increase production

and sell more because MR = $22 is greater than MC
= $18

(6) Food Fanatics caters meals where its cost of

producing an extra meal is $25. Each of its
meals sells for $20. At this rate, what should
the company do?

Answer: Produce and sell fewer meals and increase

profit because MR < MC, $20 < $25