Managerial Economics | ACC102

Notes 1: Investment Decisions sliced since its marginal value is less than the price. In purchasing 3 sliced of kutsinta at 3.00, the consumer
gets a higher consumer surplus (total value of 12.00  expenses of 9.00 = 3.00) while purchasing 5 sliced of
INVESTMENT DECISIONS kutsinta at 3.00, there will be a zero surplus (total value of 15.00  expenses of 15.00 = 0).
To make an investment, the trade-off between the current costs and future gains is unavoidable If consumers behave optimally, they will consider the difference of the value of the goods and the
which should always be considered to determine if the future gains are higher than the current costs. price they pay for it to maximize consumer surplus. In doing so, consumers think in marginal terms in making
purchase decision.
Discounting
— is a tool to determine the present value possible for cash flow that will be generated by an investment in PRICING (MARGINAL ANALYSIS)
the future The trade-off between price and quantity is at the core of pricing decisions. Raising prices will
end up in fewer units sold yet earn bigger on each unit sold while reducing prices will increase units sold yet earn
smaller on each unit sold. This trade-off can be resolved using marginal analysis.
Present Value = future value ÷ (1+i)t
MR > MC, reduce price, sell more
i = interest rate MR < MC, increase price, sell less
t = number of years
Consumer uses marginal analysis for maximization of consumer surplus, while producer uses marginal
Reverse formula of discounting is compounding. analysis for profit maximization.

Future Value = present value x (1+i)t Optimum Price

Price Quantity Revenue Marginal Revenue Marginal Cost Profit
On rule of thumb, compounding is “rule of 72”, which means that if you invest at a rate of 8 percent, 7.00 1 7,00 7.00 1.50 5.50
divide 72 with 8 percent to get to get the number of years it takes to double your money which is 9 years. 6.00 2 12.00 5.00 1.50 9.00
5.00 3 15.00 3.00 1.50 10.50
4.00 4 16.00 1.00 1.50 10.00
72 ÷ 8 percent = 9 years 3.00 5 15.00 -1,00 1.50 7.50
2.00 6 12.00 -3.00 1.50 3.00
To determine whether the investment is profitable or not, discount the future value of investment 1.00 7 7.00 -5.00 1.50 -3.50
and compare them with the current cost of the investment. The general decision rule is NPV (net present
Value). Profit = revenue – marginal cost x number of units

“If the net present value of discounted cash flow is larger than zero, the investment earns more than the cost of Example:
capital. Let us assume a price reduction from 7.00 to 6.00. There will be now 2 consumers, revenue increase
from 7.00 to 12.00, the increase in revenue of 5.00 is the marginal revenue, marginal cost of 3.00 (1.50 x 2), profit
Breakeven Analysis of 9.00 Then again, price reduction to 5.00, revenue of 15.00, marginal revenue of 3, total marginal cost of 4.50
— is a way to determine investment profitability through the breakeven quantity (1.50 x 3), profit of 10.50. Another price reduction to 4.00, revenue of 16.00, marginal revenue of 1, total
marginal cost of 6(1.50 x 4). The fourth unit gives 1.00 marginal revenue which is less than the 1.50 per unit
marginal cost so it’s no longer advantageous to sell 4 units. However, 3rd unit will give 3.00 marginal revenue
Breakeven Quantity = annual fixed cost ÷ (price per unit  marginal cost (cost per unit) which is higher than 1.50 per unit marginal cost and raise profit to a maximum level of 10.50. In this case, the
price of 5.00 is the optimum price that will maximize profit.
Q = F ÷ (P - MC)
CONCEPT OF ELASTICITY
Breakeven Quantity A. Price elasticity of demand is the responsiveness of consumers to a price change.
— is the quantity wherein there is no loss and no gain that means zero profit. But if you could sell more than
the breakeven quantity then it is now profitable since the revenue exceeds the cost. Price Elasticity of Demand Coefficient
BUYER AND SELLER SURPLUS
The individual’s value for a good or service is on the amount of money an individual is willing to give
up of it or acquire it. That means value of good lies on your willingness to pay for it so as to acquire it or the
price you are willing to sell it. In a buyer-seller relationship, buyer’s value for a certain product is how much he
will pay for it (top peso on buyers’ part) while the seller’s value of a goods is the cost of goods (bottom peso on
the part of the seller).
A buyer buys if the price is below his/her value, top peso, and a seller sells if the price is above
his/her value, bottom peso. There will be transaction if both parties gain in the exchange. If not, there will be no Price Elasticity Coefficient
transaction. In that case, voluntary transactions of both parties (buyer and seller) either create wealth or no
wealth creation at all, or a very minimal wealth creation.

Surplus
— is the difference between the price agreed upon and seller’s value
— the buyer surplus is buyer’s value less the agreed price, and the total surplus is the gain in the transaction
How to interpret price elasticity of demand coefficient
Buyer surplus + Seller surplus Because of inverse relatioship of price and quantity demanded, coefficient must be treated as absolute
number since the negative sign is construed as relationship sign.
Example:  Elastic Demand – coefficient is greater than 1
Buyer values a house at 150,000 (top peso) and a seller at 110,000 (bottom peso). If both parties A one percent change in price results in more than one percent change in quantity
agreed on 120,000 price, they both gain which means the seller gain 10,000 at a price higher than his/her bottom demanded.
peso while the buyer gains 30,000 at a price below his/her top peso.
Example: .08/.04 = 2
Exercise:  Inelastic Demand – coefficient is less than 1
A CEO of a hospital received a data about the operational cost and revenue/profit: 540 numbers of de- A one percent change in price results less than one percent change in quantity demanded.
liveries services (labor of babies), the total cost of 540 deliveries of babies is 3,132,000, the total revenue is
2,754,000. The marginal cost is 3,000/deliveries. The CEO said why we should continue the delivery services if Example: .04/.08 = .5
we are losing 700 pesos per delivery.  Unitary Demand – coefficient is equal to 1
A one percent change in price results in one percent change in quantity demanded.
Questions:
1. Why did the CEO say it so? What was his basis? Example: .08/.08 = 1
2. If you’re the CEO, will you increase the number of delivery services or stop accepting additional delivery
services? If so, what is your basis? B. Price elasticity of supply. If the quantity supplied by producers is responsive to the price changes. supply is
3. What is then the relevant and irrelevant cost in your decision either way? elastic, if insensitive to price changes, then it is inelastic.

SIMPLE PRICING (THE CASE OF A SINGLE FIRM, A SINGLE PRODUCT, AND SINGLE PRICE) Price Elasticity of Supply Coefficient
Understanding consumer behavior is necessary in determining the price of certain goods. The law of
demand and diminishing marginal utility are good tools in economics in understanding how consumer values
certain goods.
The Law of Demand says that a consumer purchase more if price decreases, purchase less if price
increases.
The demand curves show consumer behavior and say how much consumer will buy at a given price.

Demand schedule
Price per sliced kutsinta Kutsinta purchased Price Elasticity Coefficient
5.00 1
4.00 2
3.00 3
2.00 4
1.00 5

The Principle of Diminishing Marginal Utility says that an added satisfaction decreases as
consumer acquires or consumes additional unit of a certain goods. That means a subsequent or succeeding How to interpret price elasticity of supply coefficient
consumption of certain goods per unit yield less and less marginal value or utility which makes consumer buys Because of direct relatioship of price and quantity supplied, coefficient is always positive.
additional units only if the price per unit of such goods is also progressively decreases.  Elastic Supply – coefficient is greater than 1
A one percent change in price results in more than one percent change in quantity
Value table supplied.
Slice kutsinta purchased Marginal Value Total Value
1 5.00 5.00 Example: .08/.04 = 2
2 4.00 9.00  Inelastic Supply – coefficient is less than 1
3 3.00 12.00 A one percent change in price results less than one percent change in quantity supplied.
4 2.00 14.00
5 1.00 15.00 Example: .04/.08 = .5
 Unitary Demand – coefficient is equal to 1
Getting the total value is adding each of the marginal value (5.00 + 4.00 = 9.00, then add 3.00 + 9.00 = 12.00 A one percent change in price results in one percent change in quantity supplied.
and so on).
Example: .08/.08 = 1
Example:
Let us assume that if the sliced kutsinta is priced at 3.00 then consumer will purchase 5 sliced kutsinta The degree of price elasticity of supply depends on how fast producers can shift resources between al-
that will give 15.00 total value (3.00 x 5). In marginal terms, however, the fourth sliced of kutsinta has 2.00 terntive uses. The easier and faster producers can shift resources between alternative uses, the greater the
marginal value only which is less than price of 3.00. This means the consumer will not purchase a fourth
Managerial Economics | ACC102
price elasticity of supply. Market period is the period that occurs when time immediately after a change in
market price is too short for producer to respond with a change in quantity.
Price elasticity of supply in the short run is the period of time too short to change plant capacity but
long enough to use the fixed-sized plant more or less intensively.
Price elasticity of supply in the long run is the period of time long enough for firms to adjust plant
sizes and for new firms to enter or exit firms to leave the industry.

C. Cross Elasticity of Demand measures how sensitive consumer demand of one product (X) to a change in
the price of some other product (Y).

Cross elasticity Formula

Total revenue = (a) 4 x 10 = 40

(b) 1 x 40 = 40
If cross elasticity is negative the two goods are complementary, if it is positive the goods are substi -
tutes. A zero cross elasticity connotes the two goods are unrelated. Elastic Demand
If there is a price increase then the decrease in quantity is bigger than the increase in price, the revenue
D. Income Elasticity of Demand is the responsiveness of consumer purchases relative to a change in income. decrease.
If there is a price decrease then the increase in quantity is bigger than the decrease in price, the revenue
Income Elasticity Formula increase.

Inelastic demand
If there is a price increase then the decrease in quantity is smaller than the increase in price, the rev -
enue increase.
If there is a price decrease then the increase in quantity is smaller than decrease in price, the revenue
decrease.

If income elasticity is positive the goods is a normal goods, if it is negative the goods is an inferior MARGINAL REVENUE AND ELASTICITY
goods. Marginal revenue= P(1-1/e)
Exercise:
This expression is a numerical relationship between marginal revenue and elasticity which can be
Elasticity of Demand
used in place of MR in the marginal analysis rule MR > MC, and MR < MC. Such as MR > MC implies that (P-
Qx1 = 300 Qx2 = 500
MC)/P > 1/e. (1/e is an inverse of elasticity, P is price, MC is marginal cost).
P=5 P=8

Qx1 = 300 Qx2 = 500 The expression interpretation is that the left side of the expression shows the current margin of price over mar-
P=5 P=3 ginal cost, (P-MC)/P, and the right side is desired margin, 1/e (inverse of elasticity). If the current margin is
greater than desired margin means that the MR>MC so reduce price, if the current margin is less than the desired
Income Elasticity margin then increase price since MR
Q1 = 300 Q2 = 500
Y1 = 1,000 Y2 = 2,000 FORECASTING DEMAND AND ELASTICITY
Percentage change in quantity is equal to elasticity (percentage in price) to the power of ten.
Q1 = 300 Q2 = 500
Y1 = 1,000 Y2 = 300 If price elasticity of demand is -3, and price goes up by 10 percent, then quantity is forecast to decrease
by 30 percent. To determine the effect of other factors besides price that affects demand such as income, prices of
Cross Elasticity substitutes and complements, advertising, and taste and preference, we define a factor of elasticity demand:
Qx1 = 100 Qx2 = 150
Py1 = 5 Py1 = 8 Factor elasticity of demand = (% change in quantity)/(% change in factor)

Qx1 = 300 Qx2 = 500

Example:
Py1 = 5 Py2 = 8
Temperature elasticity of demand for bottled iced tea is 25% then a 1% increase in temperature will re -
sult to a 25% increase in quantity demanded.
PRICE AND PRICING ELASTICITY
The marginal analysis (MR > MC, reduce price sell more; MR < MC, increase price, sell less)
STAY-EVEN ANALYSIS AND ELASTICITY
points us to the right direction in pricing but by how are we going to determine the marginal revenue requires
information that price elasticity can provide.
Stay-even analysis shows how many units you can lose before an increase in price becomes unprof-
Elastic Demand itable. It is a function of the magnitude or size of price increases and the contribution margin:
If there is a price increase then the decrease in quantity is bigger than the increase in price, the
revenue decrease. Percentage change in quantity = percentage change in Price/(percentage change in Price + margin), margin = (P-
If there is a price decrease then the increase in quantity is bigger than the decrease in price, the revenue increase. MC)/P.

Inelastic Demand If there is an increase in price and the expected decrease in quantity demanded is smaller than the stay
If there is a price increase then the decrease in quantity is smaller than the increase in price, the even quantity, the price increase is profitable vice versa. The stayeven shows what changes in quantity demanded
revenue increase. support a given change in price. The elasticity estimates on the other hand shows what quantity changes will be.
If there is a price decrease then the increase in quantity is smaller than decrease in price, the revenue decrease.
Example:
Factors that affect demand elasticity and optimal pricing If the stay-even quantity for a given product is 100% percent increase in price and a 75% decrease in
1. More elastic demand of products happens if the products have more close substitutes – consumers respond
to a price increase by switching to substitute products. quantity, then if there is a 100 percent increase in price, and the resulting decreases in quantity demanded is less
2. Products brand individual demand is more elastic than industry aggregate demand – As a rough rule of than 75%, then price increase is profitable otherwise, unprofitable.
thumb, brand elasticity is approximately equal to industry price elasticity divided by the brand name.
Solution:
Example: If the price is .75 cents which increase by 100%, 1.50, marginal cost is .50 cents, assumed quantity
Elasticity for all shoes is -0.4 and the market share of brand A is 20 percent then the elasticity of (original) is 1000 units:
demand of brand A is -0.4/.20 = -2.
3. There is less elastic demand if the products have many complements- products that are consumed together .75 x 100%= .75 x 1.00 = .75 (change in price) + .75 (original price) = 1.50 new price
with a large bundle of complementary goods have less elastic.
4. Demand curves become more elastic in the long run horizon – given more time to find substitutes when
price goes and up and given more time to find alternative uses for a good when price goes down, consumers %change in Q = 1 / (1 + Margin) = 1 / 1.33 = .75
are more responsive to price changes. %change in Q = 1 / (1 + .33) = 1 / 1.33 = .75

Demand becomes more elastic as price increases – as price increases, consumers find more alternatives Margin = (.75 -.50) / .75 = .25/.75 = .33
to goods whose price increases.
.1,000 (original quantity) x .75 (change in quantity) = 750 units
Notes 1: Total Revenue and Elasticity of Demand 1,000 – 750 = 250 quantity after the price change:

TOTAL REVENUE AND ELASTICITY OF DEMAND Before the change in price:

In elastic demand, a decrease in price will result to an increase in total revenue. 1,000 X .75 = 750 (Total revenue before change in price)
1,000 X .5 = 500 (Total cost before change in price)
750 – 500 = 250 revenue before the change

After the change in price:

250 (change in quantity) x 1.50 (new price) = 375
250 (change in quantity) x .50 (marginal cost) = 125
375 – 125 = 250 revenue after the change

Exercise:
Total revenue = (a) P x Q = 2 x 10 = 20 Elect another level of price, percentage price change, and marginal cost, initial output(quantity), then
(b) P x Q = 1 x 40 = 40 assume the expected quantity change is 60 percent.

In inelastic demand, a decrease in price will result to a decrease in total revenue. Percentage change in quantity = percentage change in Price/(percentage change in Price + margin)
Margin = (P-MC)/P

COST-BASED PRICING
Many companies use cost-based price which is cost plus desired fixed margin for each unit of prod-
uct equal price per unit. The marginal analysis specifically optimal price which is MR = MC or (P-MC)/P = 1/e
do consider both cost structure and consumer demand.