101 – Managerial Economics

Dr Ritesh Kumar Mishra,

Department of Finance & Business Economics
University of Delhi
 Unit – 1

The Nature and Scope of Managerial Economics

 What is Economics – Definitions?
• Robert Solow (1997), paraphrasing Oscar Wilde, described modern
economics as ‘the overeducated in pursuit of the unknowable’.

• No one has ever succeeded in neatly defining the scope of

economics.

• Alfred Marshall, a leading 19th-century English economist:

– “a study of mankind in the ordinary business of life; it examines that part of
individual and social action which is most closely connected with the
attainment, and with the use of the material requisites of wellbeing”.

• Lionel Robbins (20th century economist):

– “the science which studies human behaviour as a relationship between (given)
ends and scarce means which have alternative uses.”
 What is Economics – Definitions?
• May be a foolproof definition by  Jacob Viner:
– ‘economics is what economists do’.
 Introduction to economics?

• Economics is the study of how societies, governments,

businesses, households (individuals) allocate their scarce
resources.

Limited Unlimited
Resources Needs
 Introduction – Why study economics?

• Economic resources are the various types of labor, capital, land,

and entrepreneurship used in producing goods and services.

• Since the resources of every society are limited or scarce, the

ability of every society to produce goods and services is also
limited.

• Because of this scarcity, all societies face the problems of:

– What to produce,
– How to produce,
– For whom to produce,
– How to ration the commodity over time,
– How to provide for the maintenance and growth of the system.
 Branches of Economics

• The main branches of economics are:

Economics

Micro Economics Macro Economics

Managerial Economics
 Branches of Economics
• Micro economic analysis and Macro economic analysis are two
main approaches of economic analysis:
 Business Management and Economics

• Study of economics helps in understanding and responding to

many real world problems:

– As a consumer (Consumer behavior)

– As a producer (Producer behavior)
– As an investor (Optimizing investment return)
– As a central banker (Monetary policy)
– As a policy maker (Managing a country)
 What is Managerial Economics?

• The application of economic theory and the tools of decision

science to examine how an organization can achieve its aims
or objectives most efficiently.

– Applications of economic theory

– Quantitative methods
– Statistical methods
– Computational methods
Economics and Managerial Decision Making Process
Relationship with other Disciplines
 Resources (Factors of Productions)

• There are four factors of production:

– Land (Rent),
– Labour (Wage),
– Capital (Interest),
– Entrepreneur (Profit).
A simple schematic model of economy
 The Production Possibility Frontier

• A simple graphic device called the production possibility

frontier (PPF ) illustrates the principles of constrained choice,
opportunity cost, and scarcity.

• The production-possibility frontier (or PPF ) shows the

maximum quantity of goods that can be efficiently produced by
an economy, given its technological knowledge and the
quantity of available inputs.
The Production Possibility Frontier
 The Theory of the Firm

• Combines and organizes resources for the purpose of

producing goods and/or services for sale.

• Internalizes transactions, reducing transactions costs.

• Economic theory assumes that the primary goal of managers is

to maximize the value of the firm.
 Value of the Firm

The present value of all expected future profits

1 2 n n
t
PV     
(1  r ) (1  r )
1 2
(1  r ) n
t 1 (1  r ) t

n
t n
TRt  TCt
Value of Firm   
t 1 (1  r ) t
t 1 (1  r ) t
 Limitations/Alternative Theories of Firm

• Sales maximization
– Adequate rate of profit

• Management utility maximization

– Principle-agent problem

• Satisficing behavior
 Profit – Definitions of Profit

• Business or Accounting Profit: Total revenue minus the

explicit or accounting costs of production.

• Economic Profit: Total revenue minus the explicit and

implicit costs of production.

• Opportunity Cost: Implicit value of a resource in its best

alternative use.

• Implicit and Explicit cost

 Theories of Profit

• Some important theories of profit are:

– Risk-Bearing Theories of Profit

– Frictional Theory of Profit
– Monopoly Theory of Profit
– Innovation Theory of Profit
– Managerial Efficiency Theory of Profit
 Social Function of Profit

• Profit is a signal that guides the allocation of society’s

resources.

• High profits in an industry are a signal that buyers want more

of what the industry produces.

• Low (or negative) profits in an industry are a signal that buyers

want less of what the industry produces.
 Unit – II

Consumer Behavior – Theory of Demand & Supply

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Slide 24

 Understanding Consumer Behavior

• A firm exists when a person or a group of people decides to

produce a product/service or products by transforming inputs into
outputs.

• Demand is the most crucial element for the existence, survival and
profitability of firm.

• The consuming units in an economy are households.

• A household may consist of any number of people: a single person

living alone, a married couple with four children, or 15 unrelated
people sharing a house.

• Household decisions are based on individual tastes and

preferences. The household buys what it wants and can afford.
 Demand

• Demand is the quantity of a product/service that a consumer is

willing and able to purchase at particular price and particular
point of time.

• So some important factors to keep in mind about this definition is:

• Willingness to purchase
• Ability to purchase
• At a particular price
• At a particular point of time

• Mere willingness to purchase something does not constitute

demand.

• Change in price & time will change demand.

 Demand in Product/Output Markets

• Every week you make hundreds of decisions about what to buy.

• Your choices likely look different from those of your friends or your
parents.

• For all of you, however, the decision about what to buy and how much of
it to buy depends on the following factors:

• The price of the product in question

• The income available to the household.
The household’s amount of accumulated wealth
• The prices of other products available to the household.
• The household’s tastes and preferences.
• The household’s expectations about future income, wealth, and prices.
 Quantity demanded

• Quantity demanded is the amount (number of units) of a product that a

household would buy in a given period if it could buy all it wanted at the
current market price.

• Of course, the amount of a product that households finally purchase

depends on the amount of product actually available in the market.

• The expression if it could buy all it wanted is critical to the definition of

quantity demanded because it allows for the possibility that quantity
supplied and quantity demanded are unequal.

• Sometimes surplus and sometimes a deficit.

 Changes in Quantity Demanded versus Changes in Demand

• What happens to the quantity a typical individual demands of

a product when all that changes is its price?

• Economists refer to this device as ceteris paribus, or “all else

equal.”

• We will be looking at the relationship between quantity

demanded of a good when its price changes, holding income,
wealth, other prices, tastes, and expectations constant – i.e.
ceteris paribus.

• Changes in the price of a product affect the quantity demanded

per period.

• Changes in any other factor, such as income or preferences,

affect demand.
 Price and Quantity Demanded: The Law of Demand
• A demand schedule shows how much of a product a person
or household is willing to purchase per time period (each
week or each month) at different prices.
 Price and Quantity Demanded: The Law of Demand
• Demand curve A graph illustrating how much of a given product a
household would be willing to buy at different prices.

• You will note in Figure that quantity (q) is measured along the horizontal
axis and price (P) is measured along the vertical axis.
 Features of Demand Curve
• The data in Table 3.1 show that at lower prices, Alex buys more gasoline;
at higher prices, she buys less.

• Thus, there is a negative, or inverse, relationship between quantity demanded

and price.

• When price rises, quantity demanded falls, and when price falls, quantity
demanded rises. Thus, demand curves always slope downward.

• This negative relationship between price and quantity demanded is often

referred to as the law of demand – a term first used by economist Alfred
Marshall in his 1890 textbook

• Law of Demand – The negative relationship between price and quantity

demanded: Ceteris paribus, as price rises, quantity demanded decreases;
as price falls, quantity demanded increases during a given period of
time, all other things remaining constant.
 Negative Slope of Demand Curve…why?
• Economists use the concept of utility to explain the slope of the demand
curve.

• As we consume more of a product within a given period of time, it is

likely that each additional unit consumed will yield successively less
satisfaction.

• The utility you gain from a second ice cream cone is likely to be less than
the utility you gained from the first, the third is worth even less, and so
on.

• This law of diminishing marginal utility is an important concept in

economics. If each successive unit of a good is worth less to you, you are
not going to be willing to pay as much for it.

• Thus, it is reasonable to expect a downward slope in the demand curve

for that good.
 General Demand Function

• Six variables that influence Qd

– Price of good or service (P)
– Incomes of consumers (M)
– Prices of related goods & services (P )
R

• Taste patterns of consumers (  )

• Expected future price of product (P )
e
• Number of consumers in market (N)
• General demand function

• Qd  f ( P, M , PR , , Pe , N )
2-34
 General Demand Function

Qd  a  bP  cM  dPR  e   fPe  gN

• b, c, d, e, f, & g are slope parameters

– Measure effect on Qd of changing one of the variables
while holding the others constant

• Sign of parameter shows how variable is related to Qd

– Positive sign indicates direct relationship
– Negative sign indicates inverse relationship

2-35
 General Demand Function

Variable Relation to Qd Sign of Slope Parameter

P Inverse b = Qd/P is negative

Direct for normal goods c = Qd/M is positive
M
Inverse for inferior goods c = Qd/M is negative

PR Direct for substitutes d = Qd/PR is positive

Inverse for complements d = Qd/PR is negative

 Direct e = Qd/  is positive

Pe Direct f = Qd/Pe is positive

N Direct g = Qd/N is positive

2-36
 Direct Demand Function

• The direct demand function, or simply demand, shows how

quantity demanded, Qd , is related to product price, P, when all
other variables are held constant

– Qd = f(P)

• Law of Demand

– Qd increases when P falls & Qd decreases when P rises, all else

constant
– Qd/P must be negative

2-37
 Inverse Demand Function
• Traditionally, price (P) is plotted on the vertical axis & quantity
demanded (Qd) is plotted on the horizontal axis

– The equation plotted is the inverse demand function,

P = f(Qd)

2-38
 Derivation of Demand Curve

• To illustrate the derivation of a direct demand function from the

general demand function:

• Suppose the general demand function is:

• To derive a demand function, Qd = f(P), the variables M and PR

must be assigned specific (fixed) values.

• Suppose consumer income is $60,000 and the price of a related

good is $200.
 Derivation of Demand Curve

• To find the demand function, the fixed values of M and PR are

substituted into the general demand function:
 Graphing Demand Curves

• A point on a direct demand curve shows either:

– Maximum amount of a good that will be purchased for a given

price

– Maximum price consumers will pay for a specific amount of

the good

2-41
 Demand Schedule

• Demand schedule – A table showing a list of possible product

prices and the corresponding quantities demanded.

2-42
 A Demand Curve

2-43
 Inverse Demand Functions

• We can derive the inverse demand function as:

• The direct demand equation is:

• Solving this direct demand equation for P gives the inverse demand
equation
 Graphing Demand Curves

• Change in quantity demanded

– Occurs when price changes

– Movement along demand curve

• Change in demand

– Occurs when one of the other variables, or

determinants of demand, changes
– Demand curve shifts rightward or leftward
2-45
 Shifts in Demand

2-46
 Supply

• Quantity supplied (Qs)

– Amount of a good or service offered for sale during a

given period of time

2-47
 Supply

• Six variables that influence Qs

– Price of good or service (P)
– Input prices (PI )
– Prices of goods related in production (Pr)
– Technological advances (T)
– Expected future price of product (Pe)
– Number of firms producing product (F)

• General supply function

Qs  f ( P, PI , Pr , T , Pe , F )
2-48
 General Supply Function

Qs  h  kP  lPI  mPr  nT  rPe  sF

• k, l, m, n, r, & s are slope parameters

– Measure effect on Qs of changing one of the variables
while holding the others constant

• Sign of parameter shows how variable is related to Qs

– Positive sign indicates direct relationship
– Negative sign indicates inverse relationship

2-49
 General Supply Function

Variable Relation to Qs Sign of Slope Parameter

P Direct k = Qs/P is positive

PI Inverse l = Qs/PI is negative

Inverse for substitutes m = Qs/Pr is negative

Pr Direct for complements m = Qs/Pr is positive

T Direct n = Qs/T is positive

Pe Inverse r = Qs/Pe is negative

F Direct s = Qs/F is positive

2-50
 Direct Supply Function

• The direct supply function, or simply supply, shows

how quantity supplied, Qs , is related to product price,
P, when all other variables are held constant

Qs = f(P)

2-51
 Inverse Supply Function

• Traditionally, price (P) is plotted on the vertical axis &

quantity supplied (Qs) is plotted on the horizontal axis

– The equation plotted is the inverse supply function,

P = f(Qs)

2-52
 Supply Schedule

• Supply schedule – A table showing a list of possible product

prices and the corresponding quantities supplied.

• Supply curve – A graph showing the relation between quantity

supplied and price, when all other variables influencing quantity
supplied are held constant.
 Graphing Supply Curves

• A point on a direct supply curve shows either:

– Maximum amount of a good that will be offered for

sale at a given price

– Minimum price necessary to induce producers to

voluntarily offer a particular quantity for sale

2-54
 A Supply Curve

2-55
 Graphing Supply Curves

• Change in quantity supplied

– Occurs when price changes
– Movement along supply curve

• Change in supply
– Occurs when one of the other variables, or
determinants of supply, changes
– Supply curve shifts rightward or leftward

2-56
 Shifts in Supply

2-57
 From Individual Demand to Market Demand

• So far we have been talking about what determines an

individual’s demand for a product.

• But for us to be able to say something more general about

prices in the market, we need to know about market
demand.

• Market demand is simply the horizontal sum of all the

quantities of a good or service demanded per period by all
the households buying in the market for that good or service

• A market demand curve shows the total amount of a

product that would be sold at each price if households could
buy all they wanted at that price.
 Deriving Market Demand from individual Demand
•
 From Individual Supply to Market Supply

• So far we have focused on the supply behavior of a single

producer.

• For most markets many, many suppliers bring product to

the consumer, and it is the behavior of all of those producers
together that determines supply.

• Market supply is simply the horizontal sum of all that is

supplied each period by all producers of a single product.

• Figure 3.8 (see next slide) derives a market supply curve

from the supply curves of three individual firms.
 From Individual Supply to Market Supply

•
 Position of Market Supply Curve
• The position and shape of the market supply curve depends on the
positions and shapes of the individual firms’ supply curves from which it
is derived.

• The market supply curve also depends on the number of firms that
produce in that market.

• If firms that produce for a particular market are earning high profits, other
firms may be tempted to go into that line of business.

• The popularity and profitability of professional football has, three times,

led to the formation of new leagues.

• When new firms enter an industry, the supply curve shifts to the right.

• When firms go out of business, or “exit” the market, the supply curve shifts
to the left.
 Market Equilibrium

• Equilibrium price & quantity are determined by the

intersection of demand & supply curves

– At the point of intersection of demand and supply

curve
Q d = Qs

– Consumers can purchase all they want & producers

can sell all they want at the “market-clearing” or
equilibrium price.
2-63
Market Equilibrium
 Market Equilibrium – Numerical example

– Equilibrium occurs where we have – Qd = Qs

 Market Equilibrium – Numerical example

2-66
 Market Equilibrium

• Excess demand (shortage)

– Exists when quantity demanded exceeds quantity
supplied

• Excess supply (surplus)

– Exists when quantity supplied exceeds quantity
demanded

2-67
 The Algebra of Market Equilibrium
• For simplicity, we assume that the demand and supply curves
are linear relationships between price and quantity.

• Consider the following demand and supply curves:

• We know that in equilibrium quantity demanded equals

quantity supplied, or Qd = Qs.
 The Algebra of Market Equilibrium

• But we also know that in equilibrium the price paid by the

consumers will equal the price received by the producers.

• That is, there is only one equilibrium price, which we call P*.

• Putting these two facts together we know that in equilibrium.

 The Algebra of Market Equilibrium
• We now have two equations and two unknown variables (P*
and Q*) and can proceed to solve the system of equations:

• This implies:

• Which can be solved for P* to get:

 The Algebra of Market Equilibrium
• This is the solution for the equilibrium market price.

• By substituting this value of P* back into either the demand

curve or the supply curve (it doesn’t t matter which), we get
the solution for Q*:

• Which can be simplified to be:

 The Algebra of Market Equilibrium
• Which can be further simplified to be:

• We now have the precise solutions for the equilibrium price

and quantity in this market.

• Notice that the solutions for p* and Q* naturally depend on

those (exogenous) variables that shift the demand and supply
curves.

• For example, an increase in demand for the product would be

reflected by an increase in a. This would shift the demand
curve to the right, increasing both p* and Q*.
The Algebra of Market Equilibrium
 The Algebra of Market Equilibrium
• Suppose we have the following relationships:

• Calculate equilibrium price and quantity.

Answer
 The Algebra of Market Equilibrium

Read and solve for equilibrium Q & S

2-76
 Answer

• Market equilibrium:
Demand = Supply

2-77
 Changes in Equilibrium

• Negative (adverse) supply shock (shift in supply curve)

 Changes in Equilibrium

• Negative (adverse) & Positive supply shock

Changes in Equilibrium – Shift in Demand
 Simultaneous Shifts in Demand & Supply

• When demand & supply shift simultaneously

– Can predict either the direction in which price changes or the

direction in which quantity changes, but not both

– The change in equilibrium price or quantity is said to be

indeterminate when the direction of change depends on the
relative magnitudes by which demand & supply shift
Simultaneous Shifts: (D, S)

S
S’
S’’

B
P A •
’
P •
P’’ •C
D’

Q
Q Q’ Q’’

Price may rise or fall; Quantity rises

Simultaneous Shifts: (D, S)

S
S’
S’’

A
P •
B
P
’
•
P’’ •C D

D’
Q
Q’ Q Q’’

Price falls; Quantity may rise or fall

Simultaneous Shifts: (D, S)

P
S’’
S’
S
P’’ • C

B
P
’
•
A
P •
D’

Q
Q’’ Q Q’

Price rises; Quantity may rise or fall

Simultaneous Shifts: (D, S)

S’’
S’
S

P’’ •C A
P •
P • B
’

D
D’
Q
Q’’ Q’ Q

Price may rise or fall; Quantity falls

Demand and Supply Analysis: Applications

Consumer and Producer Surplus

Measuring The Value Of Market Exchange
 Consumer Surplus
• We can now use demand and supply curves to measure the net
gain created by voluntary exchange between the buyers and
sellers in markets.

• We can show how a manager can use the demand curve to

ascertain the value a consumer or group of consumers receives
from a product.

• The concepts of Consumer and Producer surplus are

particularly useful in marketing and other disciplines that
emphasize strategies such as value pricing and price
discrimination.
 Consumer Surplus
• Typically, consumers value the goods they purchase by an
amount that exceeds the purchase price of the goods.

• For any unit of a good or service, the economic value of that

unit is simply the maximum amount some buyer is willing to
pay for the unit.

• The economic value of a specific unit of a good or service

equals the demand price for the unit, because this price is the
maximum amount any buyer is willing and able to pay for the
unit:
 Consumer Surplus
• Fortunately for consumers, they almost never have to pay the
maximum amount they are willing to pay.

• They instead must pay the market price, which is lower than the
maximum amount consumers are willing to pay (except for the
last unit sold in market equilibrium).

• The difference between the economic value of a good and the

price of the good is the net gain to the consumer, and this
difference is called consumer surplus.

• Figure 2.6 illustrates how to measure consumer surplus for the

400th unit of a good using the demand and supply curves
developed previously.
Consumer Surplus
 Consumer Surplus

CS (400 units) = area of

trapezoid uvsr

= 400 X (($80 + $40)/2)

= $24,000.

CS (800 units) = area uvA

PS (800 units) = area vwA
= $32,000 (= 0.5 X 800 X $80 )
= $16,000 (= 0.5 X 800 X $40)

PS (400 units) = area of

trapezoid vwts
= [ 400 X ($40 + $20)/2]
= $12,000
 Consumer Surplus
• The consumer surplus for the 400th unit equals $40 (= $100 -
$60), which is the difference between the demand price (or
economic value) of the 400th unit and the market price (at point
A).

• In Figure 2.6, consumer surplus of the 400th unit is the distance

between points r and s.

• To measure the total consumer surplus for all 400 units—

instead of the consumer surplus for the single 400th unit—the
vertical distance between demand and market price must be
summed for all 400 units.
 Consumer Surplus

• Total consumer surplus for 400 units is equal to the area below demand and
above market price over the output range 0 to 400 units.

• In Figure 2.6, total consumer surplus for 400 units is measured by the area
bounded by the trapezoid uvsr.

• One way to compute the area of trapezoid uvsr is to multiply the length of
its base (the distance between v and s) by the average height of its two sides
(uv and rs): 400 X (($80 + $40)/2) = $24,000.

• Of course you can also divide the trapezoid into a triangle (1/2 base X vertical
height) and a rectangle (width X height), and then you can add the two areas
to get total consumer surplus.

• Either way, the total consumer surplus when 400 units are purchased is
$24,000.
 Consumer Surplus
• Now let’s measure total consumer surplus in market equilibrium.

• At point A in Figure 2.6, 800 units are bought and sold at the market-
clearing price of $60.

• The area of the red-shaded triangle uvA in Figure 2.6 gives the total
consumer surplus in market equilibrium.

• The area of this triangle is $32,000 (5 0.5 X 800 X $80).

• Thus, $32,000 measures the net gain to all the consumers who voluntarily
buy 800 units from producers at $60 per unit.

• If the government decided for some reason to outlaw completely the

consumption of this good, and if all consumers complied with the
consumption ban, then the market would disappear, and consumers would
be $32,000 worse off by losing the opportunity to buy this good.
 Producer Surplus

• Next we consider the net gain to producers who supply

consumers with the goods and services they demand.

• Producers typically receive more than the minimum payment

necessary to induce them to supply their product.

• For each unit supplied, the difference between the market price
received and the minimum price producers would accept to
supply the unit is called producer surplus.

• In Figure 2.6, let’s consider the producer surplus for the 400th
unit supplied when market price is $60.
 Producer Surplus

• Recall from our previous discussion about inverse supply

functions that the supply price, which is $40 for the 400th unit,
gives the minimum payment required by the suppliers to
produce and sell the 400th unit.

• The producer surplus generated by the production and sale of

the 400th unit is the vertical distance between points s and t,
which is $20 (= $60 - $40).

• The total producer surplus for 400 units is the sum of the
producer surplus of each of the 400 units.

• Thus, total producer surplus for 400 units is the area below
market price and above supply over the output range 0 to 400.
 Producer Surplus
• In Figure 2.6, total producer surplus for 400 units is measured by the
area of the trapezoid vwts. By multiplying the base vs (= 400) times
the average height of the two parallel sides vw ($40) and st ($20).

• You can verify that the area of trapezoid vwts is $12,000 [= 400 X ($40
+ $20)/2].

• Now let’s measure the total producer surplus in market equilibrium.

• At point A, total producer surplus is equal to the area of the gray-

shaded triangle vwA.

• Thus, total producer surplus in equilibrium is $16,000 (= 0.5 X 800 X

$40).

• By doing business in this market, producers experience a net

gain of $16,000.
 Social Surplus

• The net gain to society as a whole from any specific level of

output can be found by adding total consumer surplus and
total producer surplus generated at that specific level of output.

• This sum is known as social surplus.

• At market equilibrium point A in Figure 2.6, social surplus

equals $48,000 (= $32,000 + $16,000).

• As you can now see, the value of social surplus in equilibrium

provides a dollar measure of the gain to society from having
voluntary exchange between buyers and sellers in this market.
 Price Restrictions And Market Equilibrium

• Shortages and surpluses can occur after a shift in demand or

supply, but as we have stressed, these shortages and
surpluses are sufficiently short in duration.

• Markets are assumed to adjust fairly rapidly, and we concern

ourselves only with the comparison of equilibriums before
and after a shift in supply or demand.

• There are, however, some types of shortages and surpluses

that market forces do not eliminate.

• These are more permanent in nature and result from

government interferences with the market mechanism.
 Price Restrictions And Market Equilibrium
• Typically these more permanent shortages and surpluses are
caused by government imposing legal restrictions on the
movement of prices.

• Shortages and surpluses can be created simply by legislating

a price below or above equilibrium.

• Governments have decided in the past, and will surely

decide in the future, that the price of a particular commodity
is “too high” or “too low” and will proceed to set a “fair
price.”

• We can use demand and supply curves to analyze the

economic effects of these two types of interference: the setting
of minimum and maximum prices.
 Price Ceiling
• Ceiling Price – The maximum price the government permits
sellers to charge for a good. When this price is below
equilibrium, a shortage occurs.

• Suppose that, for whatever reason, the government views the

equilibrium price of Pe in Figure 2–11 (next slide) as “too high”
and passes a law prohibiting firms from charging prices above
Pc. Such a price is called a price ceiling.

• Do not be confused by the fact that the price ceiling is below the
initial equilibrium price; the term ceiling refers to that price
being the highest permissible price in the market.

• It does not refer to a price set above the equilibrium price. In

fact, if a ceiling were imposed above the equilibrium price, it
would be ineffective; the equilibrium price would be below the
maximum legal price.
Price Ceiling
 Price Ceiling

• Given the regulated price of Pc, quantity demanded exceeds

quantity supplied by the distance from A to B in Figure 2–11;
there is a shortage of Qd - Qs units.

• The reason for the shortage is twofold. First, producers are

willing to produce less at the lower price, so the available
quantity is reduced from Qe to Qs.

• Second, consumers wish to purchase more at the lower price;

thus, quantity demanded increases from Qe to Qd.

• The result is that there is not enough of the good to satisfy all
consumers willing and able to purchase it at the price ceiling.
 Price Ceiling

• How, then, are the goods to be allocated now that it is no

longer legal to ration them on the basis of price?

• In most instances, goods are rationed on the basis of “first

come, first served.”

• As a consequence, price ceilings typically result in long lines

such as those created in the 1970s due to price ceilings on
gasoline.

• Thus, price ceilings discriminate against people who have a

high opportunity cost of time and do not like to wait in lines.
 Price Ceiling

• The vertical difference between the demand and supply curves

at each quantity therefore represents the change in social
welfare (consumer value less relevant production costs)
associated with each incremental unit of output.

• Summing these vertical differences for all units between Qe

and Qs yields the shaded triangle in Figure 2–11 and thus
represents the total dollar value of the lost social welfare due
to a price ceiling.

• The triangle in Figure 2–11 is sometimes called “deadweight

loss.
Price Ceiling – Application
 Price Floors

• In contrast to the case of a price ceiling, sometimes the

equilibrium competitive price may be considered too low for
sellers.

• In these instances, individuals may lobby for the government

to legislate a minimum legal price for a good. Such a price is
called a price floor.

• Floor Price – The minimum price the government permits

sellers to charge for a good. When this price is above
equilibrium, a surplus occurs.

• Perhaps the best-known price floor is the minimum wage, the

lowest legal wage that can be paid to workers, and the
minimum support price (MSP).
Price Floors
 Price Floors

• If the equilibrium price is above the price floor, the price floor
has no effect on the market.

• But if the price floor is set above the competitive equilibrium

level, such as Pf in Figure 2–12, there is an effect.

• Specifically, when the price floor is set at Pf, quantity supplied

is Qs and quantity demanded is Qd.

• In this instance, more is produced than consumers are willing

to purchase at that price, and a surplus develops.
 Price Floors

• In the context of the labor market, there are more people

looking for work than there are jobs to go around at that wage,
and unemployment results.

• In the context of a product market, the surplus translates into

unsold inventories.

• In a free market, price would fall to alleviate the

unemployment or excess inventories, but the price floor
prevents this mechanism from working.

• Buyers end up paying a higher price and purchasing fewer

units.
 Price Floors

• When price floors are above the equilibrium price, there will
be consumers with willingness to-pay that is more than
production costs but is less than the price floor.

• These consumers will be unable to purchase when the price

floor is in place, which results in a loss of social welfare.

• The dollar value of the lost social welfare is given by the blue
triangle in Figure 2–12.

• The area of the blue triangle in Figure 2–12 is deadweight loss.

 Price Floors

• Similar to the case of a price ceiling, the lost social welfare is

the vertical difference between the demand and supply curve
for all units between Qd and Qe.

• The difference is that the constraint on units purchased for a

price floor comes from constrained quantity demanded—in
response to a price floor that is higher than Pe—rather than
constrained quantity supplied—in response to a price ceiling
that is lower than Pe.
 Price Floors
• When a price floor is a minimum wage, the deadweight loss that results is
fully captured by the blue triangle in Figure 2–12.

• However, when the price floor applies to a product, the deadweight loss
can be even greater.

• How much additional deadweight loss there is depends on what happens

to the unsold inventories.

• One possibility is that the government purchases and discards the surplus.

• This is the case with price floors on many agricultural products, such as
cheese.

• This type of price floor, where the government purchases the surplus, is
called a price support.
 Price Floors
• Revisiting Figure 2–12, the quantity of unsold products is given by the
distance from G to F, and this surplus is the amount of product the
government purchases at the price floor.

• The total cost to the government then is Pf(Qs – Qd).

• If the government discards the surplus it purchases, this results in

additional deadweight loss, as indicated by the red trapezoid.

• This additional deadweight loss is the cost of producing the product that
was discarded.

• Again, if producers of cheese receiving the price support, this additional

deadweight loss is the cost of producing the cheese that the government
purchased and discarded.
Elasticity: Concept and Measurement
Elasticity of Demand and Supply and Managerial
Decision making
Price Elasticity of Demand

  ∆ 𝑄/𝑄 ∆ 𝑄 𝑃
𝐸𝑝= = X
∆𝑃/𝑃 ∆ 𝑃 𝑄
 
At Point B (from A to B)

= -5

At point F

= -1
 Price Elasticity of Demand

Q / Q Q P
Point Definition EP   
P / P P Q

P
Linear Function EP  a1 
Q
 Price Elasticity of Demand

Q2  Q1 P2  P1
Arc Definition EP  
P2  P1 Q2  Q1
Price Elasticity of Demand
 Elasticity and Total Revenue

•• Total
  Revenue (TR) = Price (P) X Quantity (Q)

TR = P.Q or (MR = )
Another Example (E, P, TR)
Another Example (E, P, TR)
Another Example (E, P, TR)
Pricing Decisions
Real world estimates of Elasticity
 Income Elasticity of Demand

Q / Q Q I
Point Definition EI   
I / I I Q

I
Linear Function EI  a3 
Q
 Income Elasticity of Demand

Q2  Q1 I 2  I1
Arc Definition EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0
Real world estimates of Income elasticity
 Cross-Price Elasticity of Demand

QX / QX QX PY
Point Definition E XY   
PY / PY PY QX

PY
Linear Function E XY  a4 
QX
 Cross-Price Elasticity of Demand

QX 2  QX 1 PY 2  PY 1
Arc Definition E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements
E XY  0 E XY  0
Real world estimates of Cross Price Elasticity
Can we ignore elasticity in pricing decisions
 Price Elasticity of Supply
• Price elasticity of supply is the measure of how responsive
quantity supplied is to price changes.

• The price elasticity of supply will tend to be positive, because

as price increases, firms tend to increase their quantity
supplied.
Price Elasticity of Supply
 Price Elasticity of Supply

Point Definition

Linear Function
 Price Elasticity of Demand

Arc Definition
Arc Price Elasticity of Supply
 Determinants of Supply Elasticity

• Some important determinants of elasticity of supply are

– Substitution (If the price of a product rises, how much more

can be produced profitably? This depends in part on how easy it is for producers to shift from the
production of other products to the one whose price has risen. If agricultural land and labor can be
readily shifted from one crop to another, the supply of each crop will be more elastic than if they
cannot ).

– Production Costs (If the costs of producing a unit of output rise rapidly as output rises, then
the stimulus to expand production in response to a rise in price will quickly be choked off by
increases in costs).

– Time – Short Run and Long Run

 Short-run and the Long-run supply curves.

• The is useful to make the distinction between the short-run and the long-
run supply curves.

• The short-run supply curve shows the immediate response of

quantity supplied to a change in price given producers’ current capacity to
produce the good.

• The long-run supply curve shows the response of quantity supplied to a

change in price after enough time has passed to allow producers’ to adjust
their productive capacity.

• The long-run supply for a product is more elastic than the short-run supply
curve.
Short-run and the Long-run supply curves.
 Application – Demand, Supply & Elasticity

• Understanding IMPACT and INCIDENCE of a tax levied by the government

• We now explore the important concept of tax incidence and show that
elasticity is crucial to determining whether consumers or producers (or
both) end up bearing the burden of excise taxes.

• Excise tax – A tax on the sale of a particular commodity.

• Tax incidence – The location of the burden of a tax that is, the identity of
the ultimate bearer of the tax
 Why should we care about elasticity? Incidence of Tax

• The Central and State governments levy special sales taxes called excise
taxes on many goods, such as cigarettes, alcohol, and gasoline.

• At the point of sale of the product, the sellers collect the tax on behalf of
the government and then periodically remit the tax collections.

• When the sellers write their cheques to the government, these firms feel
that they are the ones paying the whole tax.

• Consumers, however, argue that they are the ones who are shouldering
the burden of the tax because the tax causes the price of the product to
rise.

• Who actually bears the burden of the tax?

• The question of who bears the burden of a tax is called the question of tax
incidence.
When excise duty is levied
 When excise duty is levied… Explanation

• Let’s consider a case where the government imposes an excise tax on

cigarettes. The analysis begins in Figure 4-8.

• To simplify the problem, we analyze the case where there is initially no tax.

• The equilibrium without taxes is illustrated by the solid supply and demand
curves. What happens when a tax of $t per pack of cigarettes is
introduced?

• With an excise tax, the price paid by the consumer, called the consumer
price, and the price received by the seller, called the seller price, must
differ by the amount of the tax, t.

• In terms of the figure, we can analyze the effect of the tax by considering a
new supply curve S* that is above the original supply curve S by the
amount of the tax, t.
 When excise duty is levied… Explanation

• This reduction in supply, caused by the imposition of the excise tax, will
cause a movement along the demand curve, reducing the equilibrium
quantity.

• At this new equilibrium, E1, the consumer price rises to pc (greater than
p0), the seller price falls to ps (less than p0), and the equilibrium quantity
falls to Q1.

• Notice that the difference between the consumer price and the seller price
is exactly the amount of the excise tax.
When excise duty is levied: who will pay more?
 Who will pay more?... Explanation

• The role of the relative elasticities of supply and demand in determining the incidence
of the excise tax is illustrated in Figure 4-9.

• In part (i), demand is inelastic relative to supply; as a result, the fall in quantity is quite
small, whereas the price paid by consumers rises by almost the full extent of the tax.

• Because neither the price received by sellers nor the quantity sold changes very
much, sellers bear little of the burden of the tax.

• In part (ii), supply is inelastic relative to demand; in this case, consumers can ore
easily substitute away from cigarettes.

• There is little change in the price, and hence they bear little of the burden of the tax,
which falls mostly on suppliers.

• Notice in Figure 4-9 that the size of the upward shift in supply is the same in the two
cases, indicating the same tax in both cases.
Summary of Elasticity terms
The Theory of Consumer Behavior
 Understanding Consumer Behavior

• Understanding consumer behavior is the first step in making

profitable pricing, advertising, product design, and production
decisions.

• Firms spend a great deal of time and money trying to estimate

and forecast the demand for their products.

• Obtaining accurate estimates of demand requires more than a

superficial understanding of the underpinnings of demand
functions.

• A manager’s need for practical analysis of demand, both

estimation of demand and demand forecasting, requires an
economic model of consumer behavior to guide the analysis.
 Understanding Consumer Behaviour

• Despite the complexities of human thought processes, managers

need a model that explains how individuals behave in the
marketplace and in the work environment.

• Of course, attempts to model individual behavior cannot capture the

full range of real-world behavior.

• Life would be simpler for managers of firms if the behavior of

individuals were not so complicated.

• On the other hand, the rewards for being a manager of a firm would
be much lower.

• If you achieve an understanding of individual behavior, you will gain

a marketable skill that will help you succeed in the business world.
 Understanding Consumer Behaviour

• The consumer is assumed to be rational.

• Given his income and the market prices of the various commodities,
he plans the spending of his income so as to attain the highest
possible satisfaction or utility.

• This is the axiom of utility maximisation.

• In order to attain this objective the consumer must be able to

compare the utility (satisfaction) of the various 'baskets of goods'
which he can buy with his income.

• There are two basic approaches to the problem of comparison of

utilities, the cardinalist approach and the ordinalist approach
 Measuring Utility

•• Why do consumers demand a product?

 
• Utility is the name economists give to the benefits consumers obtain from
the goods and services they consume.

• While utility implies usefulness, many of the products most of us consume

may not be particularly useful.

• Nonetheless, we will follow tradition and refer to the benefits obtained

from goods and services as utility.

• Utility function – an equation that shows an individual’s perception of the

level of utility that would be attained from consuming each conceivable
bundle of goods:
 Measuring Utility

• The cardinalist school:

– Postulated that utility can be measured. Various suggestions have been
made for the measurement of utility.
– Others suggested the measurement of utility in subjective units, called
utils.

• The ordinalist school:

– Postulated that utility is not measurable, but is an ordinal magnitude.
– The consumer need not know in specific units the utility of various
commodities to make his choice.
– It suffices for him to be able to rank the various 'baskets of goods'
according to the satisfaction that each bundle gives him.
– The main ordinal theories are the indifference-curves approach and the
revealed preference hypothesis.
 The Cardinal Utility Theory

• Assumptions:

– Rationality

– Cardinal utility – The utility of each commodity is measurable and the most
convenient measure is money.

– Constant marginal utility of money

– Diminishing marginal utility – the utility gained from successive units of a

commodity diminishes. This is the axiom of diminishing marginal utility.
Total and Marginal Utility
Total and Marginal Utility
 Equilibrium of the consumer

•• We
  begin with the simple model of a single commodity X.
• The consumer can either buy X or retain his money income Y.

• Under these conditions the consumer is in equilibrium when the

marginal utility of X is equated to its market price (Px)·

• At equilibrium:

• If the marginal utility of X is greater than its price, the consumer can
increase his welfare by purchasing more units of X.
 Equilibrium of the consumer

•• If
  there are more commodities, the condition for the equilibrium of
the consumer is the equality of the ratios of the marginal utilities of
the individual commodities to their prices:

• The utility derived from spending an additional unit of money must

be the same for all commodities.

• If the consumer derives greater utility from any one commodity, he

can increase his welfare by spending more on that commodity and
less on the others, until the above equilibrium condition is fulfilled.
 Mathematical derivation of the equilibrium of the consumer

•• The utility function is: )

 
• If the consumer buys his expenditure is .

• Presumably the consumer seeks to maximize the difference between his

utility and his expenditure:

• The necessary condition for a maximum is that the partial derivative of the
function with respect to be equal to zero.

• Thus:

• Rearranging we obtain:
 Derivation of the demand of the consumer

•• The derivation of demand is based on the axiom of diminishing

 
marginal utility.

• The marginal utility of commodity X may be depicted by a line with a

negative slope (see next slide).

• Geometrically, the marginal utility of X is the slope of the total utility

function : )

• The total utility increases, but at a decreasing rate, up to quantity X, and

then starts declining (see next slide).

• Accordingly the marginal utility of X declines continuously, and

becomes negative beyond quantity X.
Derivation of the demand of the consumer
 Critique of the cardinal approach

• There are three basic weaknesses in the cardinalist approach.

– The assumption of cardinal utility is extremely doubtful. The

satisfaction derived from various commodities cannot be measured
objectively.

– The assumption of constant utility of money is also unrealistic. As

income increases the marginal utility of money changes. Thus money
cannot be used as a measuring-rod since its own utility changes.

– Finally, the axiom of diminishing marginal utility has been

'established' from introspection, it is a psychological law which must
be taken for granted.
The Ordinal Utility Approach: Indifference-curves theory

•• Assumptions:
 
– Rationality
– Utility is ordinal
– Diminishing marginal rate of substitution
– Consistency of choice – if in one period he chooses bundle A over B,
he will not choose B over A in another period if both bundles are
available to him.

– Transitivity of choice – if bundle A is preferred to B, and B is

preferred to C, then bundle A, is preferred to C.

– More is preferred to less (nonsatiation)

 Equilibrium of the consumer

• To define the equilibrium of the consumer (that is, his choice of the
bundle that maximizes his utility) we must introduce the following
concepts

– Indifference curves
– Slope of Indifference curves (the marginal rate of substitution),
– The budget line.
 Indifference Curves

•• Indifference
  curve – is the locus of points- particular combinations
or bundles of goods-which yield the same utility (level of
satisfaction) to the consumer, so that he is indifferent as to the
particular combination he consumes.

• Symbolically an indifference curve is given by the equation:

• Where k is a constant.
Indifference curve
Indifference Map
 Properties of the indifference curves
• An indifference curve has a negative slope.
– which denotes that if the quantity of one commodity (y) decreases, the quantity of the
other (x) must increase, if the consumer is to stay on the same level of satisfaction.

• A higher indifference curve indicates high level of utility.

– bundles of goods on a higher indifference curve are preferred by the rational consumer.

• Indifference curves do not intersect.

– If they did, the point of their intersection would imply two different levels of
satisfaction, which is impossible.

• The indifference curves are convex to the origin.

– This implies that the slope of an indifference curve decreases (in absolute terms) as we
move along the curve from the left downwards to the right: axiom of decreasing
marginal rate of substitution
 Marginal Rate of Substitution (MRS)

• MRS – A measure of the number of units of Y that must be given up

per unit of X added so as to maintain a constant level of utility.

For the movement from A to B

For the movement from C to D

 The Slope of an Indifference Curve and the MRS

• MRS – The marginal rate of substitution at a point can be closely

approximated by (the absolute value of) the slope of a line tangent
to the indifference curve at the point.

At point C, TT’, has a slope of

 The Slope of an Indifference Curve and the MRS

• MRS – The (absolute value of the) slope of the indifference curve

(at points A and C ), and hence the MRS, decreases as X increases
and Y decreases along the indifference curve.

• This results from the assumption that indifference curves are

convex.

MRS = 2

MRS = 1/2
 Total utility (TU) & Marginal Utility (MU)

•• The
  change in total utility that results when both X and Y change by
small amounts is related to the marginal utilities of X and Y:

• For points on a given indifference curve, all combinations of goods

yield the same level of utility, so is 0 for all changes in X and Y that
would keep the consumer on the same indifference curve.
 Total utility (TU) & Marginal Utility (MU)
•• Therefore,
  solving for (negative of the slope of the indifference
curve or MRS).

• Thus, the marginal rate of substitution can be interpreted as the ratio

of the marginal utility of X divided by the marginal utility of Y:
 Proof for MRS
•• The
  slope of a curve at any one point is measured by the slope of the
tangent at that point.

• The equation of a tangent is given by the total derivative or total

differential, which shows the total change of the function as all its
determinants change.

• The total utility function in the case of two commodities x and y is

• The equation of an indifference curve is

where k is a constant
 Proof for MRS
•• The
  total differential of the utility function is

• This shows the total change in utility as the quantities of both

commodities change. The total change in U caused by changes in y
and x is (approximately) equal to the change in y multiplied by its
marginal utility, plus the change in x multiplied by its marginal
utility.

• Along any particular indifference curve the total differential is by

definition equal to zero.
 Proof for MRS
•• Thus
  for any indifference curve

• Rearranging we obtain

or

• Hence, we have
 The Budget Constraint of the Consumer
•• The
  consumer has a given income which sets limits to his
maximizing behavior.

• Income acts as a constraint in the attempt for maximizing utility.

The income (M) constraint, in the case of two commodities, may be
written:

• We may present the income constraint graphically by the budget

line, whose equation is derived from the above expression, by
solving for :

• Assigning successive values to (given M, , ) we may find the

corresponding values of
The Budget Constraint of the Consumer
Changes in Income & Budget Line
Changes in Prices & Budget Line
 Budget Line – a numerical example
•• Suppose
  the consumer has a fixed income of $1,000, which is the
maximum amount that can be spent on the two goods in a given
period.

• For simplicity, assume the entire income is spent on X and Y.

• Alternatively, solving for Y in terms of X,

 
Budget Line – a numerical example
 Budget Line – a numerical example
•  
• The slope of the budget line, , indicates the amount of Y that must
be given up if one more unit of X is purchased.
Utility Maximization: Consumer Equilibrium
Marginal Utility Interpretation of Consumer Optimization

•• A
  consumer attains the highest level of utility from a given income
when the marginal rate of substitution for any two goods is equal to
the ratio of the prices of the two goods.

• Since the marginal rate of substitution is equal to the ratio of the

marginal utilities of the two goods, utility-maximization occurs
when the entire income is spent and:

• or, by rearranging this equation

 Utility Maximization: a numerical example
•• Johnson’s monthly food budget is $400, which, because she works such long
 hours, is spent only on pizzas and burgers.

• The price of a pizza is $8, and the price of a burger is $4.

• Johnson’s task is to determine the combination of pizzas and burgers that

yields the highest level of utility possible from the $400 food budget at the
given prices.

• By spending all income on Pizza (Y):

• By spending all income on Burger (X):

 Utility Maximization: a numerical example
•  
• The absolute value of the slope of the budget line is the price of
burgers divided by the price of pizzas:

• This indicates that to consume one additional $4 burger, Johnson

must give up half of an $8 pizza.

• Alternatively, 1 more pizza can be bought at a cost of 2 burgers.

Utility Maximization: a numerical example
Price Changes and Consumer Behavior
Price Changes and Consumer Behavior
 Derive a demand: individual consumer
• We can use Figure 5.9 to show how an individual consumer’s
demand curve is obtained.

• Begin with income of $1,000 and prices of good X and good Y both
equal to $10.

• The consumer maximizes utility where budget line 1 is tangent to

indifference curve I, consuming 50 units of X.

• Thus when income is $1,000, one point on this consumer’s demand

for X is $10 and 50 units of X.

• This point is illustrated on the price–quantity graph in the lower

panel of Figure 5.9 (see the next slide).
Derive a demand: individual consumer
 Substitution and Income Effects

• The total effect of a price increase thus is composed of:

– Substitution
– Income effects

• The substitution effect reflects a movement along an indifference

curve, thus isolating the effect of a relative price change on
consumption (from point A to B – see next slide).

• The income effect results from a parallel shift in the budget line;
thus, it isolates the effect of reduced “real income” on consumption
and is represented by the movement from B to C.

• The total effect of a price increase, which is what we observe in the

marketplace, is the movement from A to C.
Substitution and Income Effects
 Applications of Indifference Curve Analysis

• A very popular sales technique at pizza restaurants is to offer the

following deal:
Buy one large pizza, get one large pizza free (limit one free pizza per customer)
 Applications of Indifference Curve Analysis

• See Michael R. Baye and Jeffrey T. Prince, Managerial Economics

and Business Strategy, Ch. 4, pp. 123.
 Unit – V: Economics of Information

Uncertainty and Asymmetric Information

 Perfect Knowledge and Markets
• In our previous discussions, we assumed that consumers and firms
made choices based on perfect information.

• When consumers choose between two products, we assume that

they know the qualities of those products, and as a result their
choices reveal their true preferences.

• Similarly, when firms choose how many workers to hire or how

much capital to use, we assume that they know the productivity of
those workers or that capital.

• Of course, in many settings, perfect information seems to be a

reasonable assumption to make.
 Perfect Knowledge and Markets

• Every day you may choose whether to have cereal or fruits for
breakfast.

• Every evening you may decide what to have for dinner and whether
to go to the movies or stay home and study.

• Even for these choices, a little uncertainty can creep in; perhaps a
new cereal is on the market or a new movie has been released.

• But assuming that these choices are made with perfect information
does not seem too far a stretch
What is perfect competition (and information)?

?
 What is perfect competition (and information)?

• Pure competition (assumption)

– Large numbers of sellers and buyers
– Product homogeneity
– Free entry and exit of firms
– Profit maximization
– No government regulation

• Perfect competition
– Perfect mobility of factors of production
– Perfect knowledge
 When perfect information is not available

• How do consumers make decision when perfect information is

available?

• How do firms make decision when perfect information is available?

• What are the implications of less than perfect information?

• Is there any solutions to less than perfect information?

 Decision making with asymmetric information

• Asymmetric information is quite common, but an important,

feature of the modern market system.

• Seller of a product knows more about its quality than the buyer

– Workers usually know their own skills and abilities better than employers.

• Agent knows more about the firm and market than the Principal

– And business managers know more about their firms’ costs, competitive
positions, and investment opportunities than do the firms’ owners.
 Quality Uncertainty and the Market for Lemons

• The case:

– Suppose you bought a new car for $20,000, drove it 100 miles, and
then decided you really didn’t want it. There was nothing wrong with
the car—it performed beautifully and met all your expectations. You
simply felt that you could do just as well without it and would be
better off saving the money for other things.

– So you decide to sell the car. How much should you expect to get for
it? Probably not more than $16,000—even though the car is brand
new, has been driven only 100 miles, and has a warranty that is
transferable to a new owner.

– And if you were a prospective buyer, you probably wouldn’t pay

much more than $16,000 yourself.
 Quality Uncertainty and the Market for Lemons

• Why does the mere fact that the car is second-hand reduce its value so
much?

• To answer this question, think about your own concerns as a prospective

buyer.

• Why, you would wonder, is this car for sale?

• Did the owner really change his or her mind about the car just like that, or
is there something wrong with it?

• Is this car a “lemon”?

• Used cars sell for much less than new cars because there is asymmetric
information about their quality.
 Quality Uncertainty and the Market for Lemons

• The implications of asymmetric information about product quality

were first analyzed by George Akerlof and go far beyond the
market for used cars (George A. Akerlof (1970), The Market for "Lemons": Quality
Uncertainty and the Market Mechanism, The Quarterly Journal of Economics).

• The markets for insurance, financial credit, and even employment

are also characterized by asymmetric information about product
quality.

• To understand the implications of asymmetric information, we will

start with the market for used cars and then see how the same
principles apply to other markets
 The Market for Used Cars

• Suppose two kinds of used cars are available—high-quality cars and low-
quality cars.
• Also suppose that both sellers and buyers can tell which kind of car is
which.
• There will then be two markets, as illustrated in Figure:
 Asymmetric Information

• Asymmetric information – in a market with asymmetric information,

the information available to sellers and buyers differs.

• Asymmetry information may be either due to hidden characteristics or

hidden actions:

– Hidden Characteristics: this exists when one party in a transaction

observes characteristics of the goods or service that the other doesn’t
observe.

– Hidden Actions: occur when one side takes actions that are relevant for, but
not observed by, the other party.

• If the information gaps are large enough, it is possible in theory for a

market to completely shutdown or market failure even if everyone could
benefit from trade.
 Implications of Asymmetric Information

• Presence of asymmetric information leads to:

– Adverse selection
– Moral hazard

• In cases with hidden characteristics, agents can use their private

information to decide whether to participate in a transaction or a
market, causing adverse selection

• In cases with hidden actions, an agent can take an action that

adversely affects another agent, causing moral hazard.
 Implications of Asymmetric Information

• The used car scenario is a simplified illustration of an important

problem that affects many markets – the problem of adverse
selection.

• Adverse selection arises when products of different qualities are

sold at a single price because buyers or sellers are not sufficiently
informed to determine the true quality at the time of purchase.

• As a result, too much of the low-quality product and too little of

the high-quality product are sold in the marketplace.
 Examples of Adverse Selection

• The market for insurance

• Why do people over age 65 have difficulty buying medical

insurance at almost any price?

• Older people do have a much higher risk of serious illness, but

why doesn’t the price of insurance rise to reflect that higher risk?

• The reason is asymmetric information.

 Solution for Adverse Selection in insurance

• One solution to the problem of adverse selection is to pool risks.

• By providing insurance for all people over age 65, the government
eliminates the problem of adverse selection.

• Likewise, insurance companies will try to avoid or at least reduce

the adverse selection problem by offering group health insurance
policies at places of employment.

• By covering all workers in a firm the insurance firm reduces the

likelihood that large numbers of high-risk individuals will
purchase
insurance.
 Examples of Adverse Selection

• The Banking sector

– The Market for Credit
– The Market for Credit Card

• Credit card companies earn money by charging interest on the debit

balance.

• But how can a bank distinguish high-quality borrowers (who pay their
debts) from low-quality borrowers (who don’t)?

• Clearly, borrowers have better information—i.e., they know more about

whether they will pay than the lender does.

• Again, the lemons problem arises.

 Solution to Adverse Selection in Credit Market

• Computerized credit histories, which they often share with one

another, to distinguish low-quality from high-quality borrowers.

• CIBIL Score – Credit Information Bureau (India) Limited)

Solution to Adverse Selection in Credit Market
 Solution to Adverse Selection in Credit Market

• Credit histories perform an important function:

– They eliminate, or at least greatly reduce, the problem of

asymmetric information and adverse selection.

– That might otherwise prevent credit markets from operating.

• Without these histories, even the creditworthy borrower would find

it extremely costly to borrow money
 Other Examples of Asymmetric Information

• Asymmetric information is also present in many other markets.

Here are just a few examples:

– Retail stores: Will the store repair or allow you to return a defective product?
The store knows more about its policy than you do.

– Dealers of rare stamps, coins, books, and paintings: Are the items real or
counterfeit? The dealer knows much more about their authenticity than you
do.

– Roofers, plumbers, and electricians: When a roofer repairs or renovates the

roof of your house, do you climb up to check the quality of the work?

– Restaurants: How often do you go into the kitchen to check if the chef is
using fresh ingredients and obeying health laws?
 Asymmetric information and Market Failure

• In all the cases (previous slide), the seller knows much more about
the quality of the product than the buyer does.

• Unless sellers can provide information about quality to buyers, low-

quality goods and services will drive out high-quality ones, and
there will be market failure.

• Sellers of high-quality goods and services, therefore, have a big

incentive to convince consumers that their quality is indeed
high.
 Solutions to Asymmetric information

• When the seller knows much more about the quality of the product
than the buyers does – the following channels of market signaling
help solve the asymmetric information problem:

– Reputation

– Standardization
 Solutions to Asymmetric information

• Market signaling: Process by which sellers send signals to buyers

conveying information about product quality.

– Labor market and Job Market Signaling

– Markets for such durable goods – Guarantees and Warranties

Market signaling
 Moral Hazard and Importance of Incentives
• Moral Hazard occurs – when a party whose actions are unobserved
can affect the probability or magnitude of a payment associated
with an event.

• Absence of proper monitoring after a transaction between two

parties leads to the possibility of moral hazard.

– Insurance: car and housing

– Health insurance: doctor visit
– Job shirking
 The Principal – Agent problem

• If monitoring the productivity of workers were costless, the owners

of a business would ensure that their managers and workers were
working effectively.

• In most firms, however, owners can’t monitor everything that

employees do—employees are better informed than owners.

• This information asymmetry creates a principal–agent problem.

 The Principal – Agent problem

• An agency relationship exists whenever there is an arrangement in

which one person’s welfare depends on what another person does.

• The agent is the person who acts, and the principal is the party
whom the action affects.

• A principal– agent problem arises when agents pursue their own

goals rather than the goals of the principal.
 Asymmetric Information in Labor Markets: Efficiency Wage
Theory

• When the labor market is competitive, all who wish to work will find
jobs for wages equal to their marginal products.

• Yet most countries have substantial unemployment even though many

people are aggressively seeking work.

• Many of the unemployed would presumably work for an even lower

wage rate than that being received by employed people.

• Why don’t we see firms cutting wage rates, increasing employment

levels, and thereby increasing profit?

• Can our models of competitive equilibrium explain persistent

unemployment?
Unemployment In A Shirking Model
Efficiency wage in practice
 Readings for Asymmetric Information

• Chapter 17, Microeconomics, Robert Pindyck and Daniel

Rubinfeld, 8th Edition, pp. 623-656
Thank You… upto here
Theory of Production
 The Organization of Production

• Inputs
– Land, Labor, Capital and Entrepreneur

• Types of Inputs:
• Fixed Inputs
• Variable Inputs

• Time Duration in Production analysis:

– Short Run (At least one input is fixed)
– Long Run (All inputs are variable)
Production Function with One Variable Input

Total Product TP = Q = f(L)

TP
Marginal Product MPL = L
TP
Average Product APL = L
Law of Diminishing Returns & Stages of Production

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Slide 247

 Law of Diminishing Returns & Stages of Production

• A diminishing marginal product of labor (as well as a diminishing marginal product

of other inputs) holds for most production processes.

• The law of diminishing marginal returns states that as the use of an input increases
in equal increments (with other inputs fixed), a point will eventually be reached at
which the resulting additions to output decrease.

• When the labor input is small (and capital is fixed), extra labor adds considerably to
output, often because workers are allowed to devote themselves to specialized tasks.

• Eventually, however, the law of diminishing marginal returns applies: When there
are too many workers, some workers become ineffective and the marginal product
of labor falls.

• The law of diminishing marginal returns usually applies to the short run when at
least one input is fixed. However, it can also apply to the long run.
 Optimal Use of Variable Input
• Now the question arises, if we identified that a rational firm will operate only in
Stage – II of production, then how much labour (the variable input in our
example) should the firm used to maximize profits?

• The answer is – the firm should employ an additional unit of labour as long as
the extra revenue generated (MPR) from the sale of the output produced
exceeds the extra cost of hiring the unit of labour (MRC).

• Or where:

Marginal Revenue Product (MRP) = Marginal Resource Cost

(MRC)
Marginal Revenue Product & Marginal Resource Cost of Labour

1 2 3 4=2x3 5
Units of Labour Marginal Product Marginal Revenue Marginal Revenue Marginal Resource
(MP) =P Product Cost = w
2.5 4 Rs. 100 Rs. 400 Rs. 200
3.0 3 100 300 200
3.5 2 100 200 200
4.0 1 100 100 200
4.5 0 100 1 200
Marginal Revenue Product & Marginal Resource Cost of Labour
• The firm should hire 3.5 units of labour because that is where MRP of labour is
equal to MRC of labour = 200.
 Production with Two Variable Inputs

• To derive the equilibrium of firm using two variable inputs we need to

understand to importance concepts:
– Isoquants
– Isocost lines

• An isoquant is a curve that shows all the possible combinations of

inputs that yield the same output.

• A higher isoquant refers to a larger output, while a lower isoquant

refers to lower or smaller output.

• Isoquants can be derived from the table given in the next slide..
Isoquants when inputs are perfect substitutes
Isoquants when inputs are complementary
 Substitution among Inputs

• With two inputs that can be varied, a manager will want to consider substituting
one input for another.

• The slope of each isoquant indicates how the quantity of one input can be traded
off against the quantity of the other, while output is held constant.

• When the negative sign is removed, we call the slope the marginal rate of
technical substitution (MRTS).

• The marginal rate of technical substitution of labor for capital is the amount by
which the input of capital can be reduced when one extra unit of labor is used, so
that output remains constant.

• Like the MRS (Marginal Rate of substitution, slope of IC) , the MRTS is always
measured as a positive quantity:
 Marginal rate of technical substitution (MRTS)

• Marginal rate of technical substitution (MRTS) =

• Like indifference curves, isoquants are down-ward sloping and convex.

• The slope of the isoquant at any point measures the marginal rate of
technical substitution—the ability of the firm to replace capital with labor
while maintaining the same level of output.

• On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to 1/3.

 Marginal rate of technical substitution (MRTS)

• On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to 1/3.

Production with Two Variable Inputs

Marginal Rate of Technical Substitution

MRTS = -K/L = MPL/MPK

 Slope of Isoquants
• Derivation of the MRTS
 Ridge Lines: Economic Region of Production
• The Ridge Lines separate the relevant (i.e. negatively sloped) from the
irrelevant (or positively) portions of the isoquants.
 Optimal Combination of Inputs

Isocost lines represent all combinations of two inputs that a firm can
purchase with the same total cost.

C  wL  rK C  Total Cost
w  Wage Rate of Labor ( L)
C w
K  L r  Cost of Capital ( K )
r r
Optimal Input combination
 Returns to Scale

Production Function Q = f(L, K)

Q = f(hL, hK)

If  = h, then f has constant returns to scale.

If  > h, then f has increasing returns to scale.
If  < h, then f has decreasing returns to scale.
 Empirical Production Functions

Cobb-Douglas Production Function

Q = AKaLb

Estimated Using Logarithmic Transformation

ln Q = ln A + a ln K + b ln L
 Innovations and Global Competitiveness

• Product Innovation
• Process Innovation
• Product Cycle Model
• Just-In-Time Production System
• Competitive Benchmarking
• Computer-Aided Design (CAD)
• Computer-Aided Manufacturing (CAM)
Cost of Production & Estimation of Cost
Function
 Measuring Cost: Which Costs Matter?
• Accounting Cost – Actual expenses plus depreciation charges for capital
equipment.

• Economic Cost – Cost to a firm of utilizing economic resources in

production.

• Opportunity Cost – Cost associated with opportunities forgone when a

firm’s resources are not put to their best alternative use.

• Consider a firm that owns a building and therefore pays no rent for
office space. Does this mean the cost of office space is zero? The firm’s
managers and accountant might say yes, but an economist would
disagree.

Economic cost = Opportunity cost

 Measuring Cost: Which Costs Matter?
• Sunk Cost – Expenditure that has been made and cannot be recovered.

• A sunk cost is usually visible, but after it has been incurred it should
always be ignored when making future economic decisions.

• Because a sunk cost cannot be recovered, it should not influence the

firm’s decisions.

• Suppose the equipment can be used to do only what it was originally

designed for and cannot be converted for alternative use. The
expenditure on this equipment is a sunk cost. Because it has no
alternative use, its opportunity cost is zero.

• Thus it should not be included as part of the firm’s economic costs. The
decision to buy this equipment may have been good or bad. It doesn’t
matter. It’s water under the bridge and shouldn’t affect current decisions.
 Measuring Cost: Which Costs Matter?

• Total Cost (TC & C) – Total economic cost of production, consisting of

fixed and variable costs.

• Fixed Costs – Cost that does not vary with the level of output and that
can be eliminated only by shutting down.

• Variable Costs – Cost that varies as output varies.

 Measuring Cost: Which Costs Matter?
• Incremental Cost – is a broader concept and refers to the change in the
total cost from implementing a particular management decision (such as
the introduction of a new product line, the undertaking of a new advertising
campaign, or the production of a previously purchased component).

• Marginal and Average Cost – Increase in cost resulting from the

production of one extra unit of output. Marginal cost tells us how much
it will cost to expand output by one unit.

• Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.

• We can therefore write marginal cost as:

 Measuring Cost: Which Costs Matter?
• Average Total Cost – Firm’s total cost divided by its level of output.

• Average Fixed Cost – Fixed cost divided by the level of output.

• Average Variable Cost – Variable cost divided by the level of output.

Measuring Cost
Costs in the Short-run
The Shapes of the Cost Curves
 The Shapes of the Cost Curves

• Observe in Figure 7.1 (a) that fixed cost FC does not vary with output—
it is shown as a horizontal line at $50.

• Variable cost VC is zero when output is zero and then increases

continuously as output increases.

• The total cost curve TC is determined by vertically adding the fixed cost
curve to the variable cost curve.

• Because fixed cost is constant, the vertical distance between the two
curves is always $50.
 The Shapes of the Cost Curves
• Figure 7.1 (b) shows the corresponding set of marginal and average variable
cost curves.

• Because total fixed cost is $50, the average fixed cost curve AFC falls
continuously from $50 when output is 1, toward zero for large output.

• The shapes of the remaining curves are determined by the relationship

between the marginal and average cost curves.

• Whenever marginal cost lies below average cost, the average cost curve
falls.

• Whenever marginal cost lies above average cost, the average cost curve
rises.

• When average cost is at a minimum, marginal cost equals average cost.

 The Shapes of the Cost Curves: Second Example

1 2 3 4 5 6 7 8

Output Total Fixed Total Variable Total Cost Average Fixed Average Average Marginal
Cost Cost Cost Variable Cost Total Cost Cost
0 6000 0 6000 - - - -

1 6000 2000 8000 6000 2000 8000 2000

2 6000 3000 9000 3000 1500 4500 1000

3 6000 4500 10500 2000 1500 3500 1500

4 6000 8000 14000 1500 2000 3500 3500

5 6000 13500 19500 1200 2700 3900 5500

 AVC Curves are ‘U’ shaped – why?
• We can explain the ‘U’ shape of AVC as follows – with labour as only variable
input, TVC for any output level (Q) equal the wage rate (w, which is assumed to
be fixed) times the quantity of labor (L) used. Thus

• Since the average physical product of labour (AP or Q/L) usually rises first,
reaches a maximum, and then falls, it follows that the AVC curve first falls,
reaches a minimum, and then rises.

• Since AVC is U-shaped, the ATC curve is also U-shaped. The ATC curve
continues to fall after the AVC begins to rise as long as the decline in the AFC
exceeds the rise in AVC.
 MC Curves are ‘U’ shaped – why?
• The ‘U’ shape of MC can similarly be explained as follows:

• Since the marginal product of labour first rises, reaches a maximum, and then
falls, it follows that the MC curve first falls, reaches a minimum, and then rises.

• Thus, the rising portion of the MC curve reflects the operation of the law of
diminishing returns.
 Long-run cost curves

• Long-run total cost (LTC): The firms LTC is derived from the firm’s expansion
path and shows the minimum long-run total costs of producing various levels of
output.

• The firm’s long-run average (LAC = LTC/Q) and marginal cost (LMC =
d(LTC)/d(Q) curves are then derived from the long-run total cost curve.
 Long-run average and marginal cost curves
• Long-run Average cost (LAC) curves shows the lowest average cost of
producing each level of the output when the firm can build most appropriate
plant to produce each level of output.

• The figure in next slide (Fig-8.4) is based on the assumption that the firm can
build only four scales of plant (given SAC1, SAC2, SAC3 & SAC4).

• While the bottom panel of the figure is based on the assumption that the firm
can build many more or an infinite number of scales of plant.

• The top panel suggests that the minimum average cost of producing 1 unit of
output (1Q) is Rs. 80.00 and results when the firm operates the scale of plant
given by SAC1(the smallest scale of plant possible) at point A’’.
Long-run average and marginal cost curves
Long-run average and marginal cost curves
Long-run average and marginal cost curves
 Average Cost of Unit Q = C = aQb
Estimation Form: log C = log a + b Log Q
Cost-Volume-Profit Analysis and Operating Leverage
Cost-Volume-Profit Analysis
Total Revenue = TR = (P)(Q)

Total Cost = TC = TFC + (AVC)(Q)

Breakeven Volume TR = TC

(P)(Q) = TFC + (AVC)(Q)

QBE = TFC/(P - AVC)

Operating Leverage
 Operating Leverage

Operating Leverage = TFC/TVC

Degree of Operating Leverage = DOL

% Q( P  AVC )
DOL  
%Q Q( P  AVC )  TFC
Empirical Estimation of Cost Functions
 Empirical Estimation
Functional Form for Short-Run Cost Functions

Theoretical Form Linear Approximation

TVC  aQ  bQ 2  cQ 3 TVC  a  bQ

TVC a
AVC   a  bQ  cQ 2
AVC   b
Q Q

MC  a  2bQ  3cQ 2 MC  b
Empirical Estimation of Cost Functions
Market Structure and Pricing Practices
 Market Structure

Less Competitive
Perfect Competition
Monopolistic Competition
More Competitive

Oligopoly
Monopoly
 Perfect Competition

• Large numbers of buyers and sellers

• Product is homogeneous
• Free Entry and Exit from the market
• Perfect mobility of resources
• Economic agents have perfect knowledge

• Example: Stock Market, Agriculture – Wheat and Rice

 Monopolistic Competition

• Many sellers and buyers

• Differentiated product
• Perfect mobility of resources
• Example: Fast-food outlets
 Oligopoly

• Few sellers and many buyers

• Product may be homogeneous or differentiated
• Barriers to resource mobility

• Example: Automobile manufacturers

 Monopoly

• Single seller and many buyers

• No close substitutes for product
• Significant barriers to resource mobility
– Control of an essential input
– Patents or copyrights
– Economies of scale: Natural monopoly
– Government franchise: Post office
Equilibrium of firm in Perfect Competition
Perfect Competition: Price Determination

QD  625  5 P QD  QS QS  175  5 P
625  5 P  175  5 P
450  10P
P  $45
QD  625  5 P  625  5(45)  400
QS  175  5 P  175  5(45)  400
Perfect Competition: Short-Run Equilibrium

Firm’s Demand Curve = Market Price = Marginal Revenue

Firm’s Supply Curve = Marginal Cost

where Marginal Cost > Average Variable Cost
Perfect Competition: Long-Run Equilibrium

Quantity is set by the firm so that short-run:

Price = Marginal Cost = Average Total Cost

At the same quantity, long-run:

Price = Marginal Cost = Average Cost

Economic Profit = 0
 Monopoly

• Single seller that produces a product with

no close substitutes

• Sources of Monopoly
– Control of an essential input to a product
– Patents or copyrights
– Economies of scale: Natural monopoly
– Government franchise: Post office
 Monopoly: Short-Run Equilibrium
• Demand curve for the firm is the market
demand curve

• Firm produces a quantity (Q*) where

marginal revenue (MR) is equal to marginal
cost (MR)

• Exception: Q* = 0 if average variable cost

(AVC) is above the demand curve at all
levels of output
Short-run equilibrium of a Monopolist firm
Long run equilibrium of Monopolist
Social cost of a Monopoly system
 Monopolistic competition

• Many sellers of differentiated (similar but not identical)

products

• Limited monopoly power

• Downward-sloping demand curve

• Increase in market share by competitors causes decrease

in demand for the firm’s product
Monopolistic Competition: Short-Run equilibrium
Monopolistic Competition: Short-Run equilibrium
 Oligopolistic Competition

Some characteristics

• Few sellers of a product

• Non-price competition
• Barriers to entry

Types of Oligopoly

• Duopoly: Two sellers

• Pure oligopoly: Homogeneous product
• Differentiated oligopoly: Differentiated product
 Sources of Oligopoly

• Economies of scale
• Large capital investment required
• Patented production processes
• Brand loyalty
• Control of a raw material or resource
• Government franchise
• Limit pricing
 Measures of Oligopoly

• Concentration Ratios
– 4, 8, or 12 largest firms in an industry

• Herfindahl Index (H)

– H = Sum of the squared market shares of all firms in an
industry

• Theory of Contestable Markets

– If entry is absolutely free and exit is entirely costless
then firms will operate as if they are perfectly
competitive
Measures of Oligopoly
 Price Rigidity: Kinked Demand Curve Model

• Proposed by Paul Sweezy

• If an oligopolist raises price, other firms will not follow, so

demand will be elastic

• If an oligopolist lowers price, other firms will follow, so

demand will be inelastic

• Implication is that demand curve will be kinked, MR will

have a discontinuity, and oligopolists will not change
price when marginal cost changes
Price Rigidity: Kinked Demand Curve Model
 Cartels

• Collusion
– Cooperation among firms to restrict competition in order to
increase profits

• Market-Sharing Cartel
– Collusion to divide up markets

• Centralized Cartel
– Formal agreement among member firms to set a monopoly
price and restrict output
– Incentive to cheat
Centralized Cartels: Price and Quantity fixation
 Price Leadership

• Implicit Collusion

• Price Leader (Barometric Firm)

– Largest, dominant, or lowest cost firm in the industry
– Demand curve is defined as the market demand curve less
supply by the followers

• Followers
– Take market price as given and behave as perfect competitors
Price Leadership: Dominant firm
 Profitability and efficiency implications of oligopoly
Porter’s strategic framework

• Michael Porter developed the conceptual framework for identifying the

05 structural determinants of the intensity of competition and of the
profitability of firms in oligopoly industries.

• These 05 forces represents the strategic challenges facing firm managers

as they seek to maximize profits in oligopolistic markets.

• The firm will tend to earn higher than average industry profits if:

– It does not face much of a threat from substitute products and from entry of potential
competitors
– Buyers and suppliers do not exert much market power over the firm
– There is low intensity of rivalry and competition among existing firms.
Porter’s competitive framework
 Profitability and efficiency implications of oligopoly
Porter’s strategic framework

• The greater the differentiation and uniqueness of the product the firm
sells and the greater the brand loyalty of consumers for the firm’s
product, the higher is the mark-up that the firm can apply and the greater
are the profits.

• Example:
– There are few and imperfect substitute for Microsoft’s Windows Operating System
and this allows a high profit for the incumbent.
– limited threat of new entry into the field because of high cost of doing so.
– There are barriers that Microsoft raised by preinstalling Windows in all new
computers sold
– Similarly, airlines increase the cost of switching to other airlines for regular
passengers by establishing frequent-flier programmes.
 Sales Maximization Model

• The argument that objective of the firm is to maximize profit or the value
of the firm has been criticized as being much narrow and unrealistic and
broader theories have been proposed.

• William Baumol proposed the sales maximization model – which

postulates that managers of modern corporations seek to maximize sales
after an adequate rate of return has been earned to satisfy stockholders.

• Some early empirical studies found that a strong correlation existed

between executives’ salaries and sales, but not between sales and profits.

• But more recent studies found the opposite.

Sales Maximization Model
 Global Oligopolists

• Impetus toward globalization

– Advances in telecommunications and transportation

– Globalization of tastes
– Reduction of barriers to international trade
Pricing with Market Power
 Pricing with market power

• Many industries have only a few producers, so that each

producer has some monopoly power.

• And many firms, as buyers of raw materials, labor, or

specialized capital goods, have some monopsony power in
the markets for these factor inputs.

• The problem faced by the managers of these firms is how to

use their market power most effectively.

• They must decide how to set prices, choose quantities of

factor inputs, and determine output in both the short and
long run to maximize profit.
 Pricing with market power
• Managers of firms with market power have a harder job than those who
manage perfectly competitive firms (price taker and can supply any
quantity).

• The managers of a firm with monopoly power must also worry about
the characteristics of demand.

• Even if they set a single price for the firm’s output, they must obtain at
least a rough estimate of the elasticity of demand to determine what that
price should be.

• Furthermore, firms can often do much better by using a more

complicated pricing strategy—for example, charging different prices to
different customers.

• To design such pricing strategies, managers need ingenuity and even

more information about demand.
 Pricing methods and consumer surplus

• All the pricing strategies that we will examine have one thing in
common:

– They are means of capturing consumer surplus and transferring it to the

producer.

• Given the diagram (11.1) (in after the next) slide:

– Suppose the firm sold all its output at a single price.

– To maximize profit, it would pick a price P* and corresponding output

Q* at the intersection of its marginal cost and marginal revenue curves.

– Although the firm would then be profitable, its managers might still
wonder if they could make it even more profitable.
 Pricing methods and consumer surplus
• How can the firm capture the consumer surplus (or at least part of it) from its
customers in region A, and perhaps also sell profitably to some of its potential
customers in region B?

• Charging a single price clearly will not do the trick.

• However, the firm might charge different prices to different customers,

according to where the customers are along the demand curve.

• For example, some customers in the upper end of region A would be charged the
higher price P1, some in region B would be charged the lower price P2, and some
in between would be charged P*.

• This is the basis of price discrimination: charging different prices to different

customers.

• The problem, of course, is to identify the different customers, and to get them to
pay different prices.
Capturing consumer Surplus
 Price discrimination

Price Discrimination

Charging different prices for a product when the price differences

are not justified by cost differences.

Why?

Objective of the firm is to attain higher profits than would be

available otherwise.
 Necessary condition: Price discrimination

1. Firm must be an imperfect competitor (a price maker)

2. Price elasticity must differ for units of the product sold at

different prices

3. Firm must be able to segment the market and prevent resale of

units across market segments
 1st Degree Price Discrimination

• Each unit is sold at the highest possible price

• Firm extracts all of the consumers’ surplus

• Firm maximizes total revenue and profit from any quantity

sold
 2nd Degree Price Discrimination

• Charging a uniform price per unit for a specific quantity, a

lower price per unit for an additional quantity, and so on

• Firm extracts part, but not all, of the consumers’ surplus

First- and Second-Degree Price Discrimination

In the absence of price discrimination, a firm that

charges $2 and sells 40 units will have total
revenue equal to $80.
First- and Second-Degree Price Discrimination

In the absence of price discrimination, a firm that

charges $2 and sells 40 units will have total
revenue equal to $80.
Consumers will have consumers’ surplus equal to
$80.
First- and Second-Degree Price Discrimination

If a firm that practices first-degree price

discrimination charges $2 and sells 40 units, then
total revenue will be equal to $160 and
consumers’ surplus will be zero.
First- and Second-Degree Price Discrimination

If a firm that practices second-degree price

discrimination charges $4 per unit for the first 20
units and $2 per unit for the next 20 units, then
total revenue will be equal to $120 and
consumers’ surplus will be $40.
 Third-Degree Price Discrimination

• Charging different prices for the same product sold in different

markets

• Firm maximizes profits by selling a quantity on each market such

that the marginal revenue on each market is equal to the marginal
cost of production

• Necessary Conditions for 3rd degree price discrimination:

– The firm must have some monopoly power (i.e. control over price)
– Price elasticity of demand must be different in different markets
– The markets must be separable.
3rd Degree Price Discrimination
 3rd Degree Price Discrimination

• This refers to charging of different prices for the same product in

different markets until the marginal revenue of the last unit of the
product sold in each market equals the marginal cost of producing
the product.

• This rule to maximize profit will then involve – selling the

product at a higher price in the market with the less elastic
demand than in the market with the more elastic demand.
 International Price Discrimination

• Price discrimination can also be practiced between the domestic

and foreign markets – which is called international price
discrimination or Dumping

• Dumping – refers to the charging of a lower price abroad than at

home for the same commodity because of the greater price
elasticity of demand in the foreign market (because of
international competition).

• By so doing, the monopolist earns higher profit by selling the best

level of output at the same price in both markets.
 International Price Discrimination
• Besides dumping resulting from international price discrimination
(often referred to as persistent dumping), there are two other forms of
dumping:

– Predatory Dumping
– Sporadic Dumping

• Predatory Dumping – is the temporary sale of a commodity at below

cost or at a lower price abroad in order to drive foreign producers out of
business, after which prices are raised abroad in order to take advantage
of the newly acquired monopoly power.

• Sporadic Dumping – is the occasional sale of the commodity at below

cost or at a lower price abroad than domestically in order to unload an
unforeseen and temporary surplus of a commodity without having to
reduce domestic prices.
 Intertemporal and Peak-load Pricing

• Two other closely related forms of price discrimination are

important and widely practiced.

• The first of these is intertemporal price discrimination:

separating consumers with different demand functions into
different groups by charging different prices at different points
in time.

• The second is peak-load pricing: charging higher prices during

peak periods when capacity constraints cause marginal costs
to be high.

• Both of these strategies involve charging different prices at

different times, but the reasons for doing so are somewhat
different in each case.
Intertemporal Price discrimination
 Intertemporal price discrimination
• The objective of intertemporal price discrimination is to divide consumers into high-
demand and low-demand groups by charging a price that is high at first but falls later.

• To see how this strategy works, think about how an electronics company might price
new, technologically advanced equipment, such as high-performance digital cameras
or LCD television monitors.

• In Figure 11.7, D1 is the (inelastic) demand curve for a small group of consumers who
value the product highly and do not want to wait to buy it (e.g., photography buffs
who want the latest camera).

• D2 is the demand curve for the broader group of consumers who are more willing to
forgo the product if the price is too high.

• The strategy, then, is to offer the product initially at the high price P1, selling mostly
to consumers on demand curve D1.

• Later, after this first group of consumers has bought the product, the price is lowered
to P2, and sales are made to the larger group of consumers on demand curve D2
 Peak-load Pricing

• Peak-load pricing also involves charging different prices at different

points in time.

• Rather than capturing consumer surplus, however, the objective is to

increase economic efficiency by charging consumers prices that are close
to marginal cost.

• For some goods and services, demand peaks at particular times—for

roads and tunnels during commuter rush hours, for electricity during
late summer afternoons, and for ski resorts and amusement parks on
weekends.

• Marginal cost is also high during these peak periods because of capacity
constraints.

• Prices should thus be higher during peak periods.

Peak-Load Pricing
 Peak-load Pricing
• This is illustrated in Figure 11.8, where D1 is the demand curve for the peak period and
D2 the demand curve for the nonpeak period.

• The firm sets marginal revenue equal to marginal cost for each period, obtaining the
high price P1for the peak period and the lower price P2 for the nonpeak period, selling
corresponding quantities Q1and Q2.

• This strategy increases the firm’s profit above what it would be if it charged one price
for all periods.

• It is also more efficient: The sum of producer and consumer surplus is greater because
prices are closer to marginal cost.

• The efficiency gain from peak-load pricing is important. If the firm were a regulated
monopolist (e.g., an electric utility), the regulatory agency should set the prices P1 and
P2 at the points where the demand curves, D1 and D2, intersect the marginal cost
curve, rather than where the marginal revenue curves inter-sect marginal cost.

• In that case, consumers realize the entire efficiency gain.

 Two-Part Tariff: Single Consumer
• The two-part tariff is related to price discrimination and provides another
means of extracting consumer surplus:

– It requires consumers to pay a fee up front for the right to buy a product.
Consumers then pay an additional fee for each unit of the product they wish to
consume.

• The classic example of this strategy is an amusement park.

– You pay an admission fee to enter, and you also pay a certain amount for each
ride.

• The owner of the park must decide whether to charge a high entrance fee
and a low price for the rides or, alternatively, to admit people for free but
charge high prices for the rides.

– The two-part tariff has been applied in many settings: tennis and golf clubs (you
pay an annual membership fee plus a fee for each use of a court or round of golf)
– the rental of large mainframe computers (a flat monthly fee plus a fee for each
unit of processing time consumed);
 Transfer Pricing
• The rapid rise of modern large-scale enterprises has been accompanied by
decentralization and the establishment of semiautonomous profit centers.

• Decentralization and the creation of semiautonomous profit centers

within firms gave rise to the need for transfer pricing.

• Transfer Pricing – Pricing of intermediate products (or transfers) sold by

one division of a firm and purchased by another division of the same firm

• Example – If a steel company owned its own coal mine, the questions
would arise as to how much coal the coal mine should sell to the parent
company and how much to the outsiders, and at what prices.

– Similarly, the parent steel company must also determine how much
coal to purchase from its own coal mine and how much from the
outsiders, and at what prices.
 Transfer Pricing
• These are some of the most complex and troublesome questions
that arise in the operation of large-scale enterprises today.

• Optimal transfer pricing is of crucial importance to the efficient

operation of the individual division of the enterprise as well as to
the enterprise as a whole. This is mainly because:

– It affects the pricing and profitability of divisions and enterprise as a whole

– It affects and morale of managers and workers by affecting bonuses and
stability of job.

• We will examine how the appropriate transfer prices are

determined in cases where:

– An external market for the transfer or intermediate product does not exist.
– When it exist and is perfectly competitive
– When it exist and is imperfectly competitive
Transfer Pricing (with no external market)
Transfer Pricing (with perfectly competitive market)
Transfer Pricing (with imperfectly competitive market)
 Pricing in Practice Cost-Plus Pricing

• Cost Plus/Markup or Full-Cost Pricing

• Fully Allocated Average Cost (C)

– Average variable cost at normal output
– Allocated overhead

• Markup on Cost (m) = (P - C)/C

• Price = P = C (1 + m)
Pricing in Practice Optimal Markup

 1 
MR  P  1  
 EP 

 EP 
P  MR 
 E  1 
 p 

MR  C

 EP 
P C
 E  1 
 p 
Pricing in Practice Optimal Markup

 EP 
P C
 E  1 
 p 

P  C (1  m)

 EP 
C (1  m)  C 
 E  1 
 p 

EP
m 1
EP  1
 Incremental Analysis in Pricing

• Correct pricing and output decisions require incremental analysis.

• That is, as firm should change the price of a product or its output;
introduce a new product, or a new version of a given product,
accept a new order, and so on.

• A firm should take an action if the incremental increase in revenue

from the action exceeds the incremental increase in cost from the
action.
 Pricing in Practice

• Tying
• Bundling
• Prestige Pricing
• Price Lining
• Skimming
• Value Pricing
• Price Matching