MANAGERIAL

ECONOMICS
MEC605
15 APRIL 2017

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 MANAGERIAL ECONOMICS is the analysis of major management decision
using tools of economics.

DECISION MAKING
Lies at the heart of most important business and government. It is a process
of selecting one action from alternative courses of action.

6 steps in decision making:

Defining the problems
Determining the objectives
Exploring the alternatives
Predicting the consequences
Making a choice
Performing sensitivity analysis 2
BASIC ECONOMIC ANALYSIS that are being used in the decision making
process:
The Theory of the firm
The Role of Constraints
Demand and Supply
Functional Relationship
Marginal Analysis
The Concept of Derivative

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• DEMAND
the quantity of a good or service that consumers are willing to buy at
various prices within the time period with other factors besides prices
constant.

• SUPPLY
Is the amount of product that producers or sellers would be prepared to
produce or sell in a given period of time.

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MARKET EQUILIBRIUM exists when the plans of the producers match the plans of the consumers. The
Quantity demanded by the consumers equals to the quantity supplied by the producers.

DISEQUILIBRIUM situation exist if there is a mismatch between suppliers’ and producers’ plans: Surplus
(excess of supply) and shortage (excess of demand).

ELASTICITY measures of demand and supply which can help market to forecast demand and supply and
formulate marketing plans.

MARKET STRUCTURE can be classified into:

 Perfectly competitive market
(many buyers/sellers, homogenous product, no collusive practices, perfect info, free entry/exit into the market)
 Monopoly
(sole supplier of a particular good/service)
 Oligopoly
(few suppliers with a differentiated of good/service in the market ie. cereal, detergent, toiletries)
 Monopolistic competition
(characteristics of both competitive and monopoly) 5
MARKET STRUCTURE

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 Monopoly diagram Oligopoly diagram

Monopolistic Competition diagram

Perfect Competition diagram

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 3. PRODUCTION AND COST ANALYSIS
PRODUCTION FUNCTIONS is a mathematical and sometimes
graphical way to measure the efficiency of production by considering
the relationships between two or more variables, meaning two or
more factors that are relevant when producing a good or service, such
as raw materials and labor.
Q= f(M,L,K)

COST FUNCTIONS is mathematical formula used to predict the cost

associated with a certain action or a certain level of output. Businesses
use cost functions to forecast the expenses associated with production,
in order to determine what pricing strategies to use in order to achieve
desired profit margins.
C(Q) = fixed cost + cost per unit*Q 8
Table below shows a production function which indicates the quantity of output obtained from different combinations
of two inputs, labour and capital.
 EXAMPLE:
The maximum volume of output that can be produced with inputs of 10 workers and 10,000 square feet of plant size is
93.
The maximum volume of output that can be produced with inputs of 20 workers and 10,000 square feet of plant size is
135.
The maximum volume of output that can be produced with inputs of 10 workers and 20,000 square feet of plant size is
120.
Plant Size – Capital 10 20 30 40
(thousand of square feet)
No of Workers Volume of output
10 93 120 145 165
20 135 190 235 264
30 180 255 300 337
40 230 315 425 410
50 265 360 478 460

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THE LAW OF DIMINISHING MARGINAL RETURNS shows that if equal increments of an input are added, and
the quantities of other inputs are held constant then the resulting increments of product will decrease
beyond some points, where the marginal product of the input will diminish.

No of Total Marginal
workers product Product
10 93 4.2
When labour was increase from 10 to 30 the marginal product 20 135 4.5
also increase
30 180 5.0
40 230 3.3
Marginal product started to decline although the total number of
50 263 3.0 worker increasing

60 290 2.8
70 321 2.5
80 346 2.2
90 368 2.0
100 388 1.2
110 400 0.3
120 403 -1.2
130 391 -1.1
140 380

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 OPTIMAL LEVEL OF INPUT UTILIZATION
Marginal cost (expenditure) is the amount that an additional unit of the
variable input adds to the firm’s total costs.
MCY =∆TC
∆Y

MCY is the marginal cost of input Y

∆TC is the change in total cost resulting from a change of ∆Y in the
amount of input Y used by the firm

To maximize profits, the firm should utilize input Y where the marginal
revenue product equals the marginal cost:
MRPY = MCY
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 OPTIMAL COMBINATION OF INPUTS
To maximise profit, the firm will try to minimise the cost of producing a given level of output or maximise the
output from a given level of cost. For a given expenditure, various combinations of output can be determined.
If capital and labour are the inputs, and the price of labour is PL per unit and the price of capital is PK per unit,
the input combinations that can be obtained for a total expenditure (cost) of M is given as:

PLL + PKK = M1

L is the amount of labour input.

K is the amount of capital input.

K = M – PL
PK PK

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 RETURN TO SCALE
In the long run there are 3 possibilities of output responds to the increase in the amount of all inputs;
 Increasing returns to scale (IRS) – a doubling of all inputs may lead to more than doubling of output.
 Decreasing returns to scale (DRS) - a doubling of all inputs may lead to less than doubling of output.
 Constant returns to scale (CRS) - a doubling of all inputs may lead to a doubling of output.

 Example
1. Given Q = aKαLβ
If we double (increase) all inputs then:
Q’ = a(2K)α(2L)β
=4α+βaKαLβ
= 4α+β(aKαLβ)
= 4α+βQ > Q (a case of IRS).

2. Given Q = aK +bL
If we double (increase) all inputs then:
Q’ = a(2K) + b(2L)
= 2(aK + bL)
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= 2Q (a case of CRS).
 Three concept in the Short Run Cost Function
Total fixed costs (TFC)
Total costs per period of time incurred by the firm for the fixed inputs. TFC will be the same regardless of the firm’s output rate.
Total variable costs (TVC)
Total costs incurred by the firm for variable inputs. TVC goes up as the firm’s output rate rises. Higher output rates require higher variable input
rates, thus, bigger variable costs.
Total costs (TC)
The sum of total fixed costs and total variable costs. Total cost function and total variable cost function have the same shape.

Output TFC TVC TC

0 2000 0 2000
10 2000 100 2100
20 2000 180 2180
30 2000 280 2280
40 2000 392 2392
50 2000 510 2510
60 2000 650 2650
70 2000 800 2800
80 2000 960 2960
90 2000 1140 3140
100 2000 1340 3340
110 2000 1560 3560
120 2000 2160 4160

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The Average and Marginal Costs of the three average cost functions:
 Average fixed cost. Average fixed cost (AFC) = Total fixed cost divided by output (TFC/Q)
 Average variable cost. Average variable cost (AVC) = Total variable cost divided by output (TVC/Q)
If U is the quantity of variable input, and W is the price per unit of variable input, then:

AVC = TVC = WU = W = U = W
Q Q Q Q/U AVP
Where AVP is the average product of variable input, AVP = Q/U.
 Average total cost (ATC) = Total cost divided by output(TC/Q)
 Marginal cost (MC) = The addition to total cost resulting from the addition of the last unit of
output. If ΔTVC is the change in TVC resulting from a change in input, ΔQ and ΔTFC is the change
in TFC resulting from a change in output, ΔQ; then
Marginal cost = ∆TVC + ∆TFC = ∆TVC
∆Q ∆Q
• ΔTFC = 0 as fixed costs are fixed
In the Long Run all inputs are considered as variable. There are no fixed cost function, total or
average. 15
Break-even chart assumes that the firm’s average variable costs are constant, thus the firm’s total cost function
is a straight line. Because of this assumption, the extra cost of an extra unit (marginal cost) is also constant and
equal to average variable cost.

Economies of scope occur when products share common inputs and diversification leads to cost saving. Take for
example a firm with three activities. We can calculate the scope index S as:
S= ( C1 + C2 + C3 - C1+2+3)/ (C1+ C2 + C3 )
Where C1+ C2 + C3 is the cost of three activities carried out separately and C1+2+3 is the cost when carried out
together.
If S is negative, then the three activities are better if carried out separately.
If S is positive, then the three activities are better if carried out together in the same plant.
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 4. FUNDAMENTALS OF THE ECONOMY
 Macroeconomics is interested in the output produced by an entire nation. Total output of a nation determines how
well the citizens of that nation live.
 Gross domestic product (GDP) is the total dollar value of final goods and services produced by an economy over
some given period of time. GDP is a measure of the quantity of goods and services that can be bought with the
income of all individuals in the economy (or it is a measure of a living standard).
 There are 3 approaches to measure GDP; output, income, and value added approaches.
Calculating GDP in this manner is called the output approach. The break down is usually into
consumption (C), investment (I), government spending (G), the difference between exports (X) and
imports (M).
GDP= C+G+I+X-M
Seller Value of Uses of Fund(RM) The contribution to GDP from this process is easy
Income Farmer
Sale
RM2,000 Proprietors 200
to calculate from the output approach. It is just
Approach Income
the RM2,400 that the grocer’s customers pay for
Rent 100
the corn. But, because there are two sides to
Interest 150
each transaction, we can also find the
Employees 1100
Compensation contribution to GDP by totaling up the uses of
Capital
Consumption
300 funds or “incomes” generated by this process.
Grocer RM2,400 Farmer 2000
There are seven uses of funds and they sum to
Rent 50 GDP.
Employee 200
Compensation
Indirect business 50
Tax
Corporate Profit 100

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The growth in real GDP is a measure of the growth of people’s real income
(or the pace of improvement in living standards).
A high economic growth is when people are enjoying rapidly rising living
standards and in which jobs are easy to find.
In a slow growing or shrinking economy, living standards decline and
unemployment becomes a serious problem.
The unemployment rate is an indicator of the underutilization of available
resources.
Unemployment can be classified as seasonal, frictional, structural, and
cyclical unemployment. However, they are not mutually exclusive.
Inflation is a process of rising prices of goods and services. Equivalently, it
is a process in which money steadily loses value and buys fewer and fewer
goods and services.
Deflation Is a decline in the general level of prices in the economy.
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 5. PRICE INDEX, INFLATION AND BUSINESS CYCLE
A price index facilitate the comparison of the average level of prices prevailing in the economy in different times of periods in
particular region or country.
There are three (3) types of prices indexes that are normally used in the economy analysis:
 Consumer Price Index (CPI)
 Producer Price Index (PPI)
 GDP Deflator
Consumer Price Index Producer Price Index GDP Deflator
Lists characteristic of Price Indexes
• The cost of a basket of good and • Average changes in prices that • Measures the overall level of prices
services relative to the cost of the producer receives in their goods at in the economy.
same basket in the base year. all stages from raw materials to • Includes good and services
• Used to measure the overall level of finish product. produced rather than good s and
prices on the economy. • Includes output from the producing services consumed in CPI.
• Percentage change in the consumer sector though limited coverage of • Not affected by imported goods as
price index measures the inflation service sector outputs. in CPI.
rate. • Useful when the general focus is on • Automatically changes the group of
manufacturing inputs and outputs goods and services over time as the
such as an indicator of changes in composition of GDP changes unlike
the economy. CPI which uses the fixed basket of
• Examples of policy question that goods and services.
might be examined using the PPI as
the price index – adjusting for price
changes how has the output
Yummy’s food processing changed
over time.

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• The difference between price index and inflation rate is
PRICE INDEX INFLATION RATE
Overall price level VS Rate at which the price level is changing
• The rate of inflation in any year is equal to the percentage change in the price index between that year
and the preceding year.
• While a price index tells us the overall price level, the inflation rate tells us how fast the price level is
changing, in percentage terms.

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• The formula to calculate
Inflation Rate = (CPI Year2 - CPIYear1) x 100%
CPIYear1

Although the phases of business cycles repeat themselves, these vary considerably
in:
Duration (time span);
Intensity (rate of change); and
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Scope
 6. MONETARY AND FISCAL POLICIES
• FISCAL POLICY can be used in order to lower unemployment rate and increasing real GDP to eliminate a
recessionary gap. To achieve these goals, fiscal policy must change either aggregate demand (AD) or
aggregate supply (AS).
• If fiscal policy is designed to change aggregate demand, then it is referred to as demand-side fiscal
policy. However, if the policy is designed to change aggregate supply, then it is referred to as supply-
side fiscal policy.
• Fiscal policy refers to changes in government expenditure (ΔG) and/or taxes (ΔT) to achieve a particular
macro-economic goal.
• A budget deficit exists if government expenditures are greater than tax revenue. A budget surplus exists
if tax revenues are greater than government expenditures.
• Expansionary fiscal policy refers to increase in government expenditures and/or decreases in taxes to
achieve macroeconomic goals.
• Contractionary fiscal policy refers to decreases in government expenditures and/or increases in taxes to
achieve these goals.

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a) Marginal tax rates and aggregate supply
Consider a decrease in an individual’s marginal income tax rate. The marginal tax rate is equal to the
change in a person’s tax payment divided by the change in the person’s taxable income. Mathematically, it
can be written As an example, if my taxable income increases by RM1 and my tax payment increases by
RM0.19 then my marginal tax rate is 19 percent.

b) Tax rates and tax revenue: The Laffer curve

If individuals’ marginal income tax rates are reduced, will income tax revenues collected by the government
increase or decrease? Most people think the answer is simple, i.e. lower tax rates to the people means
lower tax revenue for the government. However, according to Arthur Laffer, an economist, this may not be
the case.

As an example, if a tax rate is 19 percent multiplied by a tax base of RM100 billion generates RM19 billion
of tax revenues. In this case, tax revenues are a function of two variables, namely (1) the tax rate, and (2)
the tax base. Whether tax revenues increase or decrease as the average tax rate is decreased depends on
whether the tax base increases by a greater or lesser percentage than the percentage reduction in the tax
rate. 24
 Tax Rate Tax Base in Tax revenue in Summary
Billion Billion
Start with 19% RM100 RM19
Case 1 15% RM120 RM20 ↓tax rate
↑tax revenue
Case 2 15% RM150 RM22.5 ↓tax rate
↑tax revenue

We start with a tax rate of 19 percent and a tax base of RM100 billion. The tax revenues is RM19 billion. Now, the
government reduces the tax rate to 15 percent and the tax base expands. Why? A reduction in tax rate induces
individuals to work more, invest more, enter into more trades, and shelter less income from taxes at a lower tax rate.
But, the real question is the extent to which the tax base expands as a result of a decrease in tax rate by 21 percent
(from 19 percent to 15 percent).

Case 1: Let say the tax base increases to RM120 billion, i.e. 20 percent (from RM100 billion to RM120 billion). Tax
revenues drop to RM18 billion.

Case 2: Let say the tax base expands by 50 percent to RM150 billion. Because the tax base increases by a greater
percentage than the percentage decrease in the tax rate, tax revenues increase to RM22.5 billion.

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• The Monetary Policy
Bank Negara carries out Malaysian monetary policy. Monetary policy can mean several different things, and the vagueness of
the term causes confusion from time to time. These changes may then have consequences for the price level, real output,
the interest rate, and so forth; but we will refer to these as the results, effects, or consequences of the policy, and not the
policy itself.
The Central Bank also serves some functions other than setting the money supply.
There are three policy tools in the hand of the Central Bank:
 The discount rate,
 Reserve requirements, and
 Open market operations.

• Problems/Effectiveness of Fiscal Policy

Some of the problems related to fiscal policy are:
 Crowding out
 Time Lags
 Incomplete information

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 7. EXCHANGE RATES AND CURRENCIES
A convertible currency can be legally exchanged for another convertible currency at a rate of exchange. The foreign
exchange rate measures the price of one currency in terms of another.

S represents the home currency price of a unit of foreign exchange

E represents the amount of foreign currency per unit of domestic currency

When S increases, it means the home currency depreciates.
When S decreases, it means the home currency appreciates.
 Example
US dollar is the “home/domestic” currency and £ is the foreign currency.
S = USD/£ = 1.6226 USD/£
E = £/USD = 0.6163 £/USD

Based on the example shown above, we can say that S and E are reciprocal of each other.
A convertible currency can be legally exchanged for another convertible currency at a rate of exchange. A currency could be partially
convertible when it can be legally used to purchase foreign exchange to finance certain transactions.

Forward exchange rate market is used in three main trading activities:

 Hedging
 Arbitrage
 Speculation 27
• Balance of payments (BOP) is an accounting statement that records a country’s
trade in goods, services and financial assets with the rest of the world. It is based
on double-entry bookkeeping. Every transaction is entered on both sides of the
balance sheet as a credit and a debit transaction.
• Transactions that will lead to an inflow of money into the country, are registered
as credit items. They are entered into the balance sheet with a plus sign.
Transactions that will lead to an outflow of money from the country are
registered as debit items. All debit items are entered into the balance sheet with
a negative sign.
Examples of some transactions that lead to an inflow of money into the country
(credit items) are:
Export of goods and services,
Capital inflow which includes sales by domestic residents or home government's
claims on domestically owned assets: corporate notes, bonds or equity known as
liability.
Direct investment in the form of acquisitions that give managerial control over
investment overseas. 28
The current account is defined as the value of trade in merchandise, services, investment income and unilateral
transfers.
 Merchandise refers to trade in tangible commodities.
 Services refers to trade in services of factors of production such as land, labour and capital. Other transaction
included in services, are travel and tourism, royalties, transportation cost and insurance premium.
 Investment income account refers to the payment for the services of physical capital or the return on investment.
 Unilateral transfer refers to foreign aid, gifts and retirement pensions.
Capital account transactions include official and private transactions of:
 Direct investment which refers to private financial transactions that result in the ownership of 10 percent or of a
business firm.
 Security purchases which refers to private sector net purchases of equity (stock) and debt securities.
 Bank claims and liabilities which include claims on loans, collections outstanding, acceptances, deposits abroad,
claims on affiliated foreign banks, foreign government obligations, and foreign commercial and finance paper.
Liabilities include deposits, certificates of deposit, liabilities to affiliated foreign banks, and other liabilities.
 Reporting country’s government assets abroad which refers to changes in the reporting government official reserve
assets (gold, SDRs, foreign currency holdings, reserve position in the IMF).
 Foreign official assets in the reporting country which refers to net purchases of reporting country securities,
obligation of the reporting country corporations and agencies, changes in liabilities to foreign official agencies
reported by reporting country banks.
 Direct trade in merchandise and service sold on credit. Trade credit financing is reflected in exporter’s bank claims
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and liabilities.
International monetary arrangement through the gold standard refers to the following:
 Currencies are valued in terms of their gold equivalent; for example an ounce of gold = US$20.67.
 All currencies are linked in a system of fixed exchange rate.

Example
Currency A is worth 0.10 ounce of gold and Currency B is worth 0.20 ounce of gold.
1 unit of currency B worths twice as much as 1 unit of A (B=2A).
A gold standard is a commodity money standard. Money has a value that is fixed in terms of the
commodity gold. The supply of money is restricted by the supply of gold.

END

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