Managerial Economics

Session 2
BASIC CONCEPTS and TOOLS

Lectured by: B. Yuliarto Nugroho

Managerial Economics
OBJECTIVES OF THIS SESSION

Identification of Goals and Constraints

Recognition of the Role of Profits
Understanding of Incentives
Understanding of Markets
Recognition the Time Value of Money
Use Marginal Analysis
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Goals and Constraints

Manager
A person who directs resources to achieve a stated
goal.
Economics
The science of making decisions in the presence of
scare resources.
Managerial Economics
The study of how to direct scarce resources in the
way that most efficiently achieves a managerial
goal.

Profit
A signal that society wants resources to be
shifted (socially desirable).
A signal that a firm is able to abuse market
power (not socially desirable). Microsoft?
An incentive for savings and investment
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Profit
Accounting Profits
Total revenue (sales) minus dollar cost of
producing goods or services
Reported on the firms income statement

Economic Profits
Total revenue minus total opportunity cost

Opportunity Cost
Accounting Costs
The explicit costs of the resources needed to produce
produce goods or services
Reported on the firms income statement

Opportunity Cost
The cost of the explicit and implicit resources that are
foregone when a decision is made

Economic Profits
Total revenue minus total opportunity cost

Opportunity Cost
Example: $100,000 invested in your
cousins internet vulture company will earn
8%. The bond market pays 10%.
The foregone income is the 10% you can
earn on bonds.
The economic profit, net the opportunity
cost of investing in bonds, is -2%.
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Market Interactions
Consumer-Producer Rivalry
Consumers attempt to locate low prices, while
producers attempt to charge high prices

Consumer-Consumer Rivalry
Scarcity of goods reduces the negotiating power of
consumers as they compete for the right to those
goods

Producer-Producer Rivalry
Scarcity of consumers causes producers to
compete with one another for the right to service
customers

The Role of Government

Disciplines the market process

Present value
Example: Your eccentric aunt leaves $100,000 per year,
for the next ten years, to her dogs. If they die early, you
get the money.
If they live the full 10 years at 10% discount rate a year,
how much money have you lost?
T

1
PV A
t
t 1 1 i

$614,460.
You cousin says he can arrange an accident in year
3. How much is it worth (he wants to be paid.)

$614,460 - $248,690 = $365,770.

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The Time Value of Money

Present value (PV) of an amount (FV)
to be received at the end of n periods
when the per-period interest rate is i:

FV
PV
n
1 i
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Present Value of a Series

Present value of a stream of future
amounts (FVt) received at the end of
each period for n periods:

FV1
FV2
FVn
PV
1
2 . . .
n
1 i 1 i
1 i
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Use of NPV in Management

Suppose a manager can purchase a stream
of future receipts (FVt ) by spending C0
dollars today. The NPV of such a decision is

FV1
FV2
FVn
N PV C 0
1
2 . . .
n
1 i 1 i
1 i
NPV < 0: Reject
NPV > 0: Accept
Think about your cousin and the accident offer.
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NPV and Firm Valuation

The value of a firm equals the present value
of all its future profits
PV = t / (1 + i)t

If profits grow at a constant rate, g < i, then:

PV = i) / ( i - g),

current profit level.

Maximizing Short-Term Profits

If the growth rate in profits < interest rate and both
remain constant, maximizing the present value of
all future profits is the same as maximizing current
profits.
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Marginal (incremental) analysis

Control Variables
Output
Price
Product Quality
Advertising
R&D

Basic Managerial Question: How much

of the control variable should be used to
maximize net benefits?
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Net Benefits
Net Benefits = Total Benefits - Total
Costs
Profits = Revenue - Costs

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Marginal Benefits and Costs

MC
Change in total costs arising from a change in the
control variable, Q:
MC = C / Q

Slope (calculus derivative) of the total cost curve

MB
Change in total benefits arising from a change in the
control variable, Q:
MB = B / Q

Slope (calculus derivative) of the total benefit curve

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Marginal Benefits and Costs

To maximize net benefits, the managerial
control variable should be increased up to the
point where MB = MC
MB > MC means the last unit of the control
variable increased benefits more than it
increased costs
MB < MC means the last unit of the control
variable increased costs more than it
increased benefits
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An Example:
The profit contribution is the difference between price and average
variable cost.
Non-linear break-even analysis
Assumptions: (1) Price may vary with output; (2) We have fixed costs; (3)
We have constant variable cost. We might have other cost functions.

R,C

Break-even
output

Total revenue
R = P*Q

Profit maximizing
output

Total cost
C = FC + VC*Q

Break-even
output

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Summary
Make sure you include all costs and
benefits when making decisions
(opportunity cost)
When decisions span time, make sure you
are comparing apples to apples (PV
analysis)
Optimal economic decisions are made at
the margin (marginal analysis)
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Supplement

Optimization Techniques
Unconstrained & Constrained Optimization

Calculus of one variable

Partial Differentiation in Economic
Problems
Appendix: Lagrangians and
Constrained Optimization
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1999 South-Western College Publishing

Supplement

UnconstrainedOptimization
UnconstrainedOptimizationisarelatively
simplecalculusproblemthatcanbesolved
usingdifferentiation,suchasfindingthe
quantitythatmaximizesprofitinthe
function:
(Q)=16QQ2
TheanswerisQ=8,aswewillsee.
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Constrained Optimization
ConstrainedOptimizationinvolvesoneormoreconstraints
ofmoney,time,capacity,orenergy.
Whenthereareinequalityconstraints(aswhenyoumust
spendlessthanorequaltoyourtotalincome),linear
programmingcanbeused.
Mostoften,managersknowthatsomeconstraintsare
binding,whichmeansthattheyareequalityconstraints.
Lagrangianmultipliersareusedtosolvetheseproblems.
(seeAppendix).
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OptimizationFormat
Economicproblemsrequiretradeoffsforcedon
usbythelimitsofourmoney,time,andenergy.
Optimizationinvolvesanobjectivefunction
andoneormoreconstraints,b.
Maximizey=f(x1,x2,...,xn)
Subjecttog(x1,x2,...,xn)<b
or:Minimizey=f(x1,x2,...,xn)
Subjecttog(x1,x2,...,xn)>b
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Using Equations
profit = f(quantity) or = f(Q)
dependent variable & independent variable(s)
average profit =Q
marginal profit = / Q
Calculus uses derivatives
d/dQ = lim / Q
Q
0
SLOPE = MARGINAL = DERIVATIVE
NEW DECISION RULE: To maximize profits,
find where d/dQ = 0 -- first order condition
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Quick Differentiation Review

Name

Function

Derivative

Example

Constant Y = c

dY/dX = 0

Y=5
dY/dX = 0

Line Y = cX

dY/dX = c

Y = 5X
dY/dX = 5

Power Y = cXb

dY/dX = bcX b-1

Y = 5X2
dY/dX = 10X
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Quick Differentiation Review

Sum Rule Y = G(X) + H(X) dY/dX = dG/dX + dH/dX

example

Y = 5X + 5X2

dY/dX = 5 + 10X

Product Rule Y = G(X)H(X)

dY/dX = (dG/dX)H + (dH/dX)G

example

Y = (5X)(5X2 )

dY/dX = 5(5X2 ) + (10X)(5X) = 75X2

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Quick Differentiation Review

Quotient Rule Y = G(X) / H(X)
dY/dX = (dG/dX)H - (dH/dX)G
H2
Y = (5X) / (5X2) dY/dX = 5(5X2) -(10X)(5X)
(5X2)2
= -25X2 / 25X4 = - X-2
Chain Rule
Y = G [ H(X) ]
dY/dX = (dG/dH)(dH/dX) Y = (5 + 5X)2
dY/dX = 2(5 + 5X)1(5) = 50 + 50X
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Applications of Calculus in
Managerial Economics
maximization problem: A profit function might look
like an arch, rising to a peak and then declining at even larger
outputs.Afirmmightsellhugeamountsatverylowprices,but
discoverthatprofitsarelowornegative.
At the maximum, the slope of the profit function is zero. The
firstorderconditionforamaximumisthatthederivativeatthat
pointiszero.If=50QQ2,thend/dQ=502Q,usingthe
rulesofdifferentiation.
Hence,Q=25willmaximizeprofits.
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More Applications of Calculus

minimization problem:Costminimization
supposesthatthereisaleastcostpointtoproduce.An
averagecostcurvemighthavea
Ushape.Attheleastcostpoint,theslopeofthecost
functioniszero.
Thefirstorderconditionforaminimumisthatthe
derivativeatthatpointiszero.IfC=5Q260Q,then
dC/dQ=10Q60.
Hence,Q=6willminimizecost.
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More Examples
Competitive Firm: Maximize Profits
where = TR - TC = PQ - TC(Q)
Use our first order condition:
d/dQ = P - dTC/dQ = 0
a function of Q
Decision Rule: P = MC

Max = 100Q - Q2
100 -2Q = 0 implies
Q = 50 and = 2,500

Max= 50 + 5X2
So, 10X = 0 implies
Q = 0 and= 50
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Second Order Condition:

One Variable

If the second derivative is negative,

then its a maximum
If the second derivative is positive, then
its a minimum

Max = 100Q - Q2
100 -2Q = 0
second derivative is: -2
implies Q =50 is a MAX

Max= 50 + 5X2
10X = 0
second derivative is: 10
implies Q = 0 is a MIN
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Partial Differentiation
Economic relationships usually involve
several independent variables.
A partial derivative is like a controlled
experiment -- it holds the other variables
constant
I.e., suppose price is increased, holding the
disposable income of the economy constant
Q = f (P, I ) Q/P holds income constant
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Problem:
Sales are a function of advertising in
newspapers and magazines ( X, Y)
Max S = 200X + 100Y -10X2 -20Y2 +20XY
Differentiate with respect to X and Y and set
equal to zero.

S/X = 200 - 20X + 20Y= 0

S/Y = 100 - 40Y + 20X = 0
solve for X & Y and Sales
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Solution: 2 equations & 2 unknowns

200 - 20X + 20Y= 0
100 - 40Y + 20X = 0
Adding them, the -20X and +20X cancel,
so we get 300 - 20Y = 0, or Y =15
Plug into one of them: 200 - 20X + 300 =
0, hence X = 25
To find Sales, plug into equation: S =
200X + 100Y -10X2 -20Y2 +20XY = 3,250
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Appendix : Lagrangians
Objective functions are often constrained by
one or more constraints (time, capacity, or
money)
Max L = (objective fct.) -{constraint set to zero}
Min L = (objective fct.) +{constraint set to zero}
Anartificialvariableiscreatedforeachconstraintin
theLagrangianmultipliertechnique.Thisartificial
variableistraditionallycalledlambda,.
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Maximize Utility Example

example: Max Utility subject to a money
constraint
Max U = XY2 subject to a $12 total budget
with the prices of X as $1, the price of Y
as $4 (suppose X represents soda and Y,
movie tickets).
Max L = XY2 -{ X + 4Y - 12}
differentiate w.r.t X, Y and lambda, .
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L/X = Y2 - = 0
Y2 =
L/Y = 2XY - 4= 0
2XY = 4
L/= X + 4Y- 12 = 0
Three equations and three unknowns
Solve: Ratio of first two equations is:
Y/2X = 1/4 or Y = .5 X. Substitute into the third
equation: We get:

X = 4; Y = 2; and= 4
Lambda is the marginal (objective function)
of the (constraint).
Here, the marginal utility of money.
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