Im Econ 351 Managerial Economics Bsa Bsma

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IM ECON-351 Managerial- Economics BSA BSMA
Managerial Economics (Polytechnic University of the Philippines)
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Polytechnic University of the Philippines

College of Social Sciences and Development
Department of Economics
INSTRUCTIONAL MATERIAL FOR

ECON 351
MANAGERIAL ECONOMICS
Prepared by
Melcah Pascua Monsura

Russel R. Penamante
Celso G. Tan Jr.

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Table of Contents
Overview…………………………………………………………………………………….……..…..…4
Chapter 1 THE NATURE, SCOPE, AND PRACTICE

OF MANAGERIAL ECONOMICS
1.1 Definition of Managerial Economics
and its Nature…………………...…………………………………..………………..……...5
1.2 Why Managerial Economics is Relevant for Managers………………..………………....6
1.3 Managerial Economics is Applicable to Different Types of Organizations…………......6
1.4 Social Responsibility of Business…………………………………………………..….…...7
1.5 Social Responsibility of Business and Social Contract………………………..………….7
Assessment 1…………………………………………………………………..……..…....….10
Chapter 2 ECONOMIC DECISION MAKING

2.1 Public Decisions: Economic View...……………………………………………..………..13
2.2 Decision within Firms: Profit-Maximization…..……………..…………………………....14
2.3 Optimal Decision using Marginal Analysis………………………..………………..…….15
Assessment 2…………………………………………………..………………..……..…...…17
Chapter 3 DEMAND ANALYSIS: Estimation and Forecasting

3.1 Demand Analysis………...………………………………………………………..……….18
A. Demand Schedule…………………………………………………………..…..….18
B. Demand Curve………………………………………………………..………….…19
C. Demand Function……………………………………………….…………….........20
3.2 Price Elasticity of Demand………………………………………..…………………….…21
3.2.1 Price Elasticity of Demand and Total Revenue Relationship………………..23
3.2.2 Cross Elasticity of Demand………………………………………..……………25
3.2.3 Income Elasticity of Demand…………………………………………..……….25
3.2.4 Price Elasticity and Prediction………………………………………..………...26
3.3 Demand Analysis and Optimal Pricing…...………………………………..…………..…27
3.3.1 Price Elasticity, Revenue, and Marginal Revenue………………….…..........28
3.3.2 Optimal Markup Pricing……………………………..…………………….........29
3.3.3 Price Discrimination……………………………………..……………………....31
3.4 Estimating Demand………..……………………………………………..........................33
3.4.1 Collecting Data……………………………………………………..……………34
3.5 Regression Analysis………………………………………………………….…………….36
3.5.1 Simple Regression……………………………………………………..……..…36
3.5.2 Multiple Regression………………………………………………..………..…..38
Assessment 3…………………………………………………………..……………………...43
Chapter 4 FORECASTING DEMAND

4.1 Qualitative Forecasting Technique………………..………………………..………........46
4.2 Quantitative Forecasting Technique…………………………………………..………….47
4.2.1 Time-Series Models………………………………………..……………………47
4.2.2 Smoothing Technique…………………………………..……………………....48
4.3 Quantitative Forecasting Technique using Econometric Models……………..……..…49
Assessment 4…………………………………..……………………………………………...53
Chapter 5 THE THEORY OF PRODUCTION AND COST

5.1 Production Function…………………………………………………………..……………55
5.2 Returns of Scale………………………………………………………………….………...56

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5.3 Production Periods…………………………………………………..……………..………56

5.3.1 Short-run Production Relationships………………………………..…….……56
5.4 Three Stages of Production……………………………….……………………………....59
5.5 Costs of Production……………………………………………………..………………….59
5.5.1 Economic Costs…………….…………………………………………………...60
5.5.2 Explicit and Implicit Costs…………………………………..……....................60
5.6 Short Run Production Costs…..………………………………..………………………....60
5.7 Marginal Decisions…….……………………………………………..…………………….63
5.8 Long-Run Production Costs…………………………………………..............................64
5.9 Production and Costs in the Long Run………………………………………..……….…66
Assessment 5………………………………………………………………..………………...70
Chapter 6 OPTIMAL OUTPUT DECISIONS AND PRICING STRATEGIES

6.1 Pure Competition…………………………………………………………………..……….72
a. Demand as Seen by a Purely Competitive Seller…………………………..........72
b. Profit Maximization in the Short Run…………………………………..……..……72
c. Loss Minimizing Case……………………………………………….…………..….75
d. Shutdown Case………………………………………………………………..........76
6.2 Pure Monopoly……………………………………………………..……………………....77
a. Monopoly Demand………………………………………………………..………...77
b. The Monopolist is a Price Maker…………………………………………..……….78
c. Profit Maximizing Position of Pure Monopolist…………………..……………..…79
d. Possibility of Losses by Monopolist………………………..……………………....79
6.3 Monopolistic Competition…………………………………..…….……………………..…80
a. A Firm’s Demand Curve……………………………………………..……………..81
b. Profit Maximization in the Short-Run………………………………….……..........81
6.4 Oligopoly………………………………………..…………………………………………...83
a. Oligopoly Behavior: Game Theory……………………………………..………….83
b. Three Oligopoly Models………………………………………………..…………...85
Assessment 6…………………………………………………………………..…………..….87
Chapter 7 ECONOMIC RISK AND UNCERTAINTY

7.1 Risk versus Uncertainty………………………………………………………..…………..88
7.2 Key Difference Between Risk and Uncertainty…………………………..……………....89
7.3 Application of the Concept of Risk and Uncertainty……………………..……………....89
7.4 Five Sources of Business Risk………………………………….…………………………90
7.5 Risk and Return………………………………………………..…………………………...90
Chapter 8 Capital Budgeting

8.1 Definition of Capital Budgeting…………………………………………….………………91
8.2 Characteristics of Capital Investment Decisions……………………………..……....…91
8.3 Capital Budgeting Process………………………………………………..……………….91
8.4 Types of Capital Investment Projects………………………………..…………………...93
8.5 Capital Budgeting Techniques………………………………………..…………………..95
8.5.1 Present Value and Net Present Value Method……………………..………..96
8.5.2 Payback Period Method………………………..…………………………........97
8.5.3 Discounted Payback Period Method……………………..…………………....98
8.5.4 Profitability Index………………………………………..……………………....98
8.5.5 Internal Rate of Return (IRR) Method…………………………………..……...98
8.6 Importance and Significance of Capital Budgeting……………………………….……..99
Assessment 7………………………………………………………………………..……….100

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Overview
Managerial Economics is the analysis of major management decisions using the tools
of economics. Managerial economics applies many familiar concepts from economics4demand
and cost, marginal analysis, monopoly and competition, the allocation of resources, and economic
trade-offs4to aid managers in making better decisions. This module provides the framework and
the economic tools needed to fulfill this goal. Furthermore, the discussions in this module illustrate
the central decision problems faced by the managers and to provide the economic analysis they
need to guide their decisions.
The first three chapters will discuss the introduction of Managerial Economics and how
managers of the firms decide based on estimating and forecasting demand using regression
analysis. Forecasting demand through trends, business cycles, seasonal variations, and random
fluctuations will also discuss. These are crucial for economic decision making of managers. The
optimal decision of the managers will be based on demand estimation and marginal analysis.
The next three chapters, Chapter 3 to Chapter 6, will discuss how the managers analyze
the production and cost of production of the firms. In addition, the optimal output and pricing
strategies to realize maximum profit will discuss using the four market structures. Each market
type has its own characteristics, demand, and pricing strategies which will be discussed in
Chapter 6.
The remaining chapters include the concepts of risks, uncertainties, and capital budgeting.
Since every firm faces risks and uncertainties in their operations and productions, it is crucial to
understand the firm’s reactions and decisions in these situations. Moreover, capital budgeting will
also consider in identifying good investment for the firm’s possible expansion and continuous
operation.

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CHAPTER 11
THE NATURE, SCOPE AND PRACTICE OF MANAGERIAL ECONOMICS
Learning Objectives: This chapter provides introduction of managerial economics and on how
the economic concepts, theories, and methodologies help managers to improve their
decision-making. This part also stresses the importance of managerial economics to the
firms. At the end of this chapter, the readers will be able to define managerial economics,
establish the relation of managerial economics to other branches of learning, and
demonstrate the use of managerial economics in the real-world managerial decision
making.
1.1 Definition of Managerial Economics and its Nature
One standard definition for economics is the study of the production, distribution, and
consumption of goods and services. Secondly, it the study of choice related to the allocation of
scarce resources. The first definition indicates that economics includes any business, nonprofit
organization, or administrative unit. The second definition establishes that economics is at the
core of what managers of these organizations do. We use economics to examine how managers
can design organizations that motivate individuals to make choices that will increase a firm’s
value. This module discusses the economic concepts and principles from the perspective of
<managerial economics,= which is a subfield of economics that places special emphasis on the
choice aspect in the second definition.
Managerial economics is a branch of economics that applies microeconomic concepts,

methods, and analysis to examine how an organization or business can achieve its aims and
objectives most efficiently through decision-making. Thus, the purpose of managerial economics
is to provide economic method and scientific reasoning to solve managerial decision problems.
These economic theories and methods involved with two different conceptual approaches to the
study of economics such as microeconomics and macroeconomics. Microeconomics studies
phenomena related to goods and services from the perspective of individual decision-making
entities4that is, households and businesses. Macroeconomics approaches the same
phenomena at an aggregate level, for example, the total consumption and production of a region.
Microeconomics and macroeconomics each have their merits. The microeconomic approach is
essential for understanding the behavior of atomic entities in an economy. However,
understanding the systematic interaction of the many households and businesses would be too
complex to derive from descriptions of the individual units. The macroeconomic approach
provides measures and theories to understand the overall systematic behavior of an economy.
Since the purpose of managerial economics is to apply economics for the improvement of
managerial decisions in an organization, most of the subject material in managerial economics
has a microeconomic focus. However, since managers must consider the state of their
environment in making decisions and the environment includes the overall economy, an
understanding of how to interpret and forecast macroeconomic measures is useful in making
managerial decisions.
Specifically, managerial economics deals with microeconomic reasoning on real-world

problems such as pricing and production decisions in selecting best strategy in difference
competitive environments. These business decisions can be analyzed through:
1Most of the discussions were derived from Principles of Managerial Economics available at Creative Commons-
NonCommercial-ShareAlike 4.0 International License (http://creativecommons.org/licenses/by-nc-sa/4.0/).

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1. Risk Analysis 3 Various uncertainty models, decision rules and risk quantification
techniques are used to assess the riskiness of a decision.
2. Production Analysis 3 Microeconomic techniques are used to analyze production
efficiency, optimum resource allocation, costs, economies of scale, and to estimate the
firm’s costs of production.
3. Pricing Analysis 3 Microeconomic techniques are used to examine various pricing
decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and optimal pricing method.
4. Budgeting 3 Investment theory is used to examine a firm’s capital purchasing decisions.
1.2 Why Managerial Economics Is Relevant for Managers
In a civilized society, we rely on others in the society to produce and distribute nearly all
the goods and services we need. However, the sources of those goods and services are usually
not other individuals but organizations created for the explicit purpose of producing and
distributing goods and services. Nearly every organization in our society4whether it is a
business, nonprofit entity, or governmental unit4can be viewed as providing a set of goods,
services, or both. The responsibility for overseeing and making decisions for these organizations
is the role of executives and managers. Most readers will readily acknowledge that the subject
matter of economics applies to their organizations and to their roles as managers. However, some
readers may question whether their own understanding of economics is essential, just as they
may recognize that physical sciences like chemistry and physics are at work in their lives but have
determined they can function successfully without a deep understanding of those subjects.
Whether or not the readers are skeptical about the need to study and understand economics per
se, most will recognize the value of studying applied business disciplines like marketing,
production/operations management, finance, and business strategy. These subjects form the
core of the curriculum for most academic business and management programs, and most
managers can readily describe their role in their organization in terms of one or more of these
applied subjects. A careful examination of the literature for any of these subjects will reveal that
economics provides key terminology and a theoretical foundation. Although we can apply
techniques from marketing, production/operations management, and finance without
understanding the underlying economics, anyone who wants to understand the why and how
behind the technique needs to appreciate the economic rationale for the technique. We live in a
world with scarce resources, which is why economics is a practical science. We cannot have
everything we want. Further, others want the same scarce resources we want.
Organizations that provide goods and services will survive and thrive only if they meet the
needs for which they were created and do so effectively. Since the organization’s customers also
have limited resources, they will not allocate their scarce resources to acquire something of little
or no value. And even if the goods or services are of value, when another organization can meet
the same need with a more favorable exchange for the customer, the customer will shift to the
other supplier. Put another way, the organization must create value for their customers, which is
the difference between what they acquire and what they produce. Thus, those managers who
understand economics have a competitive advantage in creating value.
1.3 Managerial Economics Is Applicable to Different Types of Organizations
The organization providing goods and services will often be called a <business= or a <firm,=
terms that connote a for-profit organization. And in some portions in the following discussions, we
discuss principles that presume the underlying goal of the organization is to create profit.
However, managerial economics is relevant to nonprofit organizations and government agencies

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as well as conventional, for-profit businesses. Although the underlying objective may change
based on the type of organization, all these organizational types exist for the purpose of creating
goods or services for persons or other organizations. Managerial economics also addresses
another class of manager: the regulator. The economic exchanges that result from organizations
and persons trying to achieve their individual objectives may not result in the best overall pattern
of exchange unless there is some regulatory guidance. Economics provides a framework for
analyzing regulation, both the effect on decision making by the regulated entities and the policy
decisions of the regulator.
1.4 Social Responsibility of Business
In modern capitalist economies, business firms contribute significantly to economic

welfare. Within free markets, firms compete to supply the goods and services that consumers
demand. Pursuing the profit motive, they constantly strive to produce goods of higher quality at
lower costs. By investing in research and development and pursuing technological innovation,
they endeavor to create new and improved goods and services. In most cases, the economic
actions of firms (spurred by the profit motive) promote social welfare as well: business production
contributes to economic growth, provides widespread employment, and raises standards of living.
The objective of value maximization implies that management’s primary responsibility is to the
firm’s shareholders. But the firm has other stakeholders as well: its customers, its workers, even
the local community to which it might pay taxes. This observation raises an important question:
To what extent might management decisions be influenced by the likely effects of its actions on
these parties? For instance, suppose management believes that downsizing its workforce is
necessary to increase profitability. Should it uncompromisingly pursue maximum profits even if
this significantly increases unemployment?
Alternatively, suppose that because of weakened international competition, the firm has
the opportunity to profit by significantly raising prices. Should it do so? Finally, suppose that the
firm could dramatically cut its production costs with the side effect of generating a modest amount
of pollution. Should it ignore such adverse environmental side effects? All these examples
suggest potential trade-offs between value maximization and other possible objectives and social
values. Although the customary goal of management is value maximization, there are
circumstances in which business leaders choose to pursue other objectives at the expense of
some foregone profits. For instance, management might decide that retaining 100 jobs at a
regional factory is worth a modest reduction in profit. Value maximization is not the only model of
managerial behavior. Nonetheless, the available evidence suggests that it offers the best
description of a private firm’s ultimate objectives and actions.
1.5 Social Responsibility of Business and Social Contract2
It is evident from above, the social responsibility of business implies that a corporate
enterprise has to serve interests other than that of common shareholders who, of course, expect
that their rate of return, value or wealth should be maximized. But in today’s world the interest of
other stakeholders, community and environment must be protected and promoted. Social
responsibility of business enterprises to the various stakeholders and society in general is the
result of a Social Responsibility of Business Enterprises towards Stakeholders and Society in
General contract as shown in the figure below.
2
https://www.economicsdiscussion.net/business/social-responsibility/social-responsibility-of-business/10141

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Environment
Figure: Responsibilities of Business
Employees Enterprises towards Stakeholders to
Society in General
Business Enterprise Shareholders
Consumers
Society
Social contract is a set of rules that defines the agreed interrelationship between various
elements of a society. The social contract often involves a quid pro quo (i.e. something given in
exchange for another). In the social contract, one party to the contract gives something and
expects a certain thing or behavior pattern from the other. In the present context the social
contract is concerned with the relationship of a business enterprise with various stakeholders
such as shareholders, employees, consumers, government, and society in general. The business
enterprises happen to have resources because society consisting of various stakeholders has
given them this right and therefore it expects from them to use them to for serving the interests of
all of them. Though all stakeholders including the society in general are affected by the business
activities of a corporate enterprise, managers may not acknowledge responsibility to them. Social
responsibility of business implies that corporate managers must promote the interests of all
stakeholders not merely of shareholders who happen to be the so-called owners of the business
enterprises.
1. Responsibility to Shareholders:
In the context of good corporate governance, a corporate enterprise must recognize the
rights of shareholders and protect their interests. It should respect shareholders’ right to
information and respect their right to submit proposals to vote and to ask questions at the annual
general body meeting. The corporate enterprise should observe the best code of conduct in its
dealings with the shareholders. However, the corporate Board and management try to increase
profits or shareholders’ value but in pursuing this objective, they should protect the interests of
employees, consumers, and other stakeholders. Its special responsibility is that in its efforts to
increase profits or shareholders’ value it should not pollute the environment.
2. Responsibility to Employees:
The success of a business enterprise depends to a large extent on the morale of its
employees. Employees make valuable contribution to the activities of a business organization.
The corporate enterprise should have good and fair employment practices and industrial relations
to enhance its productivity. It must recognize the rights of workers or employees to freedom of
association and free collective bargaining. Besides, it should not discriminate between various
employees. The most important responsibility of a corporate enterprise towards employees is the
payment of fair wages to them and provide healthy and good working conditions. The business
enterprises should recognize the need for providing essential labor welfare activities to their
employees, especially they should take care of women workers. Besides, the enterprises should
make arrange-ments for proper training and education of the workers to enhance their skills.
3. Responsibility to Consumers:
Some economists think that consumer is a king who directs the business enterprises to
produce goods and services to satisfy his wants. However, in the modern times this may not be

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strictly true, but the companies must acknowledge their responsibilities to protect their interests
in undertaking their productive activities. Invoking the notion of social contract, the management
expert Peter Drucker observes, <The customer is the foundation of a business and keeps it in
existence. He alone gives employment. To meet the wants and needs of a consumer, the society
entrusts wealth-producing resources to the business enterprise=. In view of above, the business
enterprises should recognize the rights of consumers and under-stand their needs and wants and
produce goods or services accordingly.
4. Obligation towards the Environment:
The foremost responsibility of business enterprises is to ensure that they should not
damage the environment and for this purpose they should reduce as much as possible air and
water pollution by their productive activities. They should not dump their toxic waste products in
rivers and streams to avoid their pollution. Pollution of environment poses a great health hazard
for the people and is a cause of several respiratory and skin diseases. In economic theory
pollution of environment is regarded as social cost that must be minimized. There is now a growing
awareness towards reduction in environment pollution. According to the recent findings the
climate change is occurring due to greater emission of carbon dioxide and other pollutants.
Therefore, the corporate enterprises should adopt high standards of environmental protection and
ensure that they are implemented regardless of enforcement of any environment laws passed by
the government. Many countries including India have passed laws to protect the environment, but
they are not properly and strictly enforced. Business enterprises in their attempt to maximize
profits recklessly and negligently pollute the environment. Therefore, it is required that
government should take tough measures and enforce environment laws strictly if environment is
to be protected.
5. Responsibility to Society in General:
Business enterprises function by public consent with the basic objective of producing
goods and services to meet the needs of the society and provide employment to the people. The
traditional view is that in performing this function businesses maximize profits or shareholders’
value and doing so they do not behave in any socially irresponsible way. According to Adam Smith
whose invisible hand theorem is often quoted that while maximizing their profits, businessmen
are led by an invisible hand to promote the interests of the society. To quote him, <An individual
or business generally, indeed neither intends to promote the public interest, nor knows how much
he is promoting it. He intends only his own gains, and he is in this, as in many other cases, led by
an invisible hand to promote an end which was no part of his intention. By pursuing his own
interest, he frequently promotes that of the society more effectively than when he really intends
to promote it=. In the present world where there are monopolies, oligopolies in product and factor
markets and there are externalities, especially detrimental externalities such as environment
pollution by the activities of business enterprises maximization of private profits does not always
lead to the maximization of social benefit. In fact, in such imperfect market conditions, consumers
are exploited by raising of prices much above the cost of production, workers are exploited as
they are not paid fair wages equal to the value of their marginal product. Besides, there are
harmful external effects to which are not given due considerations by private enterprises in making
their business decisions. Therefore, there is urgent need to make business enterprises behave in
a socially responsible manner and to work for promoting social interests.

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Assessment 1
1. Discuss and integrate microeconomics and macroeconomics in making managerial decisions

by citing examples. (5pts.)
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2. How does the scarcity of resources affect the firm’s decision making? Justify your answer
through discussing specific situations. (5pts.)
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3. Does regulating a firm will be significant for making optimal use of the resources and
production of goods and services? (5pts.)
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4. Having said that most firms chose to maximize their profit, do you think it is a hindrance in
their contribution to economic welfare? Justify your answer. (5pts.)
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_________________________________________________________________________
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CHAPTER 2
ECONOMIC DECISION MAKING
Learning Objectives: This chapter discusses the basic steps in decision making and introduces
profit-maximization as a main goal of business managers. The readers will be able to
identify and apply the basic steps of decision making to realize profit-maximization.
The best way to become acquainted with managerial economics is to come face to face
with real-world decision-making problems. Every decision can be framed and analyzed using a
common approach based on six steps, as Figure below indicates.
The Basic Steps in Decision

Making
The process of decision making

can be broken down into six
basic steps.
Step 1. Define the Problem
What is the problem the manager faces? Who is the decision maker? What is the decision
setting or context, and how does it influence managerial objectives or options?
Decisions do not occur in a vacuum. Many come about as part of the firm’s planning
process. Others are prompted by new opportunities or new problems. It is natural to ask, what
brought about the need for the decision? What is the decision all about? A key part of problem
definition involves identifying the context. Most of the decisions we study take place in the private
sector. Managers representing their respective firms are responsible for the decisions made.
Step 2. Determine the Objective
What is the decision maker’s goal? How should the decision maker value outcomes with
respect to this goal? What if he or she is pursuing multiple, conflicting objectives? When it comes
to economic decisions, it is a truism that <you can’t always get what you want.= But to make any
progress at all in your choice, you have to know what you want. In most private-sector decisions,
profit is the principal objective of the firm and the usual barometer of its performance. Thus, among
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alternative courses of action, the manager will select the one that will maximize the profit of the
firm.
In practice, profit maximization and benefit-cost analysis are not always unambiguous
guides to decision making. One difficulty is posed by the timing of benefits and costs. Both private
and public investments involve trade-offs between present and future benefits and costs.
Uncertainty poses a second difficulty. In some economic decisions, risks are minimal. The
presence of risk and uncertainty has a direct bearing on the way the decision maker thinks about
his or her objective.
Step 3. Explore the Alternatives
What are the alternative courses of action? What are the variables under the decision
maker’s control? What constraints limit the choice of options? After addressing the question <What
do we want?= it is natural to ask, <What are our options?= Given human limitations, decision
makers cannot hope to identify and evaluate all possible options. Still, one would hope that
attractive options would not be overlooked or, if discovered, not mistakenly dismissed. Moreover,
a sound decision framework should be able to uncover options in the course of the analysis.
Most managerial decisions involve more than a once-and-for-all choice from among a set
of options. Typically, the manager faces a sequence of decisions from among alternatives. In view
of the myriad uncertainties facing managers, most ongoing decisions should best be viewed as
contingent plans.
Step 4. Predict the Consequences
What are the consequences of each alternative action? Should conditions change, how
would this affect outcomes? If outcomes are uncertain, what is the likelihood of each? Can better
information be acquired to predict outcomes? Depending on the situation, the task of predicting
the consequences may be straightforward or formidable. Sometimes elementary arithmetic
suffices. For instance, the simplest profit calculation requires only subtracting costs from
revenues. The choice between two safety programs might be made according to which saves the
greater number of lives per dollar expended. Here the use of arithmetic division is the key to
identifying the preferred alternative.
MODELS
In more complicated situations, however, the decision maker often must rely on a model
to describe how options translate into outcomes. A model is a simplified description of a process,
relationship, or other phenomenon. By deliberate intent, a model focuses on a few key features
of a problem to examine carefully how they work while ignoring other complicating and less
important factors. The main purposes of models are to explain and to predict4to account for past
outcomes and to forecast future ones.
Other models rest on statistical, legal, and scientific relationships. The construction and
configuration of the new bridge (and its likely environmental impact) and the plan to convert
utilities to coal depend in large part on engineering predictions. Evaluations of test-marketing
results rely heavily on statistical models. Legal models, interpretations of statutes, precedents,
and the like are pertinent to predictions of a firm’s potential patent liability and to the outcome in
other legal disputes.
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Key distinction can be drawn between deterministic and probabilistic models. A

deterministic model is one in which the outcome is certain (or close enough to a sure thing that it
can be taken as certain) while a probabilistic model accounts for a range of possible future
outcomes, each with a probability attached.
Step 5. Make a Choice
After all the analysis is done, what is the preferred course of action? Once the decision
maker has put the problem in context, formalized key objectives, and identified available
alternatives, how does he or she go about finding a preferred course of action?
In most decisions, the objectives and outcomes are directly quantifiable. Thus, a private
firm (such as the carmaker) can compute the profit results alternative price and output plans.
Analogously, a government decision maker may know the computed net benefits (benefits minus
costs) of different program options. The decision maker could determine a preferred course of
action by enumeration, that is, by testing several alternatives and selecting the one that best
meets the objective. This is fine for decisions involving a small number of choices, but it is
impractical for more complex problems. Expanding the enumerated list could reduce this risk, but
at considerable cost.
Fortunately, the decision maker need not rely on the painstaking method of enumeration
to solve such problems. A variety of methods can identify and cut directly to the best, or optimal,
decision. These methods rely to varying extents on marginal analysis, decision trees, game
theory, benefit-cost analysis, and linear programming. These approaches are important not only
for computing optimal decisions but also for checking why they are optimal.
Step 6: Perform Sensitivity Analysis
What features of the problem determine the optimal choice of action? How does the
optimal decision change if conditions in the problem are altered? Is the choice sensitive to key
economic variables about which the decision maker is uncertain?
In tackling and solving a decision problem, it is important to understand and be able to

explain to others the <why= of your decision. The solution, after all, did not come out of thin air. It
depended on your stated objectives, the way you structured the problem (including the set of
options you considered), and your method of predicting outcomes. Thus, sensitivity analysis
considers how an optimal decision is affected if key economic facts or conditions vary.
2.1 Public Decisions: Economic View
In government decisions, the question of objectives is much broader than simply an

assessment of profit. Most observers would agree that the purpose of public decisions is to
promote the welfare of society, where the term society is meant to include all the people whose
interests are affected when a particular decision is made. The difficulty in applying the social
welfare criterion in such a general form is that public decisions inevitably carry different benefits
and costs to the many groups they affect. Some groups will gain, and others will lose from any
public decision. In our earlier example of the bridge, businesses and commuters in the region can
expect to gain, but nearby neighbors who suffer extra traffic, noise, and exhaust emissions will
lose. The program to convert utilities from oil to coal will benefit the nation by reducing our
dependence on foreign oil. However, it will increase many utilities’ costs of producing electricity,
which will mean higher electric bills for many residents. The accompanying air pollution will bring
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adverse health and aesthetic effects in urban areas. Strip mining has its own economic and
environmental costs, as does nuclear power. In short, any significant government program will
bring a variety of new benefits and costs to different affected groups.
The important question is: How do we weigh these benefits and costs to make a decision
that is best for society as a whole? One answer is provided by benefit-cost analysis, the principal
analytical framework used in guiding public decisions. Benefit-cost analysis begins with the
systematic enumeration of all the potential benefits and costs of a particular public decision. It
goes on to measure or estimate the dollar magnitudes of these benefits and costs. Finally, it
follows the decision rule: Undertake the project or program if and only if its total benefits exceed
its total costs. Benefit-cost analysis is similar to the profit calculation of the private firm with one
key difference: Whereas the firm considers only the revenue it accrues and the cost it incurs,
public decisions account for all benefits, whether or not recipients pay for them (that is, regardless
of whether revenue is generated) and all costs (direct and indirect).
Much of economic analysis is built on a description of ultrarational self-interested

individuals and profit-maximizing businesses. While this framework does an admirable job of
describing buyers and sellers in markets, workers interacting in organizations, and individuals
grappling with major life-time decisions, we all know that real-world human behavior is much more
complicated than this.
Twin lessons emerge from behavioral economics. On the one hand, personal and
business decisions are frequently marked by biases, mistakes, and pitfalls. We are not as smart
or as efficient as we think we are. On the other, decision makers are capable of learning from
their mistakes. Indeed, new methods and organizations4distinct from the traditional managerial
functions of private firms or the policy initiatives of government institutions4are emerging all the
time. Philanthropic organizations with financial clout play an influential role in social programs.
Organizations that promote and support opensource research insist that scientists make their
data and findings available to all. When it comes to targeted social innovations (whether in the
areas of poverty, obesity, delinquency, or educational attainment), governments are increasingly
likely to partner with profit and nonprofit enterprises to seek more efficient solutions.
2.2 Decision within Firms: Profit-Maximization
The main goal of a firm’s managers is to maximize the enterprise’s profit 3 either for its
private owners or for its shareholders. This goal implies that decisions that increase revenues to
be more than costs or reduce costs to be less than revenues, should be selected. This goal will
be analyzed using demand forecasting techniques, marginal analysis, cost analysis, and pricing
techniques which will be discussed on the following chapters.
Managerial economics is based on a model of the firm: how firms behave and what
objectives they pursue. The main principle of this model, or theory of the firm, is that management
strives to maximize the firm’s profits. This objective is unambiguous for decisions involving
predictable revenues and costs occurring during the same period of time. However, a more
precise profit criterion is needed when a firm’s revenues and costs are uncertain and
accrue at different times in the future. The most general theory of the firm states that
<Management’s primary goal is to maximize the value of the firm=.
The firm’s value is defined as the present value of its expected future profits. Thus, in
making any decision, the manager must attempt to predict its impact on future profit flows and
determine whether, indeed, it will add to the value of the firm. Although value maximization is the
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standard assumption in managerial economics, three other decision models should be noted. The
model of satisficing behavior posits that the typical firm strives for a satisfactory level of
performance rather than attempting to maximize its objective. Thus, a firm might aspire to a level
of annual profit, say $40 million, and be satisfied with policies that achieve this benchmark. More
generally, the firm may seek to achieve acceptable levels of performance with respect to multiple
objectives (profitability being only one such objective).
A second behavioral model posits that the firm attempts to maximize total sales subject
to achieving an acceptable level of profit. Total dollar sales are a visible benchmark of managerial
success. For instance, the business press puts particular emphasis on the firm’s market share. In
addition, a variety of studies show a close link between executive compensation and company
sales. Thus, top management’s self-interest may lie as much in sales maximization as in value
maximization.
A third issue centers on the social responsibility of business. In modern capitalist

economies, business firms contribute significantly to economic welfare. Within free markets, firms
compete to supply the goods and services that consumers demand. Pursuing the profit motive,
they constantly strive to produce goods of higher quality at lower costs. By investing in research
and development and pursuing technological innovation, they endeavor to create new and
improved goods and services. In the large majority of cases, the economic actions of firms
(spurred by the profit motive) promote social welfare as well: business production contributes to
economic growth, provides widespread employment, and raises standards of living.
The objective of value maximization implies that management’s primary responsibility is

to the firm’s shareholders. But the firm has other stakeholders as well: its customers, its workers,
even the local community to which it might pay taxes. This observation raises an important
question: To what extent might management decisions be influenced by the likely effects of its
actions on these parties? For instance, suppose management believes that downsizing its
workforce is necessary to increase profitability. Should it uncompromisingly pursue maximum
profits even if this significantly increases unemployment? Alternatively, suppose that because of
weakened international competition, the firm has the opportunity to profit by significantly raising
prices. Should it do so? Finally, suppose that the firm could dramatically cut its production costs
with the side effect of generating a modest amount of pollution. Should it ignore such adverse
environmental side effects?
All of these examples suggest potential trade-offs between value maximization and other
possible objectives and social values. Although the customary goal of management is value
maximization, there are circumstances in which business leaders choose to pursue other
objectives at the expense of some foregone profits. For instance, management might decide that
retaining 100 jobs at a regional factory is worth a modest reduction in profit. To sum up, value
maximization is not the only model of managerial behavior. Nonetheless, the available evidence
suggests that it offers the best description of a private firm’s ultimate objectives and actions.
2.3 Optimal Decision using Marginal Analysis
Marginal analysis is a method used to determine the optimal output level that will maximize
the firm’s profit. looks at the change in profit that results from making a small change in a decision
variable. We will look once again at the two components of profit, revenue, and cost, and highlight
the key features of marginal revenue and marginal cost. These marginal measurements not
only provide a numerical value to the responsiveness of the function to changes in the quantity
but also can indicate whether the business would benefit from increasing or decreasing the
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planned production volume and in some cases can even help determine the optimal level of
planned production. The marginal revenue measures the change in revenue in response to a unit
increase in production level or quantity. The marginal cost measures the change in cost
corresponding to a unit increase in the production level. The marginal profit measures the change
in profit resulting from a unit increase in the quantity. Marginal measures for economic functions
are related to the operating volume and may change if assessed at a different operating volume
level.
Marginal revenue (MR) is the extra revenue that an additional unit of product will bring to
the firm. It can also be described as the change in total revenue over the change in the number
of units sold (from Q0 to Q1). This can be expressed as:
�㕪þ�㖂ÿý�㖆 ÿÿ Ă�㖆Ā�㖆ÿÿ�㖆 ∆Ă Ă 2Ă
Marginal Revenue = = ∆ā = āĀ2āÿ
�㕪þ�㖂ÿý�㖆 ÿÿ ÿÿþāÿþ Ā ÿ
Marginal cost (MC) is the additional cost of producing an extra unit of output. The algebraic
definition is:
�㕪þ�㖂ÿý�㖆 ÿÿ �㕪Āýþ ∆�㕪 �㕪 2�㕪

Marginal Cost = �㕪þ�㖂ÿý�㖆 ÿÿ ÿÿþāÿþ = ∆ā = āĀ2āÿ
Ā ÿ
In general terms, marginal cost at each level of production includes any additional costs
required to produce next time. For instance, if producing additional vehicle requires building new
factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice,
the analysis is segregated into short-run and long-run cases where marginal costs include all
costs which vary with the level of production and other costs are considered fixed costs. This
concept will be discussed further in Chapter 6.
Profit maximization of the firms will be realized when optimal output is determined. Profit
maximization assumes that there is some output level that is most profitable. A firm might sell
huge amount at very low prices but discover that profits are low or negative. To avoid this, a firm
should sell output and charge price at MR = MC. This condition is called MR=MC rule. At this
quantity, the slopes of the revenue and cost functions are equal; the revenue tangent is parallel
to the cost line. But this simply says that marginal revenue equals marginal cost. At this optimal
output, the gap between revenue and cost is neither widening nor narrowing. Thus, maximum
profit is attained.
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Assessment 2
1. Complete the chart below by using the steps of the economic decision making.
The ABCD Grill House is selling an average of 200 units of grilled whole
chicken per day using the electric griller but there will be an electric
interruption within the area during their operating hours and so, it will
Situation affect their grilled chicken production for that day. The firm also expects
an increase in the demand for grilled chicken considering that many
households also use an electric powered stove and buying cooked meat
will be their alternative.
Define the
Problem
Determine the
Objective
Explore the
Alternatives
Predict the
Consequences
Make a Choice
Perform
Sensitivity
Analysis
2. How do you see the partnership between government and private firms in producing public
goods? Does it convert to efficiency of the government programs? Justify your answer.
_________________________________________________________________________
____________________________________________________________________________
______________________________________________________________________
_________________________________________________________________________
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CHAPTER 3
DEMAND ANALYSIS: Estimation and Forecasting
Learning Objectives: This chapter discusses the theory of demand and introduces the elasticity
properties of demand. This also examines the procedures that are used in empirical
estimates of demand functions and introduces the various methods in business and
economic forecasting. At the end of this chapter, the readers will be able to conduct
demand analysis, evaluate factors affecting demand, explain price elasticity and its
relation to total revenue, interpret income and cross elasticities, and apply the forecasting
models for decision-making.
Since the demand for a firm’s goods and services plays an important and central role in
determining the amount of cash flow which the firm will be able to generate. Thus, it is essential
that we have a strong and deep understanding about demand. Demand analysis could help
managers to provide appropriate insights necessary for effective management of demand and to
assist in forecasting sales and revenue for the firm.
3.1 Demand Analysis
Demand shows various amount of goods that consumers are willing and able to buy at a
specific period of time (day, week, month or year). This can be represented as demand schedule
or demand table, demand curve and demand function.
A. Demand Schedule
The table shows that as the price increases, the
Quantity quantity demanded decreases. This is called the
Price
Demanded law of demand.
0 100
5 90 Take note that demand is different from quantity
10 80 demanded. Demand refers to the whole schedule
15 70 while quantity demanded refers to the specific
20 60 amount of good at a given price (i.e at price 10
25 50 quantity demanded is 80).
Based on the above demand schedule, quantity demand can be changed when price
changed leaving demand unchanged. Demand can change based on the change of its
determinants known as determinants of demand. A change in demand can be easily shown using
the demand curve.
There are three explanations of the inverse relationship of price and quantity demanded:
1. The law of demand is consistent with Common Sense. People ordinarily do buy
more of a product at a low price than at a high price. Price is an obstacle that deters
consumers from buying. The higher that obstacle, the less of a product they will buy;
the lower the price obstacle, the more they will buy. The fact that businesses have
<sales= is evidence of their belief in the law of demand.
2. In any specific time period, each buyer of a product will derive less satisfaction (or
benefit, or utility) from each successive unit of the product consumed. The second Big
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Mac will yield less satisfaction to the consumer than the first, and the third still less
than the second. That is, consumption is subject to Diminishing Marginal Utility.
And because successive units of a particular product yield less and less marginal
utility, consumers will buy additional units only if the price of those units is
progressively reduced.
3. We can also explain the law of demand in terms of income and substitution effects.
The income effect indicates that a lower price increases the purchasing power
of a buyer’s money income, enabling the buyer to purchase more of the product
than before. A higher price has the opposite effect. The substitution effect suggests
that at a lower price, buyers have the incentive to substitute what is now a less
expensive product for similar products that are now relatively more expensive. The
product whose price has fallen is now <a better deal= relative to the other products.
For example, a decline in the price of chicken will increase the purchasing power of
consumer incomes, enabling people to buy more chicken (the income effect). At a
lower price, chicken is relatively more attractive, and consumers tend to substitute it
for pork, lamb, beef, and fish (the substitution effect). The income and substitution
effects combine to make consumers able and willing to buy more of a product at a low
price than at a high price.
B. Demand Curve
Transforming the above demand schedule to demand curve:
Because of the inverse relationship of price and quantity demanded, demand curve is a
downward sloping curve. Consider the following determinants of demand:
1. Tastes or preferences. If consumers have favorable response regarding the good,

demand will increase making demand curve shifts to the right. On the other hand,
unfavorable response of consumers on the good will decrease demand and will shift
demand curve to the left.
2. Number of Buyers. An increase in the number of buyers will increase in demand and
make the demand curve shift to the right. Otherwise to the left.
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3. Income. There are two kinds of goods under income, normal good or superior good
and inferior good. As income increase demand for normal good also increase. This
means a positive relationship between income and normal goods. On the other hand,
as income increase demand for inferior good will decrease. Thus, there is a negative
or inverse relationship of income and inferior good.
4. Price of Related Goods. Substitute goods and complementary goods are considered
as related goods. When there is an increase of price of a particular good and the
demand of its related good increased, the goods are considered as substitute goods.
On the other hand, when there is an increase of price of a particular good and the
demand of its related good decreased, these goods are complementary goods.
5. Expectation. Consumer’s expectations on the change of price because of weather,
tradition and culture. In example, if there will be a super typhoon tomorrow today’s
demand will increase because consumers are expecting higher price of goods after
typhoon and decrease of supply of goods.
These determinants are also known as non-price determinants. Any movement of one
point to another point along the same demand curve is called change in quantity demanded.
The movement of one curve to another demand curve is called change in demand.
C. Demand Function
Another representation of demand is a function. Considering the given demand schedule,

we can derive its demand function:
Qd = a – bP
Where:
Qd = Quantity Demanded
a = intercept (at price 0)
∆ĀĂ
b = slope ( ∆ÿ )
P = price
The negative slope represents the negative relationship of price and quantity demanded.
Intercept is the maximum amount of goods that the consumers are willing and able to buy at price
0. Thus,
Qd = 100 – 2P
∆ĀĂ
b = ∆ÿ
902100 210
= =
520 5
b = -2
To check: substitute the P with the given prices from the table.
Qd = 100 3 2(0) = 100 3 0 = 100
Qd = 100 3 2(5) = 100 3 10 = 90
Qd = 100 3 2(10) = 100 3 20 = 80
Qd = 100 3 2(15) = 100 3 30 = 70
Qd = 100 3 2(20) = 100 3 40 = 60
Qd = 100 3 2(25) = 100 3 50 = 50
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This function is applicable to linear equation where the slope is constant or equal. In this function,
the slope is -2.
3.2 Price Elasticity of Demand3
The responsiveness of consumers to a price change is measured by a product’s price

elasticity of demand. Graphically,
1. Flat demand curve, Elastic demand
Suppose the original price is 2 and original

quantity is 10 at point a. Price decreased
from 2 to 1 while quantity increased from 10
to 40. The change in price is less than the
change in quantity. Consumers consumption
is so much affected by the price change;
thus, this elasticity refers to luxury good.
2. Steep demand curve, Inelastic demand
Suppose the original price is 1 and original

quantity is 20 at point d. Price increased
from 1 to 4 while quantity decreased from 20
to 10. The change in price is greater than the
change in quantity. Consumers
consumption is slightly affected by the price
change, thus, this elasticity refers to basic
good. Even though there is a large change
in price, consumers cannot give up large
quantity of their consumption.
3. Steeper than elastic demand but flatter than inelastic demand
Let original price at 3 and original quantity

is 10 at point e. Price decreased from 3 to
1 while quantity increased from 10 to 30.
The change in price is equal to the change
in quantity, thus, this elasticity is
considered as unitary.
3
The diagrams and tables used in the discussions of elasticities were collected from McConnel, C. & Brue, S.
(2008). Economics: Principles, Problems, and Policies. 17th edition, McGraw Hill-Irwin.
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The coefficient Ed which measures the price elasticity or inelasticity of demand can be
computed as:
āăăāăÿąÿąă ā/ÿÿąă ÿÿ ĂĆÿÿąÿąþ ĂăþÿÿĂăĂ ĀĄ āăĀĂĆāą ÿ

ýĂ =
āăăāăÿąÿąă ā/ÿÿąă ÿÿ āăÿāă ĀĄ āăĀĂĆāą ÿ
This is also equal to the midpoint formula which eliminates the <up and down= problem.
ā/ÿÿąă ÿÿ ĂĆÿÿąÿąþ ā/ÿÿąă ÿÿ āăÿāă

ýĂ = ÷
ĄĆþ ĀĄ ĂĆÿÿąÿąÿăĄ/2 ĄĆþ ĀĄ āăÿāăĄ/2
Ā2 2 Ā1 ÿ2 2 ÿ1
ýĂ = |( ÷ 2) / ( ÷ 2)|
Ā1+Ā2 ÿ1+ÿ2
Since demand curve is a downward sloping curve because of the inverse relationship of
price and quantity demanded, the price-elasticity coefficient ýĂ will always be negative. To avoid
an ambiguity, negative sign is ignored by getting the absolute value. The computed price-elasticity
coefficient ýĂ will be interpreted to know the nature of elasticity such as elastic demand, inelastic
demand, and unitary.
A demand is elastic if a specific percentage change in price results in a larger percentage

change in quantity demanded. Thus, ýĂ is greater than 1 (ýĂ > 1). Example: Suppose that a 3
percent decline in the price of chocolates results in a 6 percent increase in the quantity demanded.
The demand for chocolates is elastic because:
0.06
ýĂ = 0.03 = 2; 2>1 elastic
If a specific percentage change in price produces a smaller percentage change in quantity

demanded, demand is inelastic. This means that ýĂ is less than 1 (ýĂ < 1). For example:
Suppose that a 4 percent decline in the price of coffee leads to a 2 percent increase in quantity
demanded. The demand for coffee is inelastic because:
0.02
ýĂ = 0.04 = 0.5; 0.5 <1 inelastic
In a case where the percentage change in price of the product is equal to the change in
the quantity demand is called unitary or unit elastic demand. Example: Suppose that a 2
percent drop in the price of fish causes a 2 percent increase in quantity demanded. This case is
unit elastic because ýĂ is equal to 1 (ýĂ = 1).
0.02
ýĂ = 0.02 = 1
Extreme cases where a price change results in no change whatsoever in the quantity
demanded (ýĂ = 0) and where a small price reduction causes buyers to increase their purchases
from zero to all they can obtain, the elasticity coefficient is infinite (ýĂ =∞) are called perfectly
inelastic and perfectly elastic respectively. Graphically, a perfectly inelastic demand is a vertical
demand curve while a perfectly elastic demand is a horizontal demand curve.
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Demand curve D1 in (a) represents

perfectly inelastic demand. A price
increase will result in no change in
quantity demanded. Thus, the price-
elasticity coefficient is zero.
Demand curve D2 in (b) represents

perfectly elastic demand 3 a line parallel
to the horizontal axis. A price increase will
cause quantity demanded to decline from
an infinite amount to zero.
3.2.1 Price Elasticity of Demand and Total Revenue Relationship
The importance of elasticity for firms relates to the effect of price changes on total revenue
and thus on profits (total revenue minus total costs). Total Revenue is defined as the total amount
the seller receives from the sale of a product in a particular time period; it is calculated by
multiplying the product price (P) by the quantity demanded and sold (Q). In equation form:
ăā = ÿýĀ
The easiest way to infer whether demand is elastic or inelastic is to employ the total-
revenue test. Here is the test: Note what happens to total revenue when price changes. If total
revenue changes in the opposite direction from price, demand is elastic. If total revenue changes
in the same direction as price, demand is inelastic. If total revenue does not change when price
changes, demand is unit-elastic.
Under elastic demand, a decrease in price will increase total revenue. Even though a
lesser price is received per unit, enough additional units are sold to more than make up for the
lower price. On the other hand, if demand is inelastic, a price decrease will reduce total revenue.
The increase in sales will not fully offset the decline in revenue per unit, and total revenue will
decline.
In the special case of unit elasticity, an increase or a decrease in price leaves total revenue
unchanged. The loss in revenue from a lower unit price is exactly offset by the gain in revenue
from the accompanying increase in sales. Conversely, the gain in revenue from a higher unit price
is exactly offset by the revenue loss associated with the accompanying decline in the amount
demanded.
Let us analyze the relationship of price elasticity of demand and total revenue using the
table below considering the price elasticity of demand for movie tickets:
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The table shows the demand schedule of movie tickets where (1) is the quantity demanded
of movie tickets and (2) is the price per ticket. Applying the midpoint formula for computing the
price elasticity of demand, elasticity coefficient is shown in (3). Column (4) shows the Total
Revenue (TR) which was derived by multiplying the price and quantity demanded while the last
column (5) shows the nature of elasticity.
From price 1 to 4, the price elasticity of demand is elastic, price 4 to 5 shows that the
elasticity coefficient is 1 (unit elastic), and the inelastic price elasticity of demand is evident from
price 6 to 8. To discuss the relationship of price elasticity of demand and total revenue, the table
above was presented graphically,
If demand is elastic, a price increase

will reduce total revenue. The revenue gained
on the higher-priced units will be more than
offset by the revenue lost from the lower
quantity sold.
If demand is inelastic, a price decrease

will reduce total revenue. The increase in sales
will not fully offset the decline in revenue per
unit, and total revenue will decline.
In the special case of unit elasticity, an

increase or a decrease in price leaves total
revenue unchanged. The loss in revenue from
a lower unit price is exactly offset by the gain
in revenue from the accompanying increase in
sales. Conversely, the gain in revenue from a
higher unit price is exactly offset by the
revenue loss associated with the
accompanying decline in the amount
demanded.
The above figure shows that the slope of demand curve is computed from absolute
changes in price and quantity, while elasticity involves relative or percentage changes in price
and quantity. The demand is linear which by definition means that the slope is constant
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throughout. But we have demonstrated that such a curve is elastic in its high-price ($83$5) range
and inelastic in its low-price ($43$1) range.
In addition, the total-revenue curve TR, which first slopes upward, then reaches a
maximum, and finally turns downward. Under elastic demand, as price decreases total revenue
is increasing. On the other hand, under inelastic demand, as price decreases total revenue
increases. It is also evident that when the price elasticity of demand is unit elastic, there is no
change in total revenue.
3.2.2 Cross Elasticity of Demand
The consumption of a certain good can be affected by the change of price of the other
good, thus the relationship of the goods will be examined using cross elasticity of demand. The
cross elasticity of demand measures how sensitive consumer purchases of one product (say, X)
are to a change in the price of some other product (say, Y). We calculate the coefficient of cross
elasticity of demand ýýþ just as we do the coefficient of simple price elasticity, except that we
relate the percentage change in the consumption of X to the percentage change in the price of Y:
āăăāăÿąÿąă ā/ÿÿąă ÿÿ ĂĆÿÿąÿąþ ĀĄ āăĀĂĆāą ÿ

ýýþ =
āăăāăÿąÿąă ā/ÿÿąă ÿÿ āăÿāă ĀĄ āăĀĂĆāą Ā
This cross-elasticity concept talks about the relationship of the price and consumption of
two goods, a change in price of one good and the consumption for the other good, we can fully
understand and determine substitute goods and complementary goods.
If cross elasticity of demand is positive, meaning that sales of X move in the same
direction as a change in the price of Y, then X and Y are substitute goods. An example is
Gatorade (X) and Pocari Sweat (Y). An increase in the price of Gatorade causes consumers to
buy more Pocari Sweat, resulting in a positive cross elasticity. The larger the positive cross-
elasticity coefficient, the greater is the substitutability between the two products.
On the other hand, when cross elasticity is negative, we know that X and Y <go
together=; an increase in the price of one decreases the demand for the other. So, the two
are complementary goods. For example, an increase in the price of digital cameras will
decrease the amount of memory sticks purchased. The larger the negative cross-elasticity
coefficient, the greater is the complementarity between the two goods.
However, a zero or near-zero cross elasticity suggests that the two products being
considered are unrelated or independent goods. An example is walnuts and plums: We would
not expect a change in the price of walnuts to have any effect on purchases of plums, and vice
versa.
3.2.3 Income Elasticity of Demand
The consumption of a good also is affected by a change in the price of a related product
or by a change in income. Income elasticity of demand measures the degree to which consumers
respond to a change in their incomes by buying more or less of a particular good. The coefficient
of income elasticity of demand ýÿ is determined with the formula:
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āăăāăÿąÿąă ā/ÿÿąă ÿÿ ĂĆÿÿąÿąþ ĂăþÿÿĂăĂ

ýÿ =
āăăāăÿąÿąă ā/ÿÿąă ÿÿ ÿÿāĀþă
The positive and negative signs of income elasticity coefficient determine is the particular
good is inferior good or superior good/normal good. For most goods, the income elasticity
coefficient ýÿ is positive (direct relationship of purchased good and income), meaning that more
of them are demanded as incomes rise. Such goods are called normal or superior goods.
However, a negative income-elasticity coefficient designates an inferior good. Consumers
decrease their purchases of inferior goods as incomes rise (indirect or inverse relationship of
purchased good and income). These concepts were summarized on the following table:
3.2.4 Price Elasticity and Prediction
Price elasticity is an essential tool for estimating the sales response to possible price
changes. A simple rearrangement of the elasticity definition gives the predictive equation:
∆Ā ∆ÿ
= ýā ( )
Ā ÿ
For instance, the short-term (i.e., one-year) price elasticity of demand for gasoline is
approximately -0.3. This indicates that if the average price of gasoline were to increase from $2.50
to $3.00 per gallon (a 20 percent increase), then consumption of gasoline (in gallons) would fall
by only 6 percent (-0.3x20%). Also, suppose the price elasticity of demand for luxury cars is -2.1.
A modest 5 percent increase in their average sticker price implies a 10.5 percent drop in sales.
How does one estimate the impact on sales from changes in two or more factors that
affect demand? A simple example can illustrate the method. the price and income elasticities for
nonbusiness air travel are estimated to be EP = -0.38 and EY = 1.8, respectively. In the coming
year, average airline fares are expected to rise by 8 percent and income by 5 percent. What will
be the impact on the number of tickets sold to nonbusiness travelers? The answer is found by
adding the separate effects due to each change:
∆Ā ∆ÿ ∆Ā
= ýā ( ) + ýþ ( )
Ā ÿ Ā
∆Ā
Therefore, Ā
= (. 0.38)(8%) + (1.8)(5%) = 6%. Sales are expected to increase by about 6
percent.
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3.3 Demand Analysis and Optimal Pricing
In this section, we put demand analysis to work by examining three important managerial
decisions: (1) the special case of revenue maximization, (2) optimal markup pricing, and (3) price
discrimination.
3.3.1 Price Elasticity, Revenue, and Marginal Revenue
What can we say about the elasticity along any downward-sloping, linear demand curve?
First, we must be careful to specify the starting quantity and price (the point on the demand curve)
from which percentage changes are measured. The slope of the demand curve is dP/dQ (as it is
conventionally drawn with price on the vertical axis). Thus, the first term in the elasticity
expression, dQ/dP, is simply the inverse of this slope and is constant everywhere along the curve.
The term P/Q decreases as one moves downward along the curve. Thus, along a linear demand
curve, moving to lower prices and greater quantities reduces elasticity; that is, demand becomes
more inelastic.
As a concrete illustration of this point, consider a software firm that is trying to determine
the optimal price for one of its popular software programs. Management estimates this product’s
demand curve to be:
Ā = 1,600 2 4ÿ
where Q is copies sold per week and P is in dollars. We note for future reference that dQ/dP = -
4. The following Figure shows this demand curve as well as the associated marginal revenue
curve. In the figure, the midpoint of the demand curve is marked by point M: Q = 800 and P =
$200. Two other points, A and B, along the demand curve also are shown.
Demand, Revenue, and

Marginal Revenue
In part (a), elasticity

varies along a linear demand
curve. The point of maximum
revenue occurs at a price and
quantity such that MR = 0 or,
equivalently, EP = -1.
Compute the price elasticity at point M. Show that the elasticity is unity. This result holds
for the midpoint of any linear demand curve.
The figure depicts a useful result. Any linear demand curve can be divided into two
regions. Exactly midway along the linear demand curve, price elasticity is unity. To the northwest
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(at higher prices and lower quantities), demand is elastic. To the southeast (at lower prices and
greater quantities), demand is inelastic. For example, consider a point on the inelastic part of the
curve such as B: P = $100 and Q = 1,200. Here the point elasticity is EP = (dQ/dP)(P/Q) = (-
4)(100/1,200) =-0.33. Conversely, at a point on the elastic portion of the demand curve such as
A (P = $300 and Q = 400), the point is EP = (-4)(300/400) = -3.0.
The previous figure depicts the firm’s total revenue curve for different sales volumes. It
displays the familiar shape of an upside-down U. Total revenue increases as quantity increases
up to the revenue peak; at still higher quantities, revenue falls.
Let’s carefully trace the relationship between price elasticity and changes in revenue.
Suppose that management of the software firm is operating at point A on the demand curve. Its
price is $300, it sells 400 copies of the software program, and it earns $120,000 in revenue per
week. Could the firm increase its revenue by cutting its price to spur greater sales? If demand is
elastic, the answer is yes. Under elastic demand, the percentage increase in quantity is greater
than the percentage fall in price. Thus, revenue4the product of price and quantity4must
increase. The positive change in quantity more than compensates for the fall in price. Figure b
shows clearly that starting from point A, revenue increases when the firm moves to greater
quantities (and lower prices). Starting from any point of elastic demand, the firm can increase
revenue by reducing its price.
Now suppose the software firm is operating originally at point B, where demand is inelastic.
In this case, the firm can increase revenue by raising its price. Because demand is inelastic, the
percentage drop in quantity of sales is smaller than the percentage increase in price. With price
rising by more than quantity falls, revenue necessarily increases. Again, the revenue graph in
Figure b tells the story. Starting from point B, the firm increases its revenue by reducing its quantity
(and raising its price). As long as demand is inelastic, revenue moves in the same direction as
price. By raising price and reducing quantity, the firm moves back toward the revenue peak.
Putting these two results together, we see that when demand is inelastic or elastic,
revenue can be increased (by a price hike or cut, respectively). Therefore, revenue is maximized
when neither a price hike nor a cut will help; that is, when demand is unitary elastic, EP = -1. In
the software example, the revenue-maximizing quantity is Q = 800 (Figure b). This quantity (along
with the price, P = $200) is the point of unitary elasticity (in Figure a).
Our discussion has suggested an interesting and important relationship between marginal
revenue and price elasticity. The same point can be made mathematically. By definition, MR =
dR/dQ = d(PQ)/dQ. The derivative of this product is
ĂĀ
āā = ÿ ( ) + Ăÿ/ĂĀ)Ā
ĂĀ
Ăÿ Ā
= ÿ + ÿ( )( )
ĂĀ ÿ
Ăÿ Ā
= ÿ [1 + ( ) ( )]
ĂĀ ÿ
1
= ÿ [1 + ]
ýā
For instance, if demand is elastic (say, EP = -3), MR is positive; that is, an increase in
quantity (via a reduction in price) will increase total revenue. If demand is inelastic (say, EP = -
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0.6), MR is negative; an increase in quantity causes total revenue to decline. If elasticity is

precisely =1, MR is zero. Figure a shows clearly the relationship between MR and EP.
Maximizing Revenue
Maximizing profit is the appropriate objective because it takes into account not only
revenues but also relevant costs. In some important special cases, however, the two goals
coincide or are equivalent. This occurs when the firm faces what is sometimes called a pure
selling problem: a situation where it supplies a good or service while incurring no variable cost (or
a variable cost so small that it safely can be ignored). It should be clear that, without any variable
costs, the firm maximizes its ultimate profit by setting price and output to gain as much revenue
as possible (from which any fixed costs then are paid). The following pricing problems serve as
examples.
• A software firm is deciding the optimal selling price for its software.
• A manufacturer must sell (or otherwise dispose of) an inventory of unsold merchandise.
• A professional sports franchise must set its ticket prices for its home games.
• An airline is attempting to fill its empty seats on a regularly scheduled flight.
In each of these examples, variable costs are absent (or very small). The cost of an
additional software copy (documentation and disk included) is trivial. In the case of airline or sports
tickets, revenues crucially depend on how many tickets are sold. The cost of an additional
passenger or spectator is negligible once the flight or event has been scheduled. As for inventory,
production costs are sunk; selling costs are negligible or very small. Thus, in each case the firm
maximizes profits by setting price and output to maximize revenue.
How does the firm determine its revenue-maximizing price and output? There are two
equivalent answers to this question. The first answer is to apply the fundamental rule: MR = MC.
In the case of a pure selling problem, marginal cost is zero. Thus, the rule becomes MR = 0,
exactly as one would expect. This rule instructs the manager to push sales to the point where
there is no more additional revenue to be had4MR = 04and no further. From the preceding
discussion, we have established a second, equivalent answer: Revenue is maximized at the point
of unitary elasticity. If demand were inelastic or elastic, revenue could be increased by raising or
lowering price, respectively. The following proposition sums up these results.
Note that this result confirms that the point of unitary elasticity occurs at the midpoint of a
linear demand curve. For the sales quantity at the midpoint, marginal revenue is exactly zero
(since the MR curve cuts the horizontal axis at the midpoint quantity). But when MR = 0, it is also
true that EP= -1.
3.3.2 Optimal Markup Pricing4
There is a close link between demand for a firm’s product and the firm’s optimal pricing
policy. In the remainder of this chapter, we will take a close and careful look at the trade-off
between price and profit. Once the firm determined its optimal output by weighing marginal
revenue and marginal cost, it was a simple matter to set price in order to sell exactly that much
output. Now we shift our focus to price and consider a somewhat different trade-off.
4
Discussions from Optimal Markup Pricing to Demand Forecasting were gathered from Samuelson, W.F. and
Marks, S.G., Managerial Economics, 7th Edition, John Wiley & Sons, Inc.
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To illustrate this trade-off, we can write the firm’s contribution as
�㔶ĀÿąăÿĀĆąÿĀÿ = (ÿ = ā�㔶)Ā
where, for simplicity, MC is assumed to be constant. How should the firm set its price to maximize
its contribution (and, therefore, its profit)? The answer depends on how responsive demand is to
changes in price, that is, on price elasticity of demand. Raising price increases the firm’s
contribution per unit (or margin), P = MC. But to a greater or lesser degree, a price hike also
reduces the total volume of sales Q. If sales are relatively unresponsive to price (i.e., demand is
relatively inelastic), the firm can raise its price and increase its margin without significantly
reducing quantity. In this instance, the underlying trade-off works in favor of high prices.
Alternatively, suppose demand is very elastic. In this instance, a price increase would
bring a large drop in sales to the detriment of total contribution. Here, the way to maximize
contribution (and profit) is to play the other side of the trade-off. The firm should pursue a policy
of discount pricing to maximize profitability. As we shall see, the correct pricing policy depends
on a careful analysis of the price elasticity of demand. Indeed, when the firm has the ability to
segment markets, it may benefit by trading on demand differences. As noted in this chapter’s
opening example, airlines set a variety of different ticket prices4charging high fares to less price-
sensitive business travelers and discounting prices to economy-minded vacation travelers.
It is possible to write down and apply a modified (but exactly equivalent) version of the MR
= MC rule to derive a simple rule for the firm’s profit-maximizing price. The firm’s optimal price is
determined as follows:
ÿ 2 ā�㔶 1
=
ÿ 2ýÿ
This equation, called the markup rule, indicates that the size of the firm’s markup (above marginal
cost and expressed as a percentage of price) depends inversely on the price elasticity of demand
for a good or service.
The markup is always positive. (Note that EP is negative, so the right-hand side is
positive.) What happens as demand becomes more and more price elastic (i.e., price sensitive)?
The right-hand side of the markup rule becomes smaller, and so does the optimal markup on the
left-hand side. In short, the more elastic is demand, then the smaller is the markup above marginal
cost.
The markup rule is intuitively appealing and is the most commonly noted form of the
optimal pricing rule. Nonetheless, to make computations easier, it is useful to rearrange the rule
to read
ýā
ÿ=( ) ā�㔶
1 + ýā
We see that greater elasticities imply lower prices.
The markup rule is a formal expression of the conventional wisdom that price should
depend on both demand and cost. The rule prescribes how prices should be determined in
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principle. In practice, managers often adopt other pricing policies. The most common practice is
to use full-cost pricing. With this method, price is
ÿ = (1 + þ)�㔴�㔶,
where AC denotes total average cost (defined as total cost divided by total output) and m denotes
the markup of price above average cost.
The optimal managerial decisions suggest two points of criticism about full-cost pricing.
First, full-cost pricing uses average cost4the incorrect measure of relevant cost4as its base.
The logic of marginal analysis in general and the optimal markup rule in particular show that
optimal price and quantity depend on marginal cost. Fixed costs, which are counted in AC but not
in MC, have no effect on the choice of optimal price and quantity. Thus, to the extent that AC
differs from MC, the full-cost method can lead to pricing errors.
Second, the percentage markup should depend on the elasticity of demand. There is
considerable evidence that firms vary their markups in rough accord with price elasticity. Gourmet
frozen foods carry much higher markups than generic food items. Inexpensive digital watches
($15 and under) have lower markups than fine Swiss watches or jewelers’ watches. Designer
dresses and wedding dresses carry much higher markups than off-the-rack dresses. In short,
producers’ markups are linked to elasticities, at least in a qualitative sense. Nonetheless, it is
unlikely that firms’ full-cost markups exactly duplicate optimal markups. Obviously, a firm that sets
a fixed markup irrespective of elasticity is needlessly sacrificing profit.
3.3.3 Price Discrimination
Price discrimination occurs when a firm sells the same good or service to different buyers
at different prices. As the following examples suggest, price discrimination is a common business
practice.
• Airlines charge full fares to business travelers, while offering discount fares to
vacationers.
• Firms sell the same products under different brand names or labels at different prices.
• Providers of professional services (doctors, consultants, lawyers, etc.) set different rates
for different clients.
• Manufacturers introduce products at high prices before gradually dropping price over
time.
• Publishers of academic journals charge much higher subscription rates to libraries and
institutions than to individual subscribers.
• Businesses offer student and senior citizen discounts for many goods and services.
• Manufacturers sell the same products at higher prices in the retail market than in the
wholesale market.
• Movies play in <first-run= theaters at higher ticket prices before being released to
suburban theaters at lower prices.
When a firm practices price discrimination, it sets different prices for different market
segments, even though its costs of serving each customer group are the same. Thus, price
discrimination is purely demand based. Of course, firms may also charge different prices for the
<same= good or service because of cost differences. (For instance, transportation cost may be
one reason why the same make and model of automobile sells for significantly different prices on
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the West and East coasts.) But cost-based pricing does not fall under the heading of price
discrimination.
Price discrimination is a departure from the pricing model we have examined up to this
point. Thus far, the firm has been presumed to set a single market-clearing price. Obviously,
charging different prices to different market segments, as in the examples just listed, allows the
firm considerably more pricing flexibility. More to the point, the firm can increase its profit with a
policy of optimal price discrimination (when the opportunity exists).
Two conditions must hold for a firm to practice price discrimination profitably. First, the
firm must be able to identify market segments that differ with respect to price elasticity of demand.
As we show shortly, the firm profits by charging a higher price to the more inelastic (i.e., less
price-sensitive) market segment(s). Second, it must be possible to enforce the different prices
paid by different segments. This means that market segments receiving higher prices must be
unable to take advantage of lower prices. (In particular, a low-price buyer must be unable to resell
the good or service profitably to a high-price buyer.) The conditions necessary to ensure different
prices exist in the preceding examples. Sometimes the conditions are quite subtle. Business
travelers rarely can purchase discount air tickets because they cannot meet advance booking or
minimum-stay requirements. First-run moviegoers pay a high-ticket price because they are
unwilling to wait until the film comes to a lower-price theater.
How can the firm maximize its profit via price discrimination? There are several (related)
ways to answer this question. The markup rule provides a ready explanation of this practice. To
illustrate, suppose a firm has identified two market segments, each with its own demand curve.
Then the firm can treat the different segments as separate markets for the good. The firm simply
applies the markup rule twice to determine its optimal price and sales for each market segment.
Thus, it sets price according to P = [EP/(1 + EP)]MC separately for each market segment.
Presumably the marginal cost of producing for each market is the same. With the same MC
inserted into the markup rule, the difference in the price charged to each segment is due solely to
differences in elasticities of demand. For instance, suppose a firm identifies two market segments
with price elasticities of -5 and -3, respectively. The firm’s marginal cost of selling to either
segment is $200. Then, according to the markup rule, the firm’s optimal prices are $250 and $300,
respectively. We see that the segment with the more inelastic demand pays the higher price. The
firm charges the higher price to less price sensitive buyers (with little danger of losing sales). At
the same time, it attracts the more price-sensitive customers (who would buy relatively little of the
good at the higher price) by offering them a discounted price. Thus, by means of optimal price
discrimination, the firm maximizes its profit.
Like the method just described a second approach to price discrimination treats different
segments as distinct markets and sets out to maximize profit separately in each. The difference
is that the manager’s focus is on optimal sales quantities rather than prices. The optimal sales
quantity for each market is determined by setting the extra revenue from selling an extra unit in
that market equal to the marginal cost of production. In short, the firm sets MR = MC in each
market.
Demand-Based Pricing
As these examples indicate, the ways in which firms price discriminate are varied. Indeed,
there are many forms of demand-based pricing that are closely related to price discrimination
(although not always called by that name). For instance, resorts in Florida and the Caribbean set
much higher nightly rates during the high season (December to March) than at off-peak times.
The difference in rates is demand based. (The resorts’ operating costs differ little by season.)
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Vacationers are willing to pay a much higher price for warm climes during the North American
winter. Similarly, a convenience store, open 24 hours a day and located along a high-traffic route
or intersection, will set premium prices for its merchandise. (Again, the high markups are
predominantly demand based and only partly based on higher costs.) Likewise, golf courses
charge much higher prices on weekends than on weekdays. Each of these examples illustrates
demand-based pricing.
Forms of Price Discrimination
It is useful to distinguish three forms of price discrimination. The practice of charging

different prices to different market segments (for which the firm’s costs are identical) is often
referred to as third-degree price discrimination. Airline and movie ticket pricing are examples.
Prices differ across market segments, but customers within a market segment pay the same price.
Now suppose the firm could distinguish among different consumers within a market
segment. What if the firm knew each customer’s demand curve? Then it could practice perfect
price discrimination. First-degree, or perfect, price discrimination occurs when a firm sets a
different price for each customer and by doing so extracts the maximum possible sales revenue.
As an example, consider an auto dealer who has a large stock of used cars for sale and expects
10 serious potential buyers to enter her showroom each week. She posts different model prices,
but she knows (and customers know) that the sticker price is a starting point in subsequent
negotiations. Each customer knows the maximum price he or she is personally willing to pay for
the car in question. If the dealer is a shrewd judge of character, she can guess the range of each
buyer’s maximum price and, via the negotiations, extract almost this full value. For instance, if
four buyers’ maximum prices are $6,100, $6,450, $5,950, and $6,200, the perfectly discriminating
dealer will negotiate prices nearly equal to these values. In this way, the dealer will sell the four
cars for the maximum possible revenue. As this example illustrates, perfect discrimination is fine
in principle but much more difficult in practice. Clearly, such discrimination requires that the seller
have an unrealistic amount of information. Thus, it serves mainly as a benchmark4a limiting case
at best.
Finally, second-degree price discrimination occurs when the firm offers different price
schedules, and customers choose the terms that best fit their needs. The most common example
is the offer of quantity discounts: For large volumes, the seller charges a lower price per unit, so
the buyer purchases a larger quantity. With a little thought, one readily recognizes this as a form
of profitable price discrimination. High-volume, price-sensitive buyers will choose to purchase
larger quantities at a lower unit price, whereas low-volume users will purchase fewer units at a
higher unit price. Perhaps the most common form of quantity discounts is the practice of two-part
pricing. As the term suggests, the total price paid by a customer is ÿ = �㔴 + āĀ where A is a fixed
fee (paid irrespective of quantity) and p is the additional price per unit. Telephone service,
electricity, and residential gas all carry two-part prices. Taxi service, photocopy rental
agreements, and amusement park admissions are other examples. Notice that two-part pricing
implies a quantity discount; the average price per unit, P/Q = A/Q + p, declines as Q increases.
Two-part pricing allows the firm to charge customers for access to valuable services (via A) while
promoting volume purchases (via low p).
3.4 Estimating Demand
After understanding demand equations, we will discuss where they came from. The
various techniques for collecting data and using it to estimate and forecast demand will be
discussed on the following discussions.
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3.4.1 Collecting Data
There are various types of data to be used in regressions analysis to estimate demand.
1. Consumer Surveys
A direct way to gather information is to ask people. Whether face to face, by telephone, online,
or via direct mail, researchers can ask current and prospective customers a host of questions:
How much of the product do you plan to buy this year? What if the price increased by 10 percent?
Do price rebates influence your purchase decisions, and, if so, by how much? What features do
you value most? Do you know about the current advertising campaign for the product? Do you
purchase competing products? If so, what do you like about them?
Consumer product companies use surveys extensively. In a given year, Campbell Soup
Company questions over 100,000 consumers about foods and uses the responses to modify and
improve its product offerings and to construct demand equations. Marriott Corporation used this
method to design the Courtyard by Marriott hotel chain, asking hundreds of interviewees to
compare features and prices. Today, the explosion of online surveys allows firms to collect
thousands of responses (often highly detailed) at very low cost.
SURVEY PITFALLS
Though useful, surveys have problems and limitations. For example, market researchers may
ask the right questions, but of the wrong people. Economists call this sample bias. In some
contexts, random sampling protects against sample bias. In other cases, surveys must take care
in targeting a representative sample of the relevant market segment.
A second problem is response bias. Respondents might report what they believe the
questioner wants to hear. (<Your product is terrific, and I intend to buy it this year if at all possible.=)
Alternatively, the customer may attempt to influence decision making. (<If you raise the price, I
definitely will stop buying.=) Neither response will likely reflect the potential customer’s true
preferences.
A third problem is response accuracy. Even if unbiased and forthright, a potential customer
may have difficulty in answering a question accurately. (<I think I might buy it at that price, but
when push comes to shove, who knows?=) Potential customers often have little idea of how they
will react to a price increase or to an increase in advertising. A final difficulty is cost. Conducting
extensive consumer surveys is extremely costly. As in any economic decision, the costs of
acquiring additional information must be weighed against the benefits.
2. Controlled Consumer Experiments
An alternative to consumer surveys is the use of controlled consumer experiments. For

example, consumers are given money (real or script) and must make purchasing decisions.
Researchers then vary key demand variables (and hold others constant) to determine how the
variables affect consumer purchases. Because consumers make actual decisions (instead of
simply being asked about their preferences and behavior), their results are likely to be more
accurate than those of consumer surveys. Nonetheless, this approach shares some of the same
difficulties as surveys. Subjects know they are participating in an experiment, and this may affect
their responses. For example, they may react to price much more in an experiment than they do
in real life. In addition, controlled experiments are expensive. Consequently, they generally are
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small (few subjects) and short, and this limits their accuracy. As the following example shows,
surveys and experiments do not always accurately foretell actual demand.
3. Controlled Market Studies: Cross-sectional and Time-series Data
Firms can also generate data on product demand by selling their product in several smaller
markets while varying key demand determinants, such as price, across the markets. The firm
might set a high price with high advertising spending in one market, a high price and low
advertising in another, a low price and high advertising in yet another, and so on. By observing
sales responses in the different markets, the firm can learn how various pricing and advertising
policies (and possible interactions among them) affect demand.
To draw valid conclusions from such market studies, all other factors affecting demand should
vary as little as possible across the markets. The most common4and important4of these <other=
demand factors include population size, consumer incomes and tastes, competitors’ prices, and
even differences in climate. Unfortunately, regional and cultural differences, built-up brand
loyalties, and other subtle but potentially important differences may thwart the search for uniform
markets. In practice, researchers seek to identify and control as many of these extraneous factors
as possible.
Market studies typically generate cross-sectional data4observations of economic entities

(consumers or firms) in different regions or markets during the same time period. Another type of
market study relies on time-series data. Here, the firm chooses a single geographic area and
varies its key decision variables over time to gauge market response. The firm might begin by
setting a high price and a low advertising expenditure and observing the market response.
Sometime later, it may increase advertising; later still, it may lower price; and so on. Time-series
experiments have the advantage that they test a single (and, one would hope, representative)
population, thus avoiding some of the problems of uncontrolled factors encountered in cross-
sectional studies. Whatever the type, traditional market tests and studies are expensive4often
extremely so.
4. Uncontrolled Market Data
In its everyday operation, the market itself produces a large amount of data. Many firms
operate in multiple markets. Population, income, product features, product quality, prices, and
advertising vary across markets and over time. All of this change creates both opportunity and
difficulty for the market researcher. Change allows researchers to see how changing factors affect
demand. With uncontrolled markets, however, many factors change at the same time. How, then,
can a firm judge the effect of any single factor? Fortunately, statisticians have developed methods
to handle this very problem.
During the last 20 years, firms have increasingly used sophisticated computer-based methods
to gather market data. Today more than three-quarters of all supermarkets employ check-out
scanners that provide enormous quantities of data about consumer purchases. Internet
purchases provide an expanding universe of additional data on consumer preferences and
purchasing behavior. Gathering this (relatively uncontrolled) data is quick and cheap4as little as
one-tenth the cost of controlled market tests. Today, using computers featuring massively parallel
processors and neural networks, companies can search through and organize millions of pieces
of data about customers and their buying habits, a technique known as data mining.
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Finally, firms can also purchase data and access publicly available data. Often the firm spends
less using published or purchased forecasts than gathering and processing the data itself. Firms
frequently need off-the-shelf forecasts as inputs to its own firm-generated model. For example, a
firm may have determined, via its own studies, that gross domestic product (GDP) greatly affects
the demand for its product. The firm may purchase forecasts of GDP that are more accurate than
those it could produce itself at a comparable cost.
3.5 Regression Analysis
Regression analysis is a set of statistical techniques using past observations to find (or
estimate) the equation that best summarizes the relationships among key economic variables.
The method requires that analysts (1) collect data on the variables in question, (2) specify the
form of the equation relating the variables, (3) estimate the equation coefficients, and (4) evaluate
the accuracy of the equation.
The most common method of computing coefficients is called ordinary least-squares

(OLS) regression. Ordinary least-squares regression computes coefficient values that give the
smallest sum of squared errors. Using calculus techniques, statisticians have derived standard
formulas for these least-squares estimates of the coefficients.
Many computer programs are available to carry out regression analysis. (In fact, almost
all of the best-selling spreadsheet programs include regression features.) These programs call
for the user to specify the form of the regression equation and to input the necessary data to
estimate it: values of the dependent variables and the chosen explanatory variables. Besides
computing the ordinary least-squares regression coefficients, the program produces a set of
statistics indicating how well the OLS equation performs.
3.5.1 Simple Regression
Suppose price is the only factor of the firm’s sales, a linear demand equation of this firm
has the form:
Ā = ÿ + Āÿ
The left-hand variable (the one being predicted or explained) is called the dependent variable.
The right-hand variable (the one doing the explaining) is called the independent (or explanatory)
variable. As yet, the coefficients, a and b, have been left unspecified (i.e., not given numerical
values). The coefficient a is called the constant term. The coefficient b (which we expect to have
a negative sign) represents the slope of the demand equation. Up to this point, we have selected
the form of the equation (a linear one). We now can use regression analysis to compute numerical
values of a and b and so specify the linear equation that best fits the data.
To illustrate the method of estimation using OLS, let’s start by arbitrary selecting particular
values of a and b. Suppose a = 330 and b = -1. With these values, the demand equation becomes
ā = �㗑�㗑ÿ 2 ĀĀ.
We plot this demand equation represent by the figure below. Notice that the demand curve lies
roughly along the scatter of observations. In this sense, the equation provides a <reasonable fit=
with past observations. However, the fit is far from perfect.
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The figure plots the

average number of seats
sold at different average
prices over the last 16
quarters. A <guesstimated=
demand curve also is
shown.
Table below lists the sales predictions quarter by quarter. For instance, in the second
column, the first quarter’s sales prediction (at a price of $250) is computed as 330 - 250 = 80. The
third column lists actual sales. The fourth column lists the differences between predicted sales
(column 2) and actual sales (column 3). This difference (positive or negative) is referred to as the
estimation error. To measure the overall accuracy of the equation, the OLS regression method
first squares the error for each separate estimate and then adds up the errors. The final column
lists the squared errors. The total sum of squared errors comes to 6,027.7. The average squared
error is 6,027.7/16 = 376.7.
Predicted versus
Actual Ticket Sales
Using
Q = 330 - P
The sum of squared errors (denoted simply as SSE) measures the equation’s accuracy.
The smaller the SSE, the more accurate the regression equation. The reason for squaring the
errors is twofold. First, by squaring, one treats negative errors in the same way as positive errors.
Either error is equally bad. (If one simply added the errors over the observations, positive and
negative errors would cancel out, giving a very misleading indication of overall accuracy.) Second,
large errors usually are considered much worse than small ones. Squaring the errors makes large
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errors count much more than small errors in SSE. (We might mention, without elaborating, that
there are also important statistical reasons for using the sum of squares.)
As the term suggests, ordinary least-squares regression computes coefficient values that
give the smallest sum of squared errors. Using calculus techniques, statisticians have derived
standard formulas for these least-squares estimates of the coefficients.5 Based on the airline’s 16
quarters of price and sales data, the least-squares estimates are: a = 478.6 and b=-1.63. Thus,
the estimated OLS equation is
Ā = 478.6 2 1.63ÿ
The next table lists the previous equation’s sales forecasts and prediction errors quarter
by quarter. The total sum of squared errors (SSE) is 4,847.2 4 significantly smaller than the SSE
(6,027.7) associated with Ā = 330 2 1ÿ equation.
Predicted versus
Actual Ticket
Sales Using
Q = 478.6 - 1.63P
3.5.2 Multiple Regression
Because price is not the only factor that affects sales, it is natural to add other explanatory
variables to the right-hand side of the regression equation. Suppose the airline has gathered data
on its competitor’s average price and regional income over the same four-year period. In
management’s view, these factors may strongly affect demand. The table below lists the complete
data set. Management would like to use these data to estimate a multiple-regression equation of
the form:
Ā = ÿ + Āÿ + āÿ0 + ĂĀ
In this equation, quantity depends on own price (P), competitor’s price (P0), and income
(Y). Now the OLS regression method computes four coefficients: the constant term and a
5
Suppose that the estimated equation is of the form and that the data to be fitted consist of n pairs of x-y
observations (ýÿ , þÿ ), ÿ = 1,2, & , ÿ. Then the least-squares estimators are Ā = [∑(þÿ 2 þ̅)(ýÿ 2 ý̅ )]/[∑(ýÿ 2 ý̅ )2 ]
and ÿ = þ̅ 2 Āý̅ . Here, þ̅ and ý̅ are the mean values of the variables, and the summation is over the n
observations.
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coefficient for each of the three explanatory variables. As before, the objective is to find
coefficients that will minimize SSE. The OLS equation is:
Ā = 28.84 2 2.21ÿ + 1.03ÿ0 + 3.09Ā
This table shows

the Airline Sales,
Prices, and
Income
Using the previous equation, the table below lists the predictions, prediction errors, and
squared errors for this regression equation. The equation’s sum of squared errors is 2,616.4,
much smaller than the SSE of any of the previously estimated equations. The additional variables
have significantly increased the accuracy of the equation. A quick scrutiny of the table shows that,
by and large, the equation’s predictions correspond closely to actual ticket sales.
Predicted versus
Actual Ticket
Sales Using
Q = 28.84 - 2.12P
+ 1.03P0 + 3.09Y
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This example suggests the elegance and power of the regression approach. The decision
maker starts with uncontrolled market data. The airline’s own price, the competitor’s price, and
regional income all varied simultaneously from quarter to quarter over the period. Nonetheless,
the regression approach has produced an equation (a surprisingly accurate one) that allows us
to measure the separate influences of each factor. For instance, according to the last equation, a
$10 cut in the competitor’s price would draw about 10 passengers per flight from the airline. In
turn, a drop of about $5 in the airline’s own price would be needed to regain those passengers.
Regression analysis sees through the tangle of compounding and conflicting factors that affect
demand and thus isolates separate demand effects.
The interpretation of the statistical results is crucial to know how well the equation to
estimate demand. The following statistics need to be interpreted when using multiple regression:
a. The R-squared statistic (also known as the coefficient of determination) measures the
proportion of the variation in the dependent variable (Q in our example) that is
explained by the multiple-regression equation. Sometimes we say that it is a measure
of goodness of fit, that is, how well the equation fits the data.
b. A partial remedy for this problem is to adjust R-squared according to the number of
degrees of freedom in the regression. The number of degrees of freedom is the
number of observations (N) minus the number of estimated coefficients (k).
c. The F-statistic has the significant advantage that it allows us to test the overall
statistical significance of the regression equation.
d. The standard error of a coefficient is the standard deviation of the estimated

coefficient. The lower the standard error, the more accurate is the estimate. Roughly
speaking, there is a 95 percent chance that the true coefficient lies within two standard
errors of the estimated coefficient.
e. The t-statistic is the value of the coefficient estimate divided by its standard error. The
t-statistic tells us how many standard errors the coefficient estimate is above or below
zero.
Regression analysis can be quite powerful. Nonetheless, it is important to be aware of the

limitations and potential problems of the regression approach.
1. EQUATION SPECIFICATION
In our example, we assumed a linear form, and the resulting equation tracked
the past data quite well. However, the real world is not always linear; relations do not
always follow straight lines. Thus, we may be making an error in specification, and this
can lead to poorer predictions.
2. OMITTED VARIABLES
A related problem is that of omitted variables. Recall that we began the analysis
of airline demand with price as the only explanatory variable. The resulting OLS
equation produced predictions that did a reasonably good job of tracking actual values.
However, a more comprehensive equation, accounting for competitor’s price and
income, did far better. In short, leaving out key variables necessarily worsens
prediction performance.
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3. MULTICOLLINEARITY
When two or more explanatory variables move together, we say that the
regression suffers from multicollinearity. In this case, it is difficult to tell which of the
variables is affecting the dependent variable. Suppose demand for a firm’s product is
believed to depend on only two factors: price and advertising. The data show that
whenever the firm initiated an aggressive advertising campaign, it invariably lowered
the good’s price. Sales increased significantly as a result. When the firm decreased
advertising spending it also increased price, and sales dropped. The question is:
Should the changes in sales be attributed to changes in advertising or to changes in
price? Unfortunately, it is impossible to tell, even with regression. If two right-hand
variables move together, regression cannot separate the effects. Regression does not
require that we hold one of the factors constant as we vary the other, but it does require
that the two factors vary in different ways.
4. SIMULTANEITY AND IDENTIFICATION
This brings us to a subtle, but interesting and important, issue. In the preceding
discussion, we assumed that the firm had explicit control over its price. In many
settings, however, price is determined by overall demand and supply conditions, not
by the individual firm. Here, the firm must take the price the market dictates or else sell
nothing.
Such settings are called perfectly competitive markets, which we will discuss
in the next chapter. For now, note that price and quantity in competitive markets are
determined simultaneously by supply and demand. Let’s consider the implications of
this with a simple example. Suppose both the quantity supplied and the quantity
demanded depend only on price, except for some random terms:
ĀĀ = ÿ + Āÿ + �㔀
Āÿ = ā + Ăÿ + �㔇
where ε and μ are random variables. The random terms indicate that both the supply
and demand curves jump around a bit. The equilibrium will be determined by the
intersection of the supply and demand curves. Is this an estimate of the supply curve,
the demand curve, or what? The problem is that, because price and quantity are
determined simultaneously, we cannot tell whether two points differ because of
randomness in supply, in demand, or in both; that is, we cannot identify which curve
is responsible. Simultaneity (in the determination of price and quantity) means that
the regression approach may fail to identify the separate (and simultaneous)
influences of supply and demand.
5. OTHER PROBLEMS
Finally, it is important to recognize that the regression approach depends on

certain assumptions about randomness. Here, we have added the term e. This random
term indicates that sales depend on various variables plus some randomness. The
statistical properties of regression come from the assumptions one makes about the
random term, e. The key assumption is that this term is normally distributed with a
mean of zero and a constant variance and that it is completely independent of
everything else. If this assumption is violated, regression equations estimated by
ordinary least squares will fail to possess some important statistical properties. In such
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a case, modifications to the OLS method must be made to estimate a correct equation
having desirable statistical and forecasting properties.
Two main problems concerning random errors can be identified. First,

heteroscedasticity occurs when the variance of the random error changes over the
sample. For example, demand fluctuations may be much larger in recessions (low-
income levels Y) than in good times. A simple way to track down this problem is to
look at the errors that come out of the regression: the differences between actual and
predicted values. We can, for example, divide the errors into two groups, one
associated with high income and one with low income and find the sum of squared
errors for each subgroup. If these are significantly different, this is evidence of
heteroscedasticity.
Serial correlation occurs when the errors run in patterns, that is, the
distribution of the random error in one period depends on its value in the previous
period. For instance, the presence of positive correlation means that prediction errors
tend to persist: Overestimates are followed by overestimates and underestimates by
underestimates. There are standard statistical tests to detect serial correlation (either
positive or negative). The best-known test uses the Durbin-Watson statistic (which
most regression programs compute). A value of approximately 2 for this statistic
indicates the absence of serial correlation. Large deviations from 2 (either positive or
negative) indicate that prediction errors are serially correlated. The regressions
reported for air-travel demand in our example are free of serial correlation and
heteroscedasticity.
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Assessment 3
1. Complete the chart below.
Demand Function for Good X: Qd = 200 – 5P

Price Quantity Demanded
10 1. ________________
2. __________________ 130
22 3. __________________
32 4. __________________
5. __________________ 20
6. Compute the Price Elasticity of Demand for Good X:
7. Interpret the computed Price Elasticity of Demand for Good X:
Demand Function for Good Y: Qd = 450 – 6P

Price Quantity Demanded
10 8. __________________
9. __________________ 366
18 10. __________________
11. __________________ 318
12. __________________ 222

13. Compute the Price Elasticity of Demand for Good Y:
14. Interpret the computed Price Elasticity of Demand for Good Y:
15. Compute the Cross Elasticity of Demand for Good X to Y using the price of 18 and 22.
16. Which type of good is Good Y to X?
17. Compute the Income Elasticity of Demand for Good X when the income for the price of
18 is 18000 and for the price of 22 is 26000.
18. Which type of good is Good X?
19. Compute the Income Elasticity of Demand for Good Y when the income for the price of
18 is 18000 and for the price of 22 is 26000.
20. Which type of good is Good Y?
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2. You are given market data that says when the price of pesto bread is P4, the quantity
demanded of pesto bread is 60 pieces and the quantity demanded of cheese bread is 100
pieces. When the price of pesto bread is P2, the quantity demanded of pesto bread is 80
pieces and the quantity demanded of cheese bread is 70 pieces. Calculate the price elasticity
of demand for pesto bread. If the producer of pesto bread wants to increase its revenue, is it
correct to increase to decrease the price? Why?
3. Gary operates an automobile detailing business in his town in Laguna. An automobile

detailer restores a car to the level of cleanliness and perfection that it had when it was new. His
fastidious nature, attention to detail, and ability to effectively manage employees have helped to
make his business profitable, but he believes that more information about the market would allow
him to operate more efficiently. He uses regression analysis to estimate the demand function for
his business and gets the following result:
Qx = 235 - 3PX + 40A - 20U + 8PW

The number of detailing jobs he gets per month (QX) depends on the price he charges per job
(PX), his monthly advertising expenditures (A) measured in $1,000s, the regional percentage
unemployment rate (U), and the average price charged by local car wash businesses (PW) for a
standard wash and wax.
Use the estimated demand function given above to solve Problems 3.1 and 3.2.
3.1. Is a wash and wax at the local car wash a complement or a substitute for
automobile detailing? How can you tell?
3.2. Interpret the coefficients of the price he charges per job (PX), his monthly
advertising expenditures (A) measured in P1,000, the regional percentage
unemployment rate (U), and the average price charged by local car wash
businesses (PW) for a standard wash and wax.
3.3. Gary is currently charging P650 per detailing job and spending P3,500 per month
on advertising. The regional unemployment rate is 7.5% and the average price of
a wash and wax at a local car wash is P150. How many detailing jobs per month
can Gary expect under these conditions?
4. CASE STUDY:
A. LalaFast 21
LalaFast 21 is a major carrier based in the Philippines and has made a strategy of cutting fares
drastically on certain routes with large effects on traffic in those markets. For example, on the
Baguio-Cubao route the entry of LalaFast into the market caused average fares to fall by 48 per
cent and increased market revenue from P21,327,008 to P47,064,782 annually. On the
Tuguegarao-Caloocan route, however, the average fare cut in the market when LalaFaST entered
was 70 per cent and market revenue fell from an annual P66,201,553 to P33,101,514.
Questions
1. Calculate the PEDs for the Baguio-Cubao route and Tuguegarao-Caloocan route.
2. Explain why the above market elasticities might not apply specifically to Lalafast 21.
3. If LalaFast 21 does experience a highly elastic demand on the Baguio-Cubao route,
what is the profit implication of this?
4. Explain why the fare reduction on the Tuguegarao-Caloocan route a profitable strategy
for LalaFast may still be.
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B. Nickey and Aididas
Nickey and Aididas produce trainers in the sports-shoe market. For one of their main products
they have the following demand curves:
Nickey : Pn = 175 3 1.2Qn

Aididas = Pa = 125 3 0.8Qa
where P is in Pesos and Q is in pairs per week.
Questions:
The firms are currently selling 80 and 75 pairs of their products per week respectively.
1. What are the current price elasticities for the products?
2. Assume that Nickey reduces its price and increases its sales to 90 pairs and that this
also causes a fall in Aididas’s sales to 70 pairs per week. What is the cross-elasticity
between the two products?
3. Is the above price reduction by Nickey to be recommended? Explain your answer.
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CHAPTER 4
FORECASTING DEMAND6
Learning Objectives: This chapter will discuss the different methods and techniques of
forecasting can that be used by the firms in their decision-making. At the end of this topic,
the readers should be able to discuss why business and economic forecasting is of great
importance to the firms and able to explain the circumstances under which different
methods should be used.
The major role of forecasting is to reduce the uncertainty, which faced by both private and
public organizations when conducting business activities. In order to ser reasonable targets for
its objectives, corporate management must have available and relevant forecasts, both for the
short-run and long-term terms. It can limit or control the uncertainties by predicting changes in the
economic variables of costs, price, sales, and interest rates. Accurate forecasting can assist in
the development of strategies to promote profitable trends and to reduce the harm from
unprofitable ones. A forecast is merely a prediction concerning future outcomes.
Forecasting methods often blended with qualitative and quantitative techniques.

Qualitative forecasting is based on judgments of individuals or groups. The results may be in the
form of some numerical values but they are not based on historical data. This technique normally
forecasts directions of movements including expert opinions, opinion polls and surveys.
On the other hand, quantitative forecasting method, utilizes a vast amount of historical
data or cross-sectional data as basis for prediction. Quantitative techniques can be naïve as in
time series prediction or they can be causal (explaining cause and effect) as in econometric
modelling.
4.1 Qualitative Forecasting Technique
Qualitative techniques that forecast direction of movements include surveys, opinion polls
and use of comparative statistics with demand and supply curves.
a. Expert Opinion
There are various types of techniques that fit into this category. Only a few is listed in
this section.
(1) Jury of executive opinion

In this technique, a forecast is generated by experts (corporate executives and
managers) in meetings or workshops.
(2) Opinions of Sales

Sales representatives with vast experience can be a source of a good forecast.
However, the drawback is that salespeople may be too optimistic or pessimistic
about their sales prospects. Furthermore, they may be unaware of the broader
economic patterns which may affect demand.
6
Discussions of this chapter were gathered from Samuelson, W.F. and Marks, S.G. (2012). Managerial Economics,
7th Edition, John Wiley & Sons, Inc.
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(3) Delphi Method

This technique is a form of expert opinion forecasting that uses a series written
questions and answers to obtain a consensus among experts on a forecast when
experts do not meet and agree on a forecast.
b. Opinion Polls
Opinion poll is a forecasting in which sample populations are surveyed to determine
consumption trends. This method may be able to assist us to identify trends. However,
the choice of sample is important to avoid biasness in the responses. Furthermore,
questions used in the poll must be simple and clear.
c. Market Research
Market research is closely related to opinion polls. Normally, we use market research
to indicate not only why the consumer is or is not buying a particular product, but also
who the consumer is and how he is using the product. Also, we want to know that
product attributes and what factors or characteristics the consumer thinks are
important in the purchasing decisions.
4.2 Quantitative Forecasting Technique
The quantitative techniques attempt to forecast the precise number/value for an economic
variable.
4.2.1 Time-Series Models
Time-series models seek to predict outcomes simply by extrapolating past behavior into
the future. Time-series patterns can be broken down into the following four categories.
1. Trends
2. Business cycles
3. Seasonal variations
4. Random fluctuations
A trend is a steady movement in an economic variable over time. On top of such trends
are periodic business cycles. Economies experience periods of expansion marked by rapid
growth in gross domestic product (GDP), investment, and employment. Then economic growth
may slow and even fall. A sustained fall in (real) GDP and employment is called a recession.
Seasonal variations are shorter demand cycles that depend on the time of year.
Seasonal factors affect tourism and air travel, tax preparation services, clothing, and other
products and services. Seasonal variations in time series occur during the year and they tend to
appear regularly from year to year. The seasonal effect can be added to a time series with
methods such as the ratio-to-trend method. Daily, weekly, monthly, or quarterly data provide
trends. But if a particular part of the season is above or below the trend, the forecast is adjusted
up or down by that percentage.
Finally, one should not ignore the role of random fluctuations. In any short period of time,
an economic variable may show irregular movements due to essentially random (or
unpredictable) factors. Random fluctuations and unexpected occurrences are inherent in almost
all time series. No model, no matter how sophisticated, can perfectly explain the data. These
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random factors are usually unpredictable such as natural disasters and a sudden increase in
salaries.
Forecasts suffer from the same sources of error as estimated regression equations. These
include errors due to (1) random fluctuations, (2) standard errors of the coefficients, (3) equation
misspecification, and (4) omitted variables. In addition, forecasting introduces at least two new
potential sources of error. First, the true economic relationship may change over the forecast
period. An equation that was highly accurate in the past may not continue to be accurate in the
future. Second, to compute a forecast, one must specify values of all explanatory variables. For
instance, to predict occupancy rates for its hotels in future years, Disney’s forecasters certainly
would need to know average room prices and expected changes in income of would-be visitors.
In this sense, its forecasts are conditional4that is, they depend on specific values of the
explanatory variables. Uncertainty about any of these variables (such as future regional income)
necessarily contributes to errors in demand forecasts. Indeed, an astute management team may
put considerable effort into accurately forecasting key explanatory variables.
In light of the difficulties in making economic predictions, it is important to examine how

well professional forecasters perform. First, forecast accuracy has improved over time as a result
of better data and better models. Second, many economic variables still elude accurate
forecasting. To be useful, any prediction also should report a margin of error or confidence interval
around its estimate. One way to appreciate this uncertainty is to survey a great many forecasters
and observe the range of forecasts for the same economic variable. (But even this range
understates the uncertainty. A significant portion of actual outcomes falls outside the surveyed
range; that is, the outcomes are higher than the highest forecast or lower than the lowest.) Third,
the time period for making forecasts matters. On average, accuracy falls as the forecasters try to
predict farther into the future. The time interval forecasted also matters. (Forecasts of annual
changes tend to be more accurate than forecasts of quarterly changes.) Fourth, no forecaster
consistently outperforms any other. Rather, forecast accuracy depends on the economic variable
being predicted, how it is measured, and the time horizon. But the differences in accuracy across
the major forecasters are quite small. Overall, macro models performed better than purely
extrapolative models, but, for many economic variables, the advantage (if any) is small.
4.2.2 Smoothing Technique

Smoothing techniques are another type of time-series forecasting model which assumes
that an underlying pattern can be found in the historical values of a variable that is being
forecasted. It is assumed that these historical observations represent not only the underlying
pattern but also random variations.
a. Moving Average
The forecast for the next period is the average of the last several periods. Moving
averages assume that there is no secular trend (long term changes in an economic
time series variable). A moving average of the past N periods can be used to predict
the next period. The forecast is the average of data from w periods prior to the forecast
data point.
b. Exponential Smoothing
The forecast is the weighted average of the forecast and the actual value from the
prior period.
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c. Barometric Techniques
Sometimes managers may wish to know the future of the economy of the specific
product. Barometric forecasting models are developed and used primarily to identify
potential future changes in general business conditions, rather than conditions for a
specific industry or firm. However, they can give a good indication of the future of the
industry and to some extent, the product.
Barometric models search for patterns among different variables over time. Consider
a firm that produces oil drilling equipment. Management naturally would like to forecast
demand for its product. It turns out that the seismic crew count, an index of the number
of teams surveying possible drilling sites, gives a good indication as to changes in
future demand for drilling equipment. For this reason, we call the seismic crew a
leading indicator of the demand for drilling equipment.
Economic indicator is a form of barometric method of forecasting in which economic

data are formed into indexes to reflect the state of the economy. We can use indexes
of leading, coincident, composite, diffusion, and lagging indicators to forecast changes
in economic activities. The success of the indicator approach, however, is highly
dependent on our ability to identify the historical economic data series, whose
directions not only correlate but precede those of the series to be predicted. We usually
use more than one indicator since using only one indicator may not be reliable.
Decision-Making Principles
1. Decisions are only as good as the information on which they are based. Accurate
demand forecasts are crucial for sound managerial decision making.
2. The margin of error surrounding a forecast is as important as the forecast itself.
Disasters in planning frequently occur when management is overly confident of its
ability to predict the future.
3. Important questions to ask when evaluating a demand equation are the following: Does
the estimated equation make economic sense? How well does the equation track past
data? To what extent is the recent past a predictable guide to the future?
4.3 Quantitative Forecasting Technique using Econometric Models
Econometric models use statistical techniques to and economic theories to explain and
estimate relationships of variables. Thus, these can be classified as casual or explanatory
methods.
Econometric modelling is a combination of economic theory, statistical analysis, and
mathematical method to explain economic relationships and scenarios. Econometric models may
vary in their level of complexity from simple singe-equation model using simple or multiple linear
regression to extremely complex such as systems of equations (two to three stage least squares
will be needed and will not be discuss in this module).
The specification and estimation of demand function using econometric models using
regression were discussed in the previous chapter. The results of the estimation can be used in
forecasting.
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The use of econometric models in forecasting has several advantages over the other
forecasting techniques:
1. In econometric models, we can identify independent variables (which are the factors
or determinants) that we can manipulate for demand forecasting such as prices,
income, advertising expenses and others.
2. Econometric models predict not only the direction of change in the economic data
series but also the magnitude or size of that change.
3. Econometric models are easily adaptable in that, model can be modified by re-
estimating existing parameters, adding new variables, and developing new
relationship to improve future forecasts.
Regression Using Spreadsheets
Most spreadsheet programs can run multiple-regression programs. In this section we
review the steps of running a regression using Microsoft’s Excel spreadsheet program using the
airline example in the text.
Simple Regression
Step 1: Enter the data. Suppose the average number of coach seats is the dependent variable
and the average price is the independent variable. The data for both of these variables
must be entered into the spreadsheet as columns, as the table below shows.
Step 2: Call up the regression program. The method for calling up a regression program may vary
a bit depending on the version of the program. In Excel, calling up the regression program
involves these steps: Under the Data menu select Data Analysis, then select Regression,
and click OK. A regression dialog box will appear, such as the one depicted in the table
below. The following steps show how to complete this box.
Step 3: Designate the columns of data to be used in the regression. The regression program has
to be told where to find the data. This is done by entering the cells in the boxes labeled <Y
Input Range= and <X Input Range.= The Y input range refers to the dependent variable. In
our case, the Y data range from cell A3 to cell A18. Thus, we could simply type A3:A18
into the box.
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Alternatively, we could select the range, pointing the mouse at A3, clicking, holding, and
dragging to cell A18. There will appear in the Input Range box the entry $A$3:$A$18. (Do not
worry about the dollar signs.) If you wish to include the column label in cell A2, simply select the
range $A$2:$A$18. Then click on the label box. (In our example, we chose to include the label.)
The advantage of using the label is it will appear in the output statistics, making these statistics
easier to read.
The X Input Range refers to the independent variable. In our case, the X Input Range is
from cell B3 to cell B18. To input the cells for this range, repeat the procedure described above.
Step 4: Inform the program where you want the output. The regression program needs to be told
where to put the output. This is known as the output range. Simply type in a cell name
(or point and click). The program will start with that cell and work to the right and down.
It really does not matter where you put the output except that you do not want to put it
over the data, thereby destroying the data. Thus, you should put the output either below
or to the right of the data. We specified F2 as the output range. Some programs, such as
Excel, will allow you to put the output in a separate spreadsheet.
Step 5: Run the regression. Simply click OK. For the airline example, the program produces the
output shown in the next table.
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Multiple Regression
Performing multiple-regression analysis involves virtually the same steps as performing
simple regression. Suppose there are other data such as income and competitors’ price as
explanatory variables were added to the airline’s own price. The first step is to enter the income
and competitive price data in columns C and D of the spreadsheet. After calling up the regression
menu, we again enter cells A2 to A18 for the Y range. However, next we enter cells B2 to D18 for
the X range. (We designate the three columns of data by selecting the upper left and the lower
right cells of the range containing the data. All explanatory variables must be listed in adjacent
columns.) The regression program recognizes each column of data as a separate explanatory
variable. Next, we specify the output range to begin in cell F2. Finally, we execute the regression
program by clicking OK. The multiple-regression output is displayed in next table.
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Assessment 4
1. The results of the estimated regression for quantity demanded of a commodity (which is
labeled Qx), on the price of the commodity (which is labeled Px), consumers’ income (which
is labeled Y), and the price of the related commodity (Pz) is given below. (All figures are in
peso)
QX=121.86 – 9.50 PX + 0.04Y – 2.21PZ
1.1. Evaluate the above regression results. Interpret the constant term, coefficients of
Px, Y, and Pz.
1.2. What type of commodity is Z? Explain
2. CASE STUDY
An empirical study by Pascua, Peñamante and Tan estimated a demand function for coffee in the
Philippines between 1961 and 1977, using quarterly time-series data.
The results were:
Where:
Q = pounds of coffee consumed per head
P = the relative price of coffee per pound at 1967 prices
Y = per capita personal disposable income (in P1,000 at 1967 prices)
P’= the relative price of tea per quarter pound at 1967 prices
T= the trend factor, with T = 1 for 1961-I to T = 66 for 1977-II
D1 = 1 for the first quarter; D2 = 1 for the second quarter; D3 = 1 for the third quarter
Questions:
1. Interpret the PED for coffee; does price significantly affect consumption? (5 points)
2. Interpret the YED for coffee; does income significantly affect consumption? (5 points)
3. Interpret the CED between tea and coffee; does the price of tea significantly affect the
consumption of coffee? (5 points)
4. Why do you think that advertising expenditure is omitted from the equation? (5 points)
5. Interpret the trend factor. (5 points)
6. Interpret the seasonal pattern in coffee consumption in the Philippines. (5 points)
7. How well does the model fit the data? (10 points)
3. Discussion
1. Explain the advantages of using multiple regression compared with simple regression. (5
points)
____________________________________________________________________________
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2. Explain the nature of the identification problem, and how it relates to demand
relationships. (5 points)
____________________________________________________________________________
____________________________________________________________________________
3. Explain the nature of dummy variables and their use in regression analysis. (5 points)
____________________________________________________________________________
____________________________________________________________________________
4. Explain the importance of correct model specification. (5 points)
____________________________________________________________________________
____________________________________________________________________________
5. Explain the difference between demand estimation and demand forecasting. (5 points)
____________________________________________________________________________
____________________________________________________________________________
6. What is meant by the price3quality relationship? What are its implications? (5 points)
____________________________________________________________________________
____________________________________________________________________________
7. Explain why lagged variables are useful in analysis. (5 points)
____________________________________________________________________________
____________________________________________________________________________
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CHAPTER 5
THE THEORY OF PRODUCTION AND COST7
Learning Objectives: This chapter explains the meaning of production function and law of
diminishing returns. The difference of short-run and long-run production and cost concepts
and computation of production and costs were also part of this chapter. At the end of this
section, the readers will be able to define production concepts and terms, explain law of
diminishing returns, distinguish the difference between fixed input and variable input in
short-run and long-run production, differentiate cost concepts, and use formula to solve
costs incurred by the firm.
Production is a process and methods employed in transformation of tangible inputs (raw

materials, semi-finished goods and sub assembles) and intangible inputs (ideas, information, and
know how) into goods and services.
5.1 Production Function
In economics, production function is an equation that expresses the relationship between

the quantities of productive factors (such as labour and capital) used and the amount of product
obtained. It states the amount of product that can be obtained from every combination of factors,
assuming that the most efficient available methods of production are used. There are several
ways of specifying the production function.
In a general mathematical form, a production function can be expressed as:
Ā = Ą(ÿ1 , ÿ2 , ÿ3 , & , ÿÿ )
where Q represent the quantity of output and X1, X2, X3, ..., Xn are the factor inputs (such as
capital, labor, land or raw materials). This general form does not encompass joint production, that
is a production process, which has multiple co-products or outputs.
One way of specifying a production function is simply as a table of discrete outputs and
input combinations, and not as a formula or equation at all. Using an equation usually implies
continual variation of output with minute variation in inputs, which is simply not realistic. Fixed
ratios of factors, as in the case of laborers and their tools, might imply that only discrete input
combinations, and therefore, discrete maximum outputs, are of practical interest.
One formulation is as a linear function:
Ā = ÿ + Āÿ1 + āÿ2 + Ăÿ3 & ..
where a, b, c, and d are the parameters that are determined empirically.
Another is as a Cobb-Douglas production function (multiplicative): Developed by

American economist PAUL DOUGLAS (1892-1976) and mathematician CHARLES W. COBB
Ā = �㔴Āÿ ÿ Ā
7
The diagrams and tables used in this Chapter 5 were collected from McConnel, C. & Brue, S. (2008). Economics:
Principles, Problems, and Policies. 17th edition, McGraw Hill-Irwin.
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where Q is the Total Production, L denotes as Labor, K represents as Capital, and A is the Total
Factor Productivity. In addition, a and b are the output elasticities of capital and labor.
Output elasticity measures the responsiveness of output to a change in levels of either

labor or capital used in production, ceteris paribus. For example, if α = 0.15, a 1% increase in
labor would lead to approximately a 0.15% increase in output.
Further, if:
ÿ + Ā = 1,
the production function has constant returns to scale. That is, if L and K are each increased by
20%, Y increases by 20%. If ÿ + Ā < 1, returns to scale are decreasing, and if ÿ + Ā > 1, returns
to scale are increasing.
5.2 Returns to Scale
This refers to changes in output subsequent to a proportional change in all inputs (where
all inputs increase by a constant factor). If output increases by that same proportional change
then there are constant returns to scale (CRTS). If output increases by less than that proportional
change, there are decreasing returns to scale (DRS). If output increases by more than that
proportion, there are increasing returns to scale (IRS).
5.3 Production Periods
The short run is a period (fixed plant) too brief for a firm to alter its plant capacity, yet
long enough to permit a change in the degree to which the fixed plant is used. The firm’s plant
capacity is fixed in the short run. However, the firm can vary its output by applying larger or smaller
amounts of labor, materials, and other resources to that plant. It can use its existing plant capacity
intensively in the short run.
From the viewpoint of an existing firm, the long run is a period long enough for it to adjust
the quantities of all the resources that it employs, including plant capacity. From the industry’s
viewpoint, the long run also includes enough time for existing firms to dissolve and leave the
industry or for new firms to be created and enter the industry. While the short run is a <fixed plant=
period, the long run is a <variable-plant= period.
5.3.1 Short-run Production Relationships
A firm’s costs of producing a specific output depend on the prices of the needed resources
and the quantities of resources (inputs) needed to produce that output. Resource supply and
demand determine resource prices. The technological aspects of production, specifically the
relationships between inputs and output, determine the quantities of resources needed. Our focus
will be on the labor-output relationship, given a fixed plant capacity.
There are three general terms included in this concept: Total Product (TP), Marginal
Product (MP), and Average Product (AP).
- Total Product (TP) is the total quantity, or total output, of a particular good or service
produced.
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- Marginal Product (MP) is the extra output or added product associated with adding
a unit of a variable resource, in this case labor, to the production process. Thus,
ā/ÿÿąă ÿÿ āĀāÿþ āÿĀĂĂāā
āÿăąÿÿÿý ÿăĀĂĆāą = ā/ÿÿąă ÿÿ þÿĀĀÿ ÿÿāĂā
- Average Product (AP) also called labor productivity, is output per unit of labor input:
āĀāÿþ āÿĀĂĂāā
�㔴ćăăÿąă ÿăĀĂĆāą = ĂÿÿāĀ ĀĄ þÿĀĀÿ
In the short run, a firm can for a time increase its output by adding units of labor to its fixed
plant. But by how much will output rise when it adds the labor? Why do we say <for a time=? This
can be answered by the law of diminishing returns. This law assumes that technology is fixed
and thus the techniques of production do not change. It states that as successive units of a
variable resource (say, labor) are added to a fixed resource (say, capital or land), beyond some
point the extra, or marginal, that can be attributed to each additional unit of the variable resource
will decline. For example, if additional workers are hired to work with a constant amount of capital
equipment, output will eventually rise by smaller and smaller amounts as more workers are hired.
The following table is a numerical illustration of the law of diminishing returns. Column 2
shows the total product, or total output, resulting from combining each level of a variable input
(labor) in column 1 with a fixed amount of capital.
Column 3 shows the marginal product (MP), the change in total product associated with
each additional unit of labor. Note that with no labor input, total product is zero; a plant with no
workers will produce no output. The first 3 units of labor reflect increasing marginal returns, with
marginal products of 10, 15, and 20 units, respectively. But beginning with the fourth unit of labor,
marginal product diminishes continuously, becoming zero with the seventh unit of labor and
negative with the eighth. Average product, or output per labor unit, is shown in column 4. It is
calculated by dividing total product (column 2) by the number of labor units needed to produce it
(column 1). At 5 units of labor, for example, AP is 14 (= 70/5).
The law of diminishing marginal returns and the relationships of the total, marginal and
average products can be further discussed in a graphical representation as follows:
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(a) As a variable resource (labor) is

added to fixed amounts of other
resources (land or capital), the total
product that results will eventually
increase by diminishing amounts,
reach a maximum, and then decline.
(b) Marginal product is the change in

total product associated with each new
unit of labor. Average product is simply
output per labor unit. Note that
marginal product intersects average
product at the maximum average
product.
The total product, TP, goes through three phases: It rises initially at an increasing rate;
then it increases, but at a diminishing rate; finally, after reaching a maximum, it declines.
Geometrically, marginal product 3 shown by the MP curve 3 is the slope of the total-product curve.
Marginal product measures the change in total product associated with each succeeding unit of
labor. Thus, the three phases of total product are also reflected in marginal product. Where total
product is increasing at an increasing rate, marginal product is rising. Here, extra units of labor
are adding larger and larger amounts to total product. Similarly, where total product is increasing
but at a decreasing rate, marginal product is positive but falling. Each additional unit of labor adds
less to total product than did the previous unit. When total product is at a maximum, marginal
product is zero. When total product declines, marginal product becomes negative.
Average product (AP), displays the same tendencies as marginal product. It increases,
reaches a maximum, and then decreases as more and more units of labor are added to the fixed
plant. But note the relationship between marginal product and average product: Where marginal
product exceeds average product, average product rises. And where marginal product is less
than average product, average product declines. It follows that marginal product intersects
average product where average product is at a maximum.
This relationship is a mathematical necessity. If you add a larger number to a total than
the current average of that total, the average must rise. And if you add a smaller number to a total
than the current average of that total, the average must fall. You raise your average examination
grade only when your score on an additional (marginal) examination is greater than the average
of all your past scores. You lower your average when your grade on an additional exam is below
your current average. In our production example, when the amount an extra worker adds to total
product exceeds the average product of all workers currently employed, average product will rise.
Conversely, an extra worker adds to total product an amount that is less than the current average
product, then average product will decrease.
The law of diminishing returns is embodied in the shapes of all three curves. But, as our
definition of the law of diminishing returns indicates, economists are most concerned with its
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effects on marginal product. The regions of increasing, diminishing, and negative marginal
product (returns) are shown in the graph.
5.4 Three Stages of Production
a. Primary Production
Primary production involves the extraction of raw materials (e.g. coal, iron, agricultural
commodities). Raw materials can be: Extracted 3 e.g. coal, iron ore, oil, gas, stone;
Harvested/collected 3 e.g. fish; Grown: e.g. timber, cereal crops
There is little value added in primary production. The aim is usually to produce the highest
quantity at lowest cost to a satisfactory standard.
b. Secondary Production
Secondary production involves transforming raw materials into goods. There are two main
kinds of goods: consumer goods 3 e.g. washing machines, DVD players. As the name implies,
these are used by consumers. Industrial / capital goods 3 e.g. plant and machinery, complex
information systems. Industrial and capital goods are used by businesses themselves during the
production process.
c. Tertiary Production
Tertiary production is associated with the provision of services (an intangible product). As
with the secondary sector, there are many tertiary production markets. Good examples include:
In Stage 1 (Increasing Marginal Returns) the variable input is being used with increasing
efficiency, reaching a maximum (since the average physical product is at its maximum at that
point). The average physical product of fixed inputs will also be rising in this stage (not shown in
the diagram). Because the efficiency of both fixed and variable inputs is improving throughout
stage 1, a firm will always try to operate beyond this stage. In stage 1, fixed inputs are
underutilized.
In Stage 2 (Diminishing Marginal Returns), output increases at a decreasing rate, and the
average and marginal physical product is declining. However, the average product of fixed inputs
(not shown) is still rising. In this stage, the employment of additional variable inputs increases the
efficiency of fixed inputs but decrease the efficiency of variable inputs. The optimum input/output
combination will be in stage 2. Maximum production efficiency must fall somewhere in this stage.
Note that this does not define the profit maximizing point. It takes no account of prices or demand.
If demand for a product is low, the profit maximizing output could be in stage 1 even though the
point of optimum efficiency is in stage 2.
In Stage 3 (Negative Marginal Returns), too much variable input is being used relative to
the available fixed inputs: variable inputs are over utilized. Both the efficiency of variable inputs
and the efficiency of fixed inputs decline throughout this stage. At the boundary between stage 2
and stage 3, fixed input is being utilized most efficiently and short-run output is maximum.
5.5 Costs of Production
In market economies, a wide variety of businesses produce an even wider variety of goods
and services. Each of those businesses requires economic resources in order to produce its
products. In obtaining and using resources, a firm makes monetary payments to resource owners
(for example, workers) and incurs opportunity costs when using resources, it already owns (for
example, entrepreneurial talent). Those payments and opportunity costs together make up the
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firm’s costs of production. It is the payments a firm must make, or the incomes it must provide, to
attract the resources it needs away from alternative production opportunities.
5.5.1 Economic Costs
Costs exist because resources are scarce, productive, and have alternative uses. When
society uses a combination of resources to produce a particular product, it forgoes all alternative
opportunities to use those resources for other purposes. The measure of the economic cost, or
opportunity cost, of any resource used to produce a good is the value or worth the resource would
have in its best alternative use.
5.5.2 Explicit and Implicit Costs
Now let’s consider costs from the firm’s viewpoint. Keeping opportunity costs in mind, we
can say that economic costs are the payments a firm must make, or the incomes it must provide,
to attract the resources it needs away from alternative production opportunities. Those payments
to resource suppliers are explicit (revealed and expressed) or implicit (present but not obvious).
So, in producing products firms incur explicit costs and implicit costs.
A firm’s explicit costs are the monetary payments (or cash expenditures) it makes to
those who supply labor services, materials, fuel, transportation services, and the like. Such
money payments are for the use of resources owned by others.
A firm’s implicit costs are the opportunity costs of using its self-owned, self-employed
resources. To the firm, implicit costs are the money payments that self-employed resources could
have earned in their best alternative use.
5.6 Short-Run Production Costs
In the short run some resources, those associated with the firm’s plant, are fixed. Other
resources, however, are variable. So short-run costs are either fixed or variable.
Fixed costs are those costs that in total do not vary with changes in output. Fixed costs
are associated with the very existence of a firm’s plant and therefore must be paid even if its
output is zero. Such costs as rental payments, interest on a firm’s debts, a portion of depreciation
on equipment and buildings, and insurance premiums are generally fixed costs; they do not
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increase even if a firm produces more. In column 2 of the table below, we assume that the firm’s
total fixed cost is $100. By definition, this fixed cost is incurred at all levels of output, including
zero. The firm cannot avoid paying fixed costs in the short run.
Variable costs are those costs that change with the level of output. They include
payments for materials, fuel, power, transportation services, most labor, and similar variable
resources. In column 3, we find that the total of variable costs changes directly with output. But
note that the increases in variable cost associated with succeeding 1-unit increases in output are
not equal. As production begins, variable cost will for a time increase by a decreasing amount;
this is true through the fourth unit of output. Beyond the fourth unit, however, variable cost rises
by increasing amounts for succeeding units of output.
Total Cost is the sum of fixed cost and variable cost at each level of output: TC =
TFC+TVC. TC is shown in column 4. At zero units of output, total cost is equal to the firm’s fixed
cost. Then for each unit of the 10 units of production, total cost increases by the same amount as
variable cost. The distinction between fixed and variable costs is significant to the business
manager. Variable costs can be controlled or altered in the short run by changing production
levels. Fixed costs are beyond the business manager’s current control; they are incurred in the
short run and must be paid regardless of output level.
Producers are certainly interested in their total costs, but they are equally concerned with
per-unit, or average, costs. In particular, average-cost data are more meaningful for making
comparisons with product price, which is always stated on a per-unit basis. Average fixed cost,
average variable cost, and average total cost are shown in columns 5 to 7. Average fixed cost
(AFC) for any output level is found by dividing total fixed cost (TFC) by that output (Q). That is,
Ā�㔹ÿ
�㔴þ�㔶 = Ā
. Because the total fixed cost is, by definition, the same regardless of output, AFC
must decline as output increases.
As output rises, the total fixed cost is spread over a larger and larger output. When output
is just 1 unit, TFC and AFC are the same at $100. But at 2 units of output, the total fixed cost of
$100 becomes $50 of AFC or fixed cost per unit; then it becomes $33.33 per unit as $100 is
spread over 3 units, and $25 per unit when spread over 4 units. This process is sometimes
referred to as <spreading the overhead.= The following graph shows that AFC graphs as a
continuously declining curve as total output is increased.
Total variable cost

(TVC) changes with output.
Total fixed cost (TFC) is
independent of the level of
output. The total cost (TC) at
any output is the vertical sum
of the fixed cost and variable
cost at that output.
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Average variable cost (AVC) for any output level is calculated by dividing total variable
Ā�㕉ÿ
cost (TVC) by that output (Q): �㔴�㕉�㔶 = Ā . A graph of AVC is a U-shaped or saucer-shaped curve,
as shown in the following diagram.
AFC falls as a given amount

of fixed costs is apportioned over a
larger and larger output. AVC
initially falls because of increasing
marginal returns but then rises
because of diminishing marginal
returns. Average total cost (ATC) is
the vertical sum of average variable
cost (AVC) and average fixed cost
(AFC).
Because total variable cost reflects the law of diminishing returns, so must AVC, which is
derived from total variable cost. Because marginal returns increase initially, fewer and fewer
additional variable resources are needed to produce each of the first 4 units of output. As a result,
variable cost per unit declines. AVC hits a minimum with the fifth unit of output, and beyond that
point AVC rises as diminishing returns require more and more variable resources to produce each
additional unit of output.
In simpler terms, at very low levels of output production is relatively inefficient and costly.
Because the firm’s fixed plant is understaffed, average variable cost is relatively high. As output
expands, however, greater specialization and better use of the firm’s capital equipment yield more
efficiency, and variable cost per unit of output declines. As still more variable resources are
added, a point is reached where diminishing returns are incurred. The firm’s capital equipment is
now staffed more intensively, and therefore each added input unit does not increase output by as
much as preceding inputs. This means that AVC eventually increases.
You can verify the U or saucer shape of the AVC curve by returning to the table. Assume
the price of labor is $10 per unit. By dividing average product (output per labor unit) into $10 (price
per labor unit), we determine the labor cost per unit of output. Because we have assumed labor
to be the only variable input, the labor cost per unit of output is the variable cost per unit of output,
or AVC. When average product is initially low, AVC is high. As workers are added, average
product rises and AVC falls. When average product is at its maximum, AVC is at its minimum.
Then, as still more workers are added and average product declines, AVC rises. The <hump= of
the average-product curve is reflected in the saucer or U shape of the AVC curve. As you will
soon see, the two are mirror images of each other.
Average total cost (ATC) for any output level is found by dividing total cost (TC) by that
output (Q) or by adding AFC and AVC at that output:
ă�㔶 ăþ�㔶 ă�㕉�㔶

�㔴ă�㔶 = = = = �㔴þ�㔶 + �㔴�㕉�㔶
Ā Ā Ā
Graphically, ATC can be found by adding vertically the AFC and AVC curves. Thus, the
vertical distance between the ATC and AVC curves measures AFC at any level of output.
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Marginal cost (MC) is the extra, or additional, cost of producing 1 more unit of output.
MC can be determined for each added unit of output by noting the change in total cost which that
ā/ÿÿąă ÿÿ Āÿ
unit’s production entails: ā�㔶 = ā/ÿÿąă ÿÿ Ā .
In column 4, production of the first unit of output increases total cost from $100 to $190.
Therefore, the additional, or marginal, cost of that first unit is $90 (column 8). The marginal cost
of the second unit is $80 (= $270 - $190); the MC of the third is $70 (= $340 - $270); and so forth.
The MC for each of the 10 units of output is shown in column 8. MC can also be calculated from
the total-variable-cost column, because the only difference between total cost and total variable
cost is the constant amount of fixed costs ($100). Thus, the change in total cost and the change
in total variable cost associated with each additional unit of output are always the same.
5.7 Marginal Decisions
Marginal costs are costs the firm can control directly and immediately. Specifically, MC
designates all the cost incurred in producing the last unit of output. Thus, it also designates the
cost that can be <saved= by not producing that last unit.
A firm’s decisions as to what output level to produce are typically marginal decisions, that
is, decisions to produce a few more or a few less units. Marginal cost is the change in costs when
1 more or 1 less unit of output is produced. When coupled with marginal revenue indicates the
change in revenue from 1 more or 1 less unit of output), marginal cost allows a firm to determine
if it is profitable to expand or contract its production. Marginal cost at first declines sharply,
reaches a minimum, and then rises rather abruptly. This reflects the fact that variable costs, and
therefore total cost, increase first by decreasing amounts and then by increasing amounts (see
columns 3 and 4 in the table).
Marginal Cost and Marginal Product
The marginal-cost curve’s shape is a consequence of the law of diminishing returns.

Looking back at table, we can see the relationship between marginal product and marginal cost.
If all units of a variable resource (here labor) are hired at the same price, the marginal cost of
each extra unit of output will fall as long as the marginal product of each additional worker is
rising. This is true because marginal cost is the (constant) cost of an extra worker divided by his
or her marginal product. Therefore, in Table 20.1, suppose that each worker can be hired for $10.
Because the first worker’s marginal product is 10 units of output, and hiring this worker increases
the firm’s costs by $10, the marginal cost of each of these 10 extra units of output is $1 (= $10/10
units). The second worker also increases costs by $10, but the marginal product is 15, so the
marginal cost of each of these 15 extra units of output is $.67 (= $10/15 units). Similarly, the MC
of each of the 20 extra units of output contributed by the third worker is $.50 (= $10/20 units). To
generalize, as long as marginal product is rising, marginal cost will fall.
But with the fourth worker diminishing returns set in and marginal cost begins to rise. For
the fourth worker, marginal cost is $.67 (= $10/15 units); for the fifth worker, MC is $1 ($10/10
units); for the sixth, MC is $2 (= $10/5 units); and so on. If the price (cost) of the variable resource
remains constant, increasing marginal returns will be reflected in a declining marginal cost, and
diminishing marginal returns in a rising marginal cost. The MC curve is a mirror reflection of the
marginal-product curve. As you can see in Figure 20.6, when marginal product is rising, marginal
cost is necessarily falling. When marginal product is at its maximum, marginal cost is at its
minimum. And when marginal product is falling, marginal cost is rising.
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The above diagram shows that that the marginal-cost curve MC intersects both the AVC
and the ATC curves at their minimum points. When the amount (the marginal cost) added to total
cost is less than the current average total cost, ATC will fall. Conversely, when the marginal cost
exceeds ATC, ATC will rise. This means in that as long as MC lies below ATC, ATC will fall, and
whenever MC lies above ATC, ATC will rise. Therefore, at the point of intersection where MC
equals ATC, ATC has just ceased to fall but has not yet begun to rise. This, by definition, is the
minimum point on the ATC curve. The marginal-cost curve intersects the average-total-cost curve
at the ATC curve’s minimum point.
Consider the following diagram to understand the relationship between Marginal Cost and
Marginal Product:
The relationship between

productivity curves and cost curves.
The marginal-cost (MC) curve and the
average-variable-cost (AVC) curve in
(b) are mirror images of the marginal-
product (MP) and average-product
(AP) curves in (a). Assuming that
labor is the only variable input and that
its price (the wage rate) is constant,
then when MP is rising, MC is falling,
and when MP is falling, MC is rising.
Under the same assumptions, when
AP is rising, AVC is falling, and when
AP is falling, AVC is rising.
Marginal cost can be defined as the addition either to total cost or to total variable cost
resulting from 1 more unit of output; thus, this same rationale explains why the MC curve also
crosses the AVC curve at the AVC curve’s minimum point. No such relationship exists between
the MC curve and the average-fixed-cost curve, because the two are not related; marginal cost
includes only those costs that change with output, and fixed costs by definition are those that are
independent of output.
5.8 Long-Run Production Costs
In the long run an industry and the individual firms it comprises can undertake all desired
resource adjustments. That is, they can change the amount of all inputs used. The firm can alter
its plant capacity; it can build a larger plant or revert to a smaller plant than that assumed in the
short-run period. The industry also can change its plant size; the long run allows sufficient time
for new firms to enter or for existing firms to leave an industry. We will discuss the impact of the
entry and exit of firms to and from an industry in the next chapter; here we are concerned only
with changes in plant capacity made by a single firm. Let’s couch our analysis in terms of average
total cost (ATC), making no distinction between fixed and variable costs because all resources,
and therefore all costs, are variable in the long run.
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Long-run Cost Curve
The long run average-total-cost curve: unlimited number of plant size. If the number of
possible plant sizes is very large, the long run average total cost curve approximates a smooth
curve.
The long-run average-total-cost

curve: unlimited number of plant
sizes. If the number of possible plant
sizes is very large, the long-run
average total- cost curve
approximates a smooth curve.
Economies of scale, followed by
diseconomies of scale, cause the
curve to be U-shaped.
Economies of scale, or economies of mass production, explain the downsloping part of

the long-run ATC curve, followed by diseconomies of scale cause the curve to be U-shaped.
Economies of scale is a long run concept and refers to reductions in unit cost as the size of a
facility, or scale, increases.
Various possible long-run

average-total-cost curves. In (a),
economies of scale are rather rapidly
obtained as plant size rises, and
diseconomies of scale are not
encountered until a considerably large
scale of output has been achieved.
Thus, long-run average total cost is
constant over a wide range of output. In
(b), economies of scale are extensive,
and diseconomies of scale occur only at
very large outputs. Average total cost
therefore declines over a broad range of
output. In (c), economies of scale are
exhausted quickly, followed
immediately by diseconomies of scale.
Minimum ATC thus occurs at a relatively
low output.
Diseconomies of scale are the opposite. Economies of scale may be utilized by any size
firm expanding its scale of operation. The common ones are purchasing (bulk buying of materials
through long-term contracts), managerial (increasing the specialization of managers), financial
(obtaining lower-interest charges when borrowing from banks and having access to a greater
range of financial instruments), and marketing (spreading the cost of advertising over a greater
range of output in media markets). Each of these factors reduces the long run average costs
(LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the
right.
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In time the expansion of a firm may lead to diseconomies and therefore higher average
total costs. The main factor causing diseconomies of scale is the difficulty of efficiently controlling
and coordinating a firm’s operations as it becomes a large-scale producer. In a small plant a
single key executive may make all the basic decisions for the plant’s operation. Because of the
firm’s small size, the executive is close to the production line, understands the firm’s operations,
and can digest information and make efficient decisions.
Constant Returns to Scale
In some industries a rather wide range of output may exist between the output at which
economies of scale end and the output at which diseconomies of scale begin. That is, there may
be a range of constant returns to scale over which long-run average cost does not change. The
q1 q2 output range is an example from the above graph. Here a given percentage increase in all
inputs of, say, 10 percent will cause a proportionate 10 percent increase in output. Thus, in this
range ATC is constant.
5.9 Production and Costs in the Long Run
In the long run, a firm has the freedom to vary all of its inputs. Two aspects of this flexibility
are important. First, a firm must choose the proportion of inputs to use. For instance, a law firm
may vary the proportion of its inputs to economize on the size of its clerical staff by investing in
computers and software specifically designed for the legal profession. In effect, it is substituting
capital for labor. Steeply rising fuel prices have caused many of the major airlines to modify their
fleets, shifting from larger aircraft to smaller, fuel-efficient aircraft.
Second, a firm must determine the scale of its operations. Would building and operating
a new facility twice the size of the firm’s existing plants achieves a doubling (or more than
doubling) of output? Are there limits to the size of the firm beyond which efficiency drastically
declines? These are all important questions that can be addressed using the concept of returns
to scale.
In the long run, the firm can vary all of its inputs. Because inputs are costly, this flexibility
raises the question: How can the firm determine the mix of inputs that will minimize the cost of
producing a given level of output? To answer this question, let’s return to the case of two inputs,
labor and capital. Here the firm’s production function is of the form
Ā = Ą(Ā, ÿ)
where L is the number of labor hours per month and K is the amount of capital used per
month. There are possibly many different ways to produce a given level of output (call this Q0),
utilizing more capital and less labor or vice versa. The optimal mix of labor and capital in producing
output Q0 depends on the costs and marginal products of the inputs. Let’s denote the firm’s labor
cost per hour by PL and its cost per unit of capital by PK. Then the firm’s total cost of using L and
K units of inputs is
ă�㔶 = ÿĀ Ā + ÿÿ ÿ.
The firm seeks to minimize this cost, subject to the requirement that it use enough L and
K to produce Q0. We now state the following important result concerning optimal long-run
production: in the long run, the firm produces at least cost when the ratios of marginal products
to input costs are equal across all inputs.
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āÿĀ āÿÿ
For the case of two inputs, we have ÿĀ
= ÿÿ
The equation above shows that when total cost is minimized, the extra output per dollar
of input must be the same for all inputs. To see why this must be true, assume to the contrary that
the ratios differ. As an example, let āÿĀ be 30 units per hour and ÿĀ be $15 per hour; in turn, let
āÿ āÿ
āÿÿ be 60 and ÿÿ be $40. Then ÿ Ā = 30/15 = 2 units per dollar of labor, while ÿ ÿ = 60/40 = 1.5
Ā ÿ
units per dollar of capital. Because labor’s productivity per dollar exceeds capital’s, it is
advantageous for the firm to increase its use of labor and reduce its use of capital. The firm could
maintain its present output level by using two extra units of labor in place of one fewer unit of
capital. (The 60 units of output given up by reducing capital is exactly matched by (2)(30) = 60
units of output provided by the additional labor.) The net savings in total cost is $40 (the saved
capital cost) minus $30 (the cost of two labor hours), or $10. If one input’s productivity per dollar
exceeds another’s, the firm can produce the same output at lower cost by switching toward greater
use of the more productive input. It should continue to make such switches until the ratios come
into equality. At that point, the firm will have found its least cost input mix.
Example: A manufacturer of home appliances faces the production function Ā = 40Ā 2

Ā2 + 54ÿ 2 1.5ÿ 2 and input costs of ÿĀ = $10 and ÿÿ = $15. Thus, the inputs’ respective marginal
products are
�㔕Ā
āÿĀ = = 40 2 2Ā
�㔕Ā
and
�㔕Ā
āÿý = = 54 2 3ÿ
�㔕ÿ
āÿĀ āÿÿ
We know that the firm’s least-cost combination of inputs must satisfy ÿĀ
= ÿÿ
This
implies that
[40 2 2Ā] [54 2 3ÿ]
=
10 15
Solving for L, we find L=K+2. This relation prescribes the optimal combination of capital
and labor. For instance, the input mix K = 8 and L = 10 satisfies this relationship. The resulting
output is Q = (40)(10) - (10)2 + (54)(8) - 1.5(8)2 = 636. The firm’s total input cost is TC = ($10)(10)
+ ($15)(8) = $220. In other words, the minimum cost of producing 636 units is $220 using 10 units
of labor and 8 units of capital.
A GRAPHICAL APPROACH: Isoquant and Isocost Curves
We saw that the firm could produce Q = 636 units of output using L = 10 and K = 8 units
of inputs. The same output, Q = 636, can be produced using different combinations of labor and
capital: 6 units of labor and 12 units of capital, for instance.
An isoquant is a curve that shows all possible combinations of inputs that can produce a
given level of output. The isoquant corresponding to Q = 636 is drawn in the following Figure. The
amounts of the inputs are listed on the axes. Three input combinations along the Q = 636 isoquant,
(L = 6, K = 12), (L = 10, K = 8), and (L = 14.2, K = 6), are indicated by points A, B, and C,
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respectively. A separate isoquant has been drawn for the output Q = 800 units. This isoquant lies
above and to the right of the isoquant for Q = 636 because producing a greater output requires
larger amounts of the inputs.
The isoquant’s negative slope embodies the basic trade-off between inputs. If a firm uses
less of one input, it must use more of the other to maintain a given level of output. For example,
consider a movement from point B to point A in Figure a4a shift in mix from (L = 10, K = 8) to (L
= 6, K = 12). Here an additional 12 - 8 = 4 units of capital substitute for 10 - 6 = 4 units of labor.
But moving from point B to point C implies quite a different trade-off between inputs. Here 4.2
units of labor are needed to compensate for a reduction of only 2 units of capital. The changing
ratio of input requirements directly reflects diminishing marginal productivity in each input. As the
firm continually decreases the use of one input, the resulting decline in output becomes greater
and greater. As a result, greater and greater amounts of the other input are needed to maintain a
constant level of output.
The general rule is that the slope of the isoquant at any point is measured by the ratio of
the inputs’ marginal products:
∆ÿ 2āÿĀ
(ĄĀă Ā āĀÿĄąÿÿą) =
∆Ā āÿÿ
Notice that the ratio is -MPL/MPK and not the other way around. The greater is labor’s marginal
product (and the smaller capital’s), the greater the amount of capital needed to substitute for a
∆ÿ
unit of labor, that is, the greater the ratio ∆Ā . This ratio is important enough to warrant its own
terminology. The marginal rate of technical substitution (MRTS) denotes the rate at which one
input substitutes for the other and is defined as
∆ÿ āÿĀ
āāăĂ = 2 (ĄĀă Ā āĀÿĄąÿÿą) = 2
∆Ā āÿÿ
The two isoquants in part (a) show the different combinations of labor and capital needed
to produce 636 and 800 units of output. The isocost lines in part (b) show combinations of inputs
a firm can acquire at various total costs.
Suppose the manager sets out to produce an output of 636 units at least cost. Which
combination of inputs along the isoquant will accomplish this objective? The answer is provided
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by portraying the firm’s least-cost goal in graphic terms. Recall that the firm’s total cost of using L
and K units of input is
ă�㔶 = ÿĀ Ā + ÿÿ ÿ
Using this equation, let’s determine the various combinations of inputs the firm can obtain
at a given level of total cost (i.e., expenditure). To do this, we rearrange the cost equation to read
ă�㔶 ÿĀ
ÿ= 2 ( )Ā
ÿÿ ÿÿ
To illustrate, suppose the firm faces the input prices, ÿĀ = $10 and ÿÿ = $15. If it limits its
total expenditures to TC = $120, the firm can use any mix of inputs satisfying K = 120/15 - (10/15)L
or K = 8 - (2/3)L. This equation is plotted in Figure b. This line is called an isocost line because
it shows the combination of inputs the firm can acquire at a given total cost. We can draw a host
of isocost lines corresponding to different levels of expenditures on inputs. In the figure, the
isocost lines corresponding to TC = $220 and TC = $300 are shown. The slope of any of these
∆ÿ
lines is given by the ratio of input prices, = 2ÿĀ /ÿÿ . The higher the price of capital (relative to
∆Ā
labor), the lower the amount of capital that can be substituted for labor while keeping the firm’s
total cost constant.
By superimposing isocost lines on the same graph with the appropriate isoquant, we can
determine the firm’s least-cost mix of inputs. We simply find the lowest isocost line that still
touches the given isoquant. For instance, to produce 636 units of output at minimum cost, we
must identify the point along the isoquant that lies on the lowest isocost line. The figure shows
that this is point B, the point at which the isocost line is tangent to the isoquant. Point B confirms
Example 3’s original solution: The optimal combination of inputs is 10 units of labor and 8 units of
capital. Since point B lies on the $220 isocost line, we observe that this is the minimum possible
cost of producing the 636 units.
Producing Output at
Minimum Cost
The firm produces 636

units at minimum cost at point
B, where the isoquant is tangent
to the lowest possible isocost
line. Point B corresponds to10
units of labor and 8 units of
capital.
Note that at the point of tangency, the slope of the isoquant and the slope of the isocost
ÿ
line are the same. The isoquant’s slope is 2āÿĀ /āÿÿ . In turn, the isocost line’s slope is 2 ÿ Ā .
ÿ
Thus, the least-cost combination of inputs is characterized by the condition
āÿĀ
āāăĂ = = ÿĀ /ÿÿ
āÿÿ
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The ratio of marginal products exactly matches the ratio of input prices. (If one input is
twice as expensive as another, optimal usage requires that it have twice the marginal product.)
This relationship can be rearranged to read
āÿĀ āÿÿ
=
ÿĀ ÿÿ
The marginal product per dollar of input should be the same across all inputs.
Assessment 5
1. Differentiate implicit and explicit cost by citing examples.
2. Explain how isoquant curves and isocost lines determine the producer's equilibrium using
graphs.
3. Explain the Law of Diminishing Returns and Returns to Scale.
4. Differentiate short-run and long-run production.
5. Complete the worksheet below.
Average
Units of Fixed Variable Average Marginal
Total Cost Variable
Production Cost Cost Total Cost Cost
Cost
0 2000 *** 1. ________ *** *** ***
20 2000 4000 2. ________ 3. ________ 4. ________ 5. ________

40 2000 6000 6. ________ 7. ________ 8. ________ 9. ________
10. 11. 12.
60 2000 9000 13. ________
________ ________ ________
14. 15. 16.
80 2000 11000 17. ________
________ ________ ________
18. 19. 20.
100 2000 14000 21. ________
________ ________ ________
22. 23. 24.
120 2000 18000 25. ________
________ ________ ________
6. Use the table above and transform into a graph. Show the marginal cost, average total cost,
and average variable cost.
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CHAPTER 68
OPTIMAL OUTPUT DECISIONS AND PRICING STRATEGIES
Learning Objectives: This chapter introduces the four market models. This section also
discusses the two approaches of profit maximization and loss minimization, welfare effects
of the four market structures, optimal output and price level, and effects of different pricing
strategies of each market structure.
The managerial decisions of typical firms were examined in the previous chapters using
demand and cost conditions. This chapter will discuss the firm’s decisions in choosing optimal
output and price to experience maximum profit. Our discussion will focus on market structures to
explain these decisions.
Economists and management scientists traditionally divide markets into four main types:
perfect competition, monopolistic competition, oligopoly, and pure monopoly. These market types
differ with respect to several key attributes: the number of firms, the extent of barriers to entry for
new firms, and the degree to which individual firms control price. In perfect competition and
monopolistic competition, many sellers supply the market, and new sellers can enter the industry
easily. In a pure monopoly, in contrast, a single firm is the industry. There are no direct
competitors, and barriers to new entry are prohibitive. Oligopoly represents an intermediate case:
The industry is dominated by a small number of firms and is marked by significant, but not
prohibitive, entry barriers.
The Four Market Models
Pure Competition involves a very large number of firms producing a standardized product
(that is, a product identical to that of other producers, such as corn or cucumbers). New firms can
enter or exit the industry very easily.
Pure Monopoly is a market structure in which one firm is the sole seller of a product or
service. Since the entry of additional firms is blocked, one firm constitutes the entire industry.
Because the monopolist produces a unique product, it makes no effort to differentiate its product.
Monopolistic Competition is characterized by relatively large number of sellers

producing differentiated products. There is widespread nonprice competition, a selling strategy in
8
The diagrams and tables used in this Chapter 6 were collected from McConnel, Brue, & Flynn. (2012).
Microeconomics: Principles, Problems, and Policies. 19th edition, McGraw Hill-Irwin.
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which one firm tries to its product or service from all competing products on the basis of attributes
like design and workmanship (an approach called product differentiation). Either entry to or exit
from monopolistically competitive industries is quite easy.
Oligopoly involves only a few sellers of a standardized or differentiated product; so each

firm is affected by the decisions of its rivals and must take those decisions in account in
determining its own prices and output.
Let us examine the characteristics of each firm and the determination of their output and
price.
6.1 PURE COMPETITON
Characteristics and Occurrence

1. Very Large number
Presence of large number of independently acting sellers, often offering their products in
large national or international markets
2.Standardized product
Produce a standardize (identical or homogenous)
3. Price takers
Individual firms exert no significant control over product price.
4. Free entry and exit
New firm can freely enter and existing firms can freely leave purely competitive industries.
a. Demand as Seen by a Purely Competitive Seller
The demand schedule faced by the individual firm in a purely competitive industry is
perfectly elastic at the market price. The firm represented cannot obtain a higher price by
restricting its output, nor does it need to lower its price to increase its sales volume.
b. Profit Maximization in the Short run
PROFIT = TOTAL REVENUE 3 TOTAL COST

TOTAL COST = FIXED COST + VARIABLE COST
Two Approaches
Because the purely competitive firm is a price taker, it can maximize its economic profit
(or minimize its loss) only by adjusting its output. And, in the short run, the firm has a fixed plant.
Thus, it can adjust its output only through changes in the amount of variable resources materials,
labor) it uses. It adjusts its variable resources to achieve the output level that maximizes its profit.
There are two ways to determine the level of output at which a competitive firm will realize
maximum profit or minimum loss. One method is to compare total revenue and total cost; the
other is to compare marginal revenue and marginal cost. Both approaches apply to all firms,
whether they are pure competitors, pure monopolists, monopolistic competitors, or oligopolists.
1. TOTAL REVENUE-TOTAL COST APPROACH
Assuming that the market price is $131, the total revenue for each output level is found
by multiplying output (total product) by price. Total revenue data are in column 5. Then in column
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6 we find the profit or loss at each output level by subtracting total cost, TC (column 4), from total
revenue, TR (column 5).
Column 6 tells us that this is the output at which total economic profit is at a maximum.
What economic profit (or loss) will it realize? A $299 economic profit 3 the difference between
total revenue ($1179) and total cost ($880).
The following diagram compares total revenue and total cost graphically for this profit-
maximizing case. Observe again that the total-revenue curve for a purely competitive firm is a
straight line.
- Total Revenue and total cost are equal where the two curves in figure intersect BREAK
EVEN POINT
- An output at which firm makes a normal profit but not an economic profit.
- Any output within the two break-even points identified in the figure will produce an economic
profit.
The profit maximizing output is easier to see in figure where the total revenue and total cost
curves intersect, economic profit is zero.
Economic Profit is at its peak at 299$. This firm will produce 9 units since an output maximize
profit.
Total-revenue3total-cost
approach to profit maximization
for a purely competitive firm. (a)
The firm’s profit is maximized at
that output (9 units) where total
revenue, TR, exceeds total cost,
TC, by the maximum amount. (b)
The vertical distance between TR
and TC in (a) is plotted as a total-
economic-profit curve. Maximum
economic profit is $299 at 9 units
of output.
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2. MARGINAL REVUNUE- MARGINAL COST APPROACH
The firm compares the amounts that each additional unit of output would add to total
revenue and to total cost.
MR= MC Rule
In the short run, the firm will maximize profit or minimize loss by producing the output at
which marginal revenue equal marginal cost.
Three Characteristics
1. The rule applies only if producing is preferably to be shutting down
If the marginal revenue does not equal average variable cost the firm should shut down
2.The rule is an accurate guide to profit maximization for all firms whether they are purely
competitive, monopolistic, monopolistically competitive, oligopolists.
3. The rule can be restated as P= MC when applied to purely competitive firm.
When producing is preferable to shutting down, the competitive firm that wants to
maximize its profit or minimize its loss should produce at that point where price equal
marginal cost (P=MC).
Profit Maximizing output
Every unit of output up to and including the ninth unit represents greater marginal revenue
than marginal cost of output.
Each of the first 9 units therefore adds to the firm’s profit and should be produced.
The tenth unit, however, should not be produced. It would add more to cost (150$) than to
revenue (131$).
The Short Run Profit Maximizing Position of Purely Competitive Firm
- The MR = MC output enables the purely competitive firm to maximize profits or to

minimize losses.
- In this case MR and MC are equal at an output Q of 9 units.
- There P exceeds the average total cost A = 97.78, so the firm realizes an economic
profit of P-A per unit.
-
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The first five columns reproduce the AFC, AVC, ATC, and MC data derived for our product
in the previous table. It is the marginal-cost data of column 5 that we will compare with price
(equals marginal revenue) for each unit of output. Suppose first that the market price, and
therefore marginal revenue, is $131.
The MR=MC output enables

the purely competitive firm to
maximize profits or to minimize
losses. In this case MR (= P in pure
competition) and MC are equal at an
output Q of 9 units. There P exceeds
the average total cost A = ($97.78,
so the firm realizes an economic
profit of P-A per unit. The total
economic profit is represented by
the green rectangle and is 9 X (P-A).
c. Loss Minimizing Case
Wherever price P exceeds average variable cost (AVC) but is less than ATC, the firm can
pay part, but not all, of its fixed cost by producing. Column 6 shows the new price (equal to MR),
$81. Comparing columns 5 and 6, we find that the first unit of output adds $90 to total cost but
only $81 to total revenue. The price3 marginal cost relationship improves with increased
production. For units 2 through 6, price exceeds marginal cost. Each of these 5 units adds more
to revenue than to cost, and as shown in column 7, they decrease the total loss. Together they
more than compensate for the <loss= taken on the first unit. Beyond 6 units, however, MC exceeds
MR (=P). The firm should therefore produce 6 units. In general, the profit-seeking producer should
always compare marginal revenue (or price under pure competition) with the rising portion of the
marginal-cost schedule or curve.
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Will production be profitable? No, because at 6 units of output the average total cost of
$91.67 exceeds the price of $81 by $10.67 per unit. If we multiply that by the 6 units of output,
we find the firm’s total loss is $64. Alternatively, comparing the total revenue of $486 (=6 X $81)
with the total cost of $550 (= 6 X $91.67), we see again that the firm’s loss is $64.
If price P falls below

the minimum AVC (here $74
at Q = 5), the competitive
firm will minimize its losses
in the short run by shutting
down. There is no level of
output at which the firm can
produce and realize a loss
smaller than its total fixed
cost.
Then why produce? Because this loss is less than the firm’s $100 of fixed costs, which is
the $100 loss the firm would incur in the short run by closing down. The firm receives enough
revenue per unit ($81) to cover its average variable costs of $75 and also provide $6 per unit, or
a total of $36, to apply against fixed costs. Therefore, the firm’s loss is only $64 (= $100 - $36),
not $100.
d. Shutdown Case
Suppose now that the market yields a price of only $71. Should the firm produce? No,
because at every output the firm’s average variable cost is greater than the price (compare
columns 3 and 8). The smallest loss it can incur by producing is greater than the $100 fixed cost
it will lose by shutting down (as shown by column 9). The best action is to shut down. You can
see this shutdown situation in the next figure.
If price P falls below

the minimum AVC (here $74
at Q = 5), the competitive firm
will minimize its losses in the
short run by shutting down.
There is no level of output at
which the firm can produce
and realize a loss smaller
than its total fixed cost.
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Price comes closest to covering average variable costs at the MR (= P) = MC output of 5

units. But even here, price or revenue per unit would fall short of average variable cost by $3 (=
$74 - $71). By producing at the MR (= P) MC output, the firm would lose its $100 worth of fixed
cost plus $15 ($3 of variable cost on each of the 5 units), for a total loss of $115. This compares
unfavorably with the $100 fixed-cost loss the firm would incur by shutting down and producing no
output. So, it will make sense for the firm to shut down rather than produce at a $71 price4or at
any price less than the minimum average variable cost of $74.
The shutdown case reminds us of the qualifier to our MR (= P) = MC rule. A competitive

firm will maximize profit or minimize loss in the short run by producing that output at which MR (=
P) = MC, provided that market price exceeds minimum average variable cost.
6.2 PURE MONOPOLY
Exists when a single firm is the sole producer of a product for which there are no close
substitute.
Main Characteristics of Pure Monopoly
1. SINGLE SELLER
A pure, or absolute, monopoly is an industry in which a single firm is the sole producer of
a specific good or the sole supplier of a services; the firm and industry are synonymous.
2. NO CLOSE SUBSTITUTE
A Pure monopoly’s product is unique in that there are no close substitutes.
3. PRICE MAKER
The pure monopolist controls the total quantity supplied and thus has considerable control
over price.
a. Monopoly Demand
The demand curve for the monopolist (and for any imperfectly competitive seller) is very
different from that of the pure competitor. Because the pure monopolist is the industry, its demand
curve is the market demand curve. And because market demand is not perfectly elastic, the
monopolist’s demand curve is downsloping.
A pure monopolist, or any other

imperfect competitor with a downsloping
demand curve such as D, must set a lower
price in order to sell more output. Here, by
charging $132 rather than $142, the
monopolist sells an extra unit (the fourth unit)
and gains $132 from that sale. But from this
gain must be subtracted $30, which reflects
the $10 less the monopolist charged for each
of the first 3 units. Thus, the marginal
revenue of the fourth unit is $102 (= $132 -
$30), considerably less than its $132 price.
The above diagram was derived from the following table:
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b. The Monopolist is a Price Maker
All imperfect competitors, whether pure monopoly, oligopoly, or monopolistic competition,

face downward sloping demand curves. So, firms in those industries can to one degree or another
influence total supply through their own output decisions. In changing market supply, they can
also influence product price. Firms with downward sloping demand curves are price makers.
This is most evident in pure monopoly, where one firm controls total output. The
monopolist faces a downsloping demand curve in which each output is associated with some
unique price. Thus, in deciding on what volume of output to produce, the monopolist is also
indirectly determining the price it will charge. Through control of output, it can <make the price.=
From columns 1 and 2 in the table, we find that the monopolist can charge a price of $72 if it
produces and offers for sale 10 units, a price of $82 if it produces and offers for sale 9 units, and
so forth.
The Monopolist Sets Prices in the Elastic Region of Demand
The total-revenue test for price elasticity of demand is the basis for our third implication.
Recall that the total-revenue test reveals that when demand is elastic, a decline in price will
increase total revenue. Similarly, when demand is inelastic, a decline in price will reduce total
revenue.
Demand, marginal revenue, and total

revenue for a pure monopolist. (a) Because it
must lower price on all units sold in order to
increase its sales, an imperfectly competitive
firm’s marginal-revenue curve (MR) lies
below its downsloping demand curve (D). The
elastic and inelastic regions of demand are
highlighted. (b) Total revenue (TR) increases
at a decreasing rate, reaches a maximum,
and then declines. Note that in the elastic
region, TR is increasing and hence MR is
positive. When TR reaches its maximum, MR
is zero. In the inelastic region of demand, TR
is declining, so MR is negative.
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Beginning at the top of demand curve, observe that as the price declines from $172 to
approximately $82, total revenue increases (and marginal revenue therefore is positive). This
means that demand is elastic in this price range. Conversely, for price declines below $82, total
revenue decreases (marginal revenue is negative), indicating that demand is inelastic there.
The implication is that a monopolist will never choose a price-quantity combination where
price reductions cause total revenue to decrease (marginal revenue to be negative). The profit-
maximizing monopolist will always want to avoid the inelastic segment of its demand curve in
favor of some price-quantity combination in the elastic region. Here’s why: To get into the inelastic
region, the monopolist must lower price and increase output. In the inelastic region a lower price
means less total revenue. And increased output always means increased total cost. Less total
revenue and higher total cost yield lower profit.
c. Profit Maximizing Position of Pure Monopolist
A monopolist seeking to maximize total profit will employ the same rationale as a profit-
seeking firm in a competitive industry. If producing is preferable to shutting down, it will produce
up to the output at which marginal revenue equals marginal cost (MR = MC).
Profit maximization by a pure

monopolist. The pure monopolist
maximizes profit by producing at the
MR = MC output, here Qm = 5 units.
Then, as seen from the demand
curve, it will charge price Pm = $122.
Average total cost will be A = $94,
meaning that per-unit profit is Pm =
A and total profit is 5 X (Pm - A).
Total economic profit is thus
represented by the green rectangle.
d. Possibility of Losses by Monopolist
The likelihood of economic profit is greater for a pure monopolist than for a pure
competitor. In the long run the pure competitor is destined to have only a normal profit, whereas
barriers to entry mean that any economic profit realized by the monopolist can persist. In pure
monopoly there are no new entrants to increase supply, drive down price, and eliminate economic
profit. But pure monopoly does not guarantee profit. The monopolist is not immune from changes
in tastes that reduce the demand for its product. Nor is it immune from upward-shifting cost curves
caused by escalating resource prices. If the demand and cost situation faced by the monopolist
is far less favorable than that in latter figure, the monopolist will incur losses in the short run.
Despite its dominance in the market (as, say, a seller of home sewing machines), the monopoly
enterprise in next figure suffers a loss, as shown, because of weak demand and relatively high
costs. Yet it continues to operate for the time being because its total loss is less than its fixed
cost. More precisely, at output Qm the monopolist’s price Pm exceeds its average variable cost
V. Its loss per unit is A - Pm, and the total loss is shown by the red rectangle.
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The loss-minimizing
position of a pure monopolist. If
demand D is weak and costs
are high, the pure monopolist
may be unable to make a profit.
Because Pm exceeds V, the
average variable cost at the MR
= MC output Qm, the
monopolist will minimize losses
in the short run by producing at
that output. The loss per unit is
A - Pm, and the total loss is
indicated by the red rectangle.
6.3 MONOPOLISTIC COMPETITION
Monopolistic competition mixes a small amount of monopoly power with a large amount
of competition. It is a common market structure where many competing producers sell products
that are differentiated from one another (that is, the products are substitutes, but are not exactly
alike, similar to brand loyalty).
Characteristics of Monopolistic Competition
1. Relatively Large Numbers of Sellers

Monopolistic competition is characterized by a fairly large number of firms, say, 25, 35,
60, or 70, not by the hundreds or thousands of firms in pure competition. Consequently,
monopolistic competition involves:
• Small market shares - Each firm has a comparatively small percentage of the total
market and consequently has limited control over market price.
• No collusion - The presence of a relatively large number of firms ensures that collusion
by a group of firms to restrict output and set prices is unlikely.
• Independent action - With numerous firms in an industry, there is no feeling of
interdependence among them; each firm can determine its own pricing policy without
considering the possible reactions of rival firms. A single firm may realize a modest
increase in sales by cutting its price, but the effect of that action on competitors’ sales will
be nearly imperceptible and will probably trigger no response.
2. Differentiated Products
In contrast to pure competition, in which there is a standardized product, monopolistic
competition is distinguished by product differentiation. Monopolistically competitive firms
turn out variations of a particular product.
They produce products with slightly different physical characteristics, offer varying
degrees of customer service, provide varying amounts of locational convenience, or
proclaim special qualities, real or imagined, for their products.
3. Easy Entry and Exit of the Firms

Entry into monopolistically competitive industries is relatively easy compared to oligopoly
or pure monopoly. Because monopolistic competitors are typically small firms, both
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absolutely and relatively, economies of scale are few and capital requirements are low.
On the other hand, compared with pure competition, financial barriers may result from the
need to develop and advertise a product that differs from rivals’ products. Some firms
have trade secrets relating to their products or hold trademarks on their brand names,
making it difficult and costly for other firms to imitate them.
Exit from monopolistically competitive industries is relatively easy. Nothing prevents an

unprofitable monopolistic competitor from holding a going-out-of-business sale and
shutting down.
a. A Firm’s Demand Curve
The basic feature of the next diagram is the elasticity of demand as shown by the
individual firm’s demand curve. The demand curve faced by a monopolistically competitive seller
is highly, but not perfectly, elastic. It is precisely this feature that distinguishes monopolistic
competition from pure monopoly and pure competition. The monopolistic competitor’s demand is
more elastic than the demand faced by a pure monopolist because the monopolistically
competitive seller has many competitors producing closely substitutable goods. The pure
monopolist has no rivals at all. Yet, for two reasons, the monopolistic competitor’s demand is not
perfectly elastic like that of the pure competitor. First, the monopolistic competitor has fewer rivals;
second, its products are differentiated, so they are not perfect substitutes.
The price elasticity of demand faced by the monopolistically competitive firm depends on
the number of rivals and the degree of product differentiation. The larger the number of rivals and
the weaker the product differentiation, the greater the price elasticity of each seller’s demand,
that is, the closer monopolistic competition will be to pure competition.
b. Profit Maximization in the Short-Run
Because of free entry and exit of the firms in the market, there will be an adjustment in
the market. Thus, we will analyze the profit in the short-run and long-run periods.
The Short Run: Profit or Loss
The monopolistically competitive firm maximizes its profit or minimizes its loss in the short
run just as do the other firms we have discussed: by producing the output at which marginal
revenue equals marginal cost (MR = MC). In the above figure, the firm produces output Q1, where
MR = MC. As shown by demand curve D1, it then can charge price P1. It realizes an economic
profit, shown by the green area [= (P1 - A1) X Q1].
But with less favorable demand or costs, the firm may incur a loss in the short run. We
show this possibility in figure b, where the firm’s best strategy is to minimize its loss. It does so
by producing output Q2 (where MR = MC) and, as determined by demand curve D2, by charging
price P2. Because price P2 is less than average total cost A2, the firm incurs a per-unit loss of
A2 - P2 and a total loss represented as the red area [= (A2 - P 2) X Q2].
The Long Run: Only Normal Profit
Figure c represents the long run situation in this market. firms will enter a profitable
monopolistically competitive industry and leave an unprofitable one. So, a monopolistic
competitor will earn only a normal profit in the long run or, in other words, will only break even.
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The monopolistic competitor maximizes

profit or minimizes loss by producing the output
at which MR = MC. The economic profit shown in
(a) will induce new firms to enter, eventually
eliminating economic profit. The loss shown in (b)
will cause an exit of firms until normal profit is
restored. After such entry and exit, the price will
settle in (c) to where it just equals average total
cost at the MR = MC output. At this price P3 and
output Q3, the monopolistic competitor earns
only a normal profit, and the industry is in long-
run equilibrium.
Profits: Firms Enter
In the case of short-run profit (Figure a), economic profits attract new rivals, because entry
to the industry is relatively easy. As new firms enter, the demand curve faced by the typical firm
shifts to the left (falls). Why? Because each firm has a smaller share of total demand and now
faces a larger number of close-substitute products. This decline in the firm’s demand reduces its
economic profit. When entry of new firms has reduced demand to the extent that the demand
curve is tangent to the average-total-cost curve at the profit-maximizing output, the firm is just
making a normal profit. This situation is shown in Figure c, where demand is D3 and the firm’s
long-run equilibrium output is Q3. As Figure c indicates, any greater or lesser output will entail an
average total cost that exceeds product price P3, meaning a loss for the firm. At the tangency
point between the demand curve and ATC, total revenue equals total costs. With the economic
profit gone, there is no further incentive for additional firms to enter.
Losses: Firms Leave
When the industry suffers short-run losses, as in Figure b, some firms will exit in the long
run. Faced with fewer substitute products and blessed with an expanded share of total demand,
the surviving firms will see their demand curves shift to the right (rise), as to D3. Their losses will
disappear and give way to normal profits (Figure c).
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6.4 OLIGOPOLY
Oligopoly is a market dominated by a few large producers of a homogeneous or

differentiated product. Because of their <fewness,= oligopolists have considerable control over
their prices, but each must consider the possible reaction of rivals to its own pricing, output, and
advertising decisions.
Characteristics
1. A Few Large Producers

The phrase <a few large producers= is necessarily vague because the market model of
oligopoly covers much ground, ranging between pure monopoly, on the one hand, and
monopolistic competition, on the other. Generally, when you hear a term such as <Big
Three,= <Big Four,= or <Big Six,= you can be sure it refers to an oligopolistic industry.
2. Homogeneous or Differentiated Products

An oligopoly may be either a homogeneous oligopoly or a differentiated oligopoly,
depending on whether the firms in the oligopoly produce standardized or differentiated
products. Many industrial products (steel, zinc, copper, aluminum, lead, cement, industrial
alcohol) are virtually standardized products that are produced in oligopolies. Alternatively,
many consumer goods industries (automobiles, tires, household appliances, electronics
equipment, breakfast cereals, cigarettes, and many sporting goods) are differentiated
oligopolies. These differentiated oligopolies typically engage in considerable nonprice
competition supported by heavy advertising.
3. Control over Price, but Mutual Interdependence

Unlike the monopolist, which has no rivals, the oligopolist must consider how its rivals will
react to any change in its price, output, product characteristics, or advertising. Oligopoly
is thus characterized by strategic behavior and mutual interdependence. By strategic
behavior, we simply mean self-interested behavior that takes into account the reactions
of others. Firms develop and implement price, quality, location, service, and advertising
strategies to <grow their business= and expand their profits. But because rivals are few,
there is mutual interdependence: a situation in which each firm’s profit depends not
entirely on its own price and sales strategies but also on those of the other firms. So
oligopolistic firms base their decisions on how they think rivals will react.
4. Entry Barriers
The same barriers to entry that create pure monopoly also contribute to the creation of
oligopoly. Economies of scale are important entry barriers in a number of oligopolistic
industries, such as the aircraft, rubber, and copper industries. In addition, the ownership
and control of raw materials help explain why oligopoly exists in many mining industries,
including gold, silver, and copper.
a. Oligopoly Behavior: Game Theory
Oligopoly pricing behavior has the characteristics of certain games of strategy, such as
poker, chess, and bridge. The best way to play such a game depends on the way one’s opponent
plays. Players (and oligopolists) must pattern their actions according to the actions and expected
reactions of rivals. The study of how people behave in strategic situations is called game theory.
And we will use a simple game-theory model to analyze the pricing behavior of oligopolists. We
assume that a duopoly, or two-firm oligopoly, is producing athletic shoes. Each of the two firms4
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let’s call them RareAir and Uptown4 has a choice of two pricing strategies: price high or price
low. The profit each firm earns will depend on the strategy it chooses and the strategy its rival
chooses.
There are four possible combinations of strategies for the two firms, and a lettered cell in
the next figure represents each combination. For example, cell C represents a low-price strategy
for Uptown along with a high-price strategy for RareAir. The figure is called a payoff matrix,
because each cell shows the payoff (profit) to each firm that would result from each combination
of strategies. Cell C shows that if Uptown adopts a low-price strategy and RareAir a high-price
strategy, then Uptown will earn $15 million (tan portion) and RareAir will earn $6 million (green
portion).
Profit payoff (in millions) for

two-firm oligopoly. Each firm has two
possible pricing strategies. RareAir’s
strategies are shown in the top
margin, and Uptown’s in the left
margin. Each lettered cell of this
four-cell payoff matrix represents
one combination of a RareAir
strategy and an Uptown strategy and
shows the profit that combination
would earn for each firm.
Oligopolistic firms can increase their profits, and influence their rivals’ profits, by changing
their pricing strategies. Each firm’s profit depends on its own pricing strategy and that of its rivals.
This mutual interdependence of oligopolists is the most obvious point demonstrated by the above
Figure. If Uptown adopts a high-price strategy, its profit will be $12 million provided that RareAir
also employs a high-price strategy (cell A). But if RareAir uses a low-price strategy against
Uptown’s high-price strategy (cell B), RareAir will increase its market share and boost its profit
from $12 to $15 million. RareAir’s higher profit will come at the expense of Uptown, whose profit
will fall from $12 million to $6 million. Uptown’s high-price strategy is a good strategy only if
RareAir also employs a high-price strategy.
The figure also suggests that oligopolists often can benefit from collusion 4that is,
cooperation with rivals. To see the benefits of collusion, first suppose that both firms in the figure
are acting independently and following high-price strategies. Each realizes a $12 million profit
(cell A).
Note that either RareAir or Uptown could increase its profit by switching to a low-price
strategy (cell B or C). The low-price firm would increase its profit to $15 million, and the high-price
firm’s profit would fall to $6 million. The high-price firm would be better off if it, too, adopted a low-
price policy. Doing so would increase its profit from $6 million to $8 million (cell D). The effect of
all this independent strategy shifting would be the reduction of both firms’ profits from $12 million
(cell A) to $8 million (cell D).
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How could oligopolists avoid the low-profit outcome of cell D? The answer is that they
could collude, rather than establish prices competitively or independently. In our example, the
two firms could agree to establish and maintain a high-price policy. So, each firm will increase its
profit from $8 million (cell D) to $12 million (cell A).
Incentive to Cheat
The payoff matrix also explains why an oligopolist might be strongly tempted to cheat on
a collusive agreement. Suppose Uptown and RareAir agree to maintain high-price policies, with
each earning $12 million in profit (cell A). Both are tempted to cheat on this collusive pricing
agreement, because either firm can increase its profit to $15 million by lowering its price. If
Uptown secretly cheats on the agreement by charging low prices, the payoff moves from cell A
to cell C. Uptown’s profit rises to $15 million, and RareAir’s falls to $6 million. If RareAir cheats,
the payoff moves from cell A to cell B, and RareAir gets the $15 million.
b. Three Oligopoly Models
1. Kinked-Demand Theory: Noncollusive Oligopoly
Suppose there is an oligopolistic industry made up of three hypothetical firms (Arch, King,
and Dave’s), each having about one-third of the total market for a differentiated product. Assume
that the firms are <independent,= meaning that they do not engage in collusive price practices.
Assume, too, that the going price for Arch’s product is P0 and its current sales are Q0, as shown
in the next figure.
The kinked-demand curve. (a) The slope of a noncollusive oligopolist’s demand and
marginal-revenue curves depends on whether its rivals match (straight lines D1 and MR1) or
ignore (straight lines D2 and MR2) any price changes that it may initiate from the current price
P0. (b) In all likelihood an oligopolist’s rivals will ignore a price increase but follow a price cut.
This causes the oligopolist’s demand curve to be kinked (D2eD1) and the marginal-revenue curve
to have a vertical break, or gap (fg). Because any shift in marginal costs between MC1 and MC2
will cut the vertical (dashed) segment of the marginal-revenue curve, no change in either price
P0 or output Q0 will result from such a shift.
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Two possible price strategies:

a. Match price changes. One possibility is that King and Dave’s will exactly match any price
change initiated by Arch. In this case, Arch’s demand and marginal-revenue curves will
look like the straight lines labeled D1 and MR1 in next graph. Why are they so steep?
Reason: If Arch cuts its price, its sales will increase only modestly because its two rivals
will also cut their prices to prevent Arch from gaining an advantage over them. The small
increase in sales that Arch (and its two rivals) will realize is at the expense of other
industries; Arch will gain no sales from King and Dave’s. If Arch raises its price, its sales
will fall only modestly, because King and Dave’s will match its price increase. The industry
will lose sales to other industries, but Arch will lose no customers to King and Dave’s.
b. Ignore price changes. The other possibility is that King and Dave’s will ignore any price
change by Arch. In this case, the demand and marginal-revenue curves faced by Arch will
resemble the straight lines D2 and MR2 in the figure. Demand in this case is considerably
more elastic than it was under the previous assumption. The reasons are clear: If Arch
lowers its price and its rivals do not, Arch will gain sales significantly at the expense of its
two rivals because it will be underselling them. Conversely, if Arch raises its price and its
rivals do not, Arch will lose many customers to King and Dave’s, which will be underselling
it. Because of product differentiation, however, Arch’s sales will not fall to zero when it
raises its price; some of Arch’s customers will pay the higher price because they have a
strong preference for Arch’s product.
2. Cartels and Other Collusion

Our game-theory model demonstrated that oligopolists might benefit from collusion.
Collusion and the tendency toward joint

profit maximization. If oligopolistic firms face
identical or highly similar demand and cost
conditions, they may collude to limit their joint
output and to set a single, common price. Thus,
each firm acts as if it were a pure monopolist,
setting output at Q0 and charging price P0.
This price and output combination maximizes
each oligopolist’s profit (green area) and thus
the combined or joint profit of both.
3. Price Leadership Model
Price leadership entails a type of implicit understanding by which oligopolists can

coordinate prices without engaging in outright collusion based on formal agreements and secret
meetings. Rather, a practice evolves whereby the <dominant firm=4usually the largest or most
efficient in the industry4 initiates price changes and all other firms more or less automatically
follow the leader.
Breakdowns in Price Leadership: Price Wars
Price leadership in oligopoly occasionally breaks down, at least temporarily, and

sometimes results in a price war. Most price wars eventually run their course. When all firms
recognize that low prices are severely reducing their profits, they again yield price leadership to
one of the industry’s leading firms. That firm then begins to raise prices, and the other firms
willingly follow suit.
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Assessment 6
1. Complete the table below.

Pure Monopolistic
Characteristics Monopoly Oligopoly
Competition Competition
Number of 1. 6. 11. 16.
Firms
Type of 2. 7. 12. 17.

Products
Price Setting 3. 8. 13. 18.

and Control
Entry of Firm 4. 9. 14. 19.
Local 5. 10. 15. 20.

Examples
2. How does the purely competitive firm maximize its profit? Explain using graphical illustration.
_________________________________________________________________________
3. How does a monopolist firm maximize its profit? Explain using graphical illustration.
_________________________________________________________________________
4. When should a monopolistically competitive firm exit the market? Explain using graphical
illustration.
_________________________________________________________________________
5. Explain the three models of Oligopoly.
_________________________________________________________________________
6. Many golf clubs offer two alternative plans for playing golf:
3.1. A two-part tariff: Pay an annual membership fee (e.g. P10,000) and then pay a
small fee for the use of the golf course (e.g. P1,000 per game).
3.2. A straight rental fee: Pay no membership fee, but pay a higher fee per game (e.g.
P2,000).
What is the logic behind the two-part tariff in this case? Why offer the customer a choice of the
two plans rather than simply a two-part tariff?
7. A certain car manufacturer regards his business as highly competitive because he is keenly
aware of his rivalry with the other few manufacturers in the market like the other car
manufacturers. He undertakes vigorous advertising campaigns seeking to convince potential
buyers of the superior quality and better style of his automobiles and reacts very quickly to
claims of superiority by rivals. Is this the meaning of perfect competition from an economic
point of view?
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CHAPTER 79
ECONOMIC RISK AND UNCERTAINTY
Learning Objectives: This section tackles concepts of risk and uncertainty, sources of business
risk, and risk measurement method to assess present risks in an investment. At the end
of this chapter, the readers will be able to differentiate risk from uncertainty, identify and
explain the sources of business and economic risks, and identify and apply the risk
measure methods to assess the present risks experience by the firm in their investment.
Uncertainty about a situation can often indicate risk, which is the possibility of loss,
damage, or any other undesirable event,
7.1 Risk versus Uncertainty
Risk 3 is considered as a situation where there is more than one possible outcome to a
decision and the probability of each outcome is known.
Uncertainty 3 It is considered as the situation where there is more than one possible
outcome to a decision and the probability of each outcome is unknown.
Risk Uncertainty
A situation when you can predict the chance of A situation when you cannot predict the
an outcome in the future. chance of an outcome in the future.
BASIS FOR
RISK UNCERTAINTY
COMPARISON
The probability of winning or

Uncertainty implies a situation where
Meaning losing something worthy is
the future events are not known.
known as risk.
Ascertainment It can be measured It cannot be measured.
Chances of outcomes are

Outcome The outcome is unknown.
known.
Control Controllable Uncontrollable
Minimization Yes No
Probabilities Assigned Not assigned
9
Discussions of this chapter were gathered from
https://ag.purdue.edu/commercialag/Pages/Resources/Risk/Introduction/Measuring-Risk-
Uncertainty.aspx#:~:text=Uncertainty%20represents%20a%20situation%20in,a%20distribution%20of%20possible
%20outcomes.
https://keydifferences.com/difference-between-risk-and-uncertainty.html
Douglas, E. J. (2012). Managerial Economics. San Diego: Bridgepoint Education, Inc.
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7.2 Key Differences Between Risk and Uncertainty

The difference between risk and uncertainty can be drawn clearly on the following grounds:
1. The risk is defined as the situation of winning or losing something worthy. Uncertainty is a
condition where there is no knowledge about the future events.
2. Risk can be measured and quantified, through theoretical models. Conversely, it is not
possible to measure uncertainty in quantitative terms, as the future events are
unpredictable.
3. The potential outcomes are known in risk, whereas in the case of uncertainty, the
outcomes are unknown.
4. Risk can be controlled if proper measures are taken to control it. On the other hand,
uncertainty is beyond the control of the person or enterprise, as the future is uncertain.
5. Minimization of risk can be done, by taking necessary precautions. As opposed to the
uncertainty that cannot be minimized.
6. In risk, probabilities are assigned to a set of circumstances which is not possible in case
of uncertainty.
7.3 Application of the Concept of Risk and Uncertainty

A generous university benefactor has agreed to donate a large amount of money for
student scholarships. The money can be provided in one lump sum of $12 million in Year 0 (the
current year), or in parts, in which $7 million can be provided at the end of Year 1, and another
$7 million can be provided at the end of Year 2.
In the chart below you will find both explanations for each scenario the university have as
for which payment option is best and what their gains or losses would be between one or the
other.
Year
Lump Sum Year One Explanation
two
12,000,000 7,000,000 7,000,000

With a rate of 8 %, the university should accept two
(2) $7M payments. Given the time value of money,
12,482,853.22
(482,853) they would be gaining $482,853 if they accept two
NPV of two $7M
Gain payments. This option should be chosen at an 8%
Installments @ 8%
interest rate.
With a rate of 12%, the university should accept one
lump sum payment. Given the time value of money,
11,830,357.14
(169,643) they will lose an approximate of $169,643 if they
NPV of two $7M
Loss forego a lump sum payment. The lump sum option
installments @ 12%
should be chosen at the 12% interest rate.
For this problem between the two alternatives, the first
alternative would be better suited for the students
since it will get them $480,000 scholarships
***NPV – Net Present Value, FV – Future Value
Deciding between two types of payment methods is a relation to how an actual business
would determine how to extend credit to their customers. Businesses need to evaluate what is
best for their initial investment and what is going to give them and their shareholders the better
return. For them to properly execute this process, they hire financial managers or account
managers to manage all accounts making sure that the business is not losing any money and that
all lines of credit are current. This process is important for any business owner since it is what
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allows them to offer credit lines and great partnerships with creditors, banks, and shareholders.
For accounting managers to calculate and manage each account they use present value
(NPV/FV) to get their calculation for the time value of money, also known as NPV. An example
of NPV is when businesses offer companies a service with the flexibility of paying for it a later
time.
7.4 Five Sources of Business Risk

• Market and opportunity risk. There is always less risk with a well-defined problem in a
large and growing market. All the people in China are a large and growing market, but all the
people with cancer is much more well-defined. It is hard to make money in a shrinking market,
or with a solution that is "nice to have" versus painfully needed.
• Competitive risk. Think seriously about the number and clout of your competitors. Having
none is a red flag (may mean no market) but having more than a couple of large ones may
mean this is a crowded space. Even in an open space, you need intellectual property, like
patents, to keep potential competitors from overrunning you.
• Financial risk. Very few businesses can be started without money. You as the founder will
be expected to put your own "skin in the game." The business plan should be realistic about
how much cash will be required to break-even, and how big the return will be for investors in
the first five-year timeframe.
• Market entry strategy risk. The selection of an inappropriate pricing, marketing, or

distribution strategy is a large potential risk. For example, many new social websites proclaim
that they will offer a free service and live on ad revenues (not likely in the first year without a
huge marketing investment).
• Political and economic risk. Sometimes founders are just in the wrong place at the wrong
time. Recessions are a tough time to sell luxury goods. Under-developed countries may have
a strong need for your product but are often unstable and dangerous. Four specifics include
tax rates, tariffs, expropriation of assets, and repatriation of profits.
7.5 Risk and Return

Risk is present anywhere and everyday. Driving a car or riding a motorcycle, crossing a
busy street, even eating your favorite meals, involves some form of risk. With investment
decisions, balancing risk and return can be very tricky. Investors want to maximize risk.
Unfortunately, for most investments, the higher the return, the higher is the risk associated with
it.
Some investments are certainly <riskier= than others, but no investment is risk-free.
Avoiding risk by not investing at all can be the riskiest move of all. For instance, try to keep your
money under pillow and you will not earn anything from it. You will definitely lose due to inflation
or worse, somebody might steal it from you. Trying to avoid risk is like standing at the curb, never
setting your foot into the street to get to the other side. You will never be able to get to your
destination if you do not accept some risk. Investing, just like crossing that street, you carefully
consider the situation, accept a comfortable level of risk and proceed to where you are going.
Risk can never be eliminated but it be managed.
In an investment decision, we can divide the required return into two parts, the risk-free
return and a risk premium.
Required Return = Risk-free Return + Risk Premium

The greater the risk, the greater must be the risk premium as a reward for accepting that risk.
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CHAPTER 810
CAPITAL BUDGETING
Learning Objectives: This section introduces the concepts of capital budgeting, principles of
capital budgeting on business decisions, and criteria for capital budgeting solutions. At the
end of the discussions, the readers will be able to solve budgeting problems and apply the
principles of capital budgeting on business decisions.
8.1 Definition of Capital Budgeting
- The process of identifying, evaluating, planning, and financing capital investment projects
of an organization.
- Involves capital investment projects which require large sum of outlay and involve a long
period of time longer than the usual cut-off of one year or normal operating cycle.
8.2 Characteristics of Capital Investment Decisions
● Capital investment decisions usually require relatively large commitments of resources.

● Most capital investment decisions involve long-term commitments.
● Capital investment decisions are more difficult to reverse than short-term decisions.
● Capital investment decisions influence the firm’s growth in the long run.
● They affect the risk of the firm.
● They are among the most difficult decisions to make.
8.3 Capital Budgeting Process
Identification of Investment Proposal
Estimation of Cost and Benefits
Evaluation of Proposed Projects
Development of the Capital Expenditure Budget
Implementing the Investment Proposal
1. Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There
could be various reasons for taking up investments in a business. It could be addition of a
10
https://www.thebalancesmb.com/types-of-capital-investment-projects-392918
https://www.economicsdiscussion.net/india/capital-market/capital-investment-projects-firm/24322
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new product line or expanding the existing one. It could be a proposal to either increase
the production or reduce the costs of outputs.
2. Project Screening and Evaluation:
This step mainly involves selecting all correct criteria to judge the desirability of a proposal.
This has to match the objective of the firm to maximize its market value. The tool of time
value of money comes handy in this step.
Also, the estimation of the benefits and the costs needs to be done. The total cash inflow
and outflow along with the uncertainties and risks associated with the proposal has to be
analyzed thoroughly and appropriate provisioning has to be done for the same.
3. Project Selection:
There is no such defined method for the selection of a proposal for investments as different
businesses have different requirements. That is why, the approval of an investment
proposal is done based on the selection criteria and screening process which is defined
for every firm keeping in mind the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring
funds have to be explored by the finance team. This is called preparing the capital budget.
The average cost of funds has to be reduced. A detailed procedure for periodical reports
and tracking the project for the lifetime needs to be streamlined in the initial phase itself.
The final approvals are based on profitability, Economic constituents, viability and market
conditions.
4. Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the requisite time period and
reduction of cost are allotted. The management then takes up the task of monitoring and
containing the implementation of the proposals.
5. Performance review:
The final stage of capital budgeting involves comparison of actual results with the standard
ones. The unfavorable results are identified and removing the various difficulties of the
projects helps for future selection and execution of the proposals.
The firm’s capital budgeting may be affected by structure of capital, management

decisions, accounting methods, taxation policy, lending terms of financial institutions, working
capital, capital return, need of the project, government policy, earning or income, and economic
value of the project. These factors are crucial to assess decisions of capital budgeting. The goal
of capital budgeting is for the firm to realize profit maximization through examining revenues
(increasing) and costs (reduced). The increase in revenues can be achieved by expansion of
operations by adding a new product line. Reducing costs means representing obsolete return on
assets. Thus, a project may be decided as Accept/Reject, Mutually exclusive project decision,
and capital rationing decision.
1. Accept / Reject decision 3 If a proposal is accepted, the firm invests in it and if rejected
the firm does not invest. Generally, proposals that yield a rate of return greater than a
certain required rate of return or cost of capital are accepted and the others are
rejected. All independent projects are accepted. Independent projects are projects that
do not compete with one another in such a way that acceptance gives a fair possibility
of acceptance of another.
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2. Mutually exclusive project decision 3 Mutually exclusive projects compete with other
projects in such a way that the acceptance of one will exclude the acceptance of the
other projects. Only one may be chosen. Mutually exclusive investment decisions gain
importance when more than one proposal is acceptable under the accept / reject
decision. The acceptance of the best alternative eliminates the other alternatives.
3. Capital rationing decision 3 In a situation where the firm has unlimited funds, capital
budgeting becomes a very simple process. In that, independent investment proposals
yielding a return greater than some predetermined level are accepted. But actual
business has a different picture. They have fixed capital budget with large number of
investment proposals competing for it. Capital rationing refers to the situation where
the firm has more acceptable investments requiring a greater amount of finance than
that is available with the firm. Ranking of the investment project is employed on the
basis of some predetermined criterion such as the rate of return. The project with
highest return is ranked first and the acceptable projects are ranked thereafter.
8.4 Types of Capital Investment Projects
Capital investment in most profitable projects will help the firm to grow continuously. The
following are the various types of capital investment projects that provide value to the firm and
economy at large.
1. New Market
A new capital investment project is important for the growth and expansion of a company.
It is also important for the economy at large as it often leads to research and development.
This type of project is one that is either for expansion into a new product line or a new
product market, often called the target market.
A new product or a new target market could, conceivably, change the nature of the
business. It should be approved by higher-ups in the business organization. A new project,
either a new product or a new target market, requires a detailed financial analysis and the
approval of possibly even the firm's Board of Directors.
2. Expansion
The expansion of existing products or target markets means an expansion of the business.
If a company undertakes this kind of capital budgeting product, they are effectively
acknowledging a surge in growth of demand.
A detailed financial analysis is required, but not as detailed as that required for the
expansion of the company into new products or new target markets.
3. Replacement Project to Continue Normal Operations

An example of a replacement project necessary to continue usual operations would be
funding the replacement of a worn-out piece of equipment with a new piece designed to
do the same job in a manufacturing plant.
It is a simple capital budgeting project to evaluate. It would be possible to use one of these
simpler capital budgeting methods to evaluate this project and abide by the decision of
the capital budgeting method.
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The cash flows from a replacement project necessary to continue operations, as usual,
are fairly easy to estimate, at least compared to other types of projects, because the
business owner is replacing the same type of equipment and is, therefore, somewhat
familiar with it.
4. Replacement Project to Reduce Business Cost

During the Great Recession, many companies have been looking at this type of capital
project. Sometimes, businesses need to replace some projects with others to reduce
costs. An example would be replacing a piece of obsolete equipment with a more modern
piece of equipment that is easier to have serviced.
This type of capital budgeting project would require a detailed financial analysis with cash
flows estimated from each piece of equipment to determine which generates the most in
cash flows and, thus, saves money. These are the four basic types of capital budgeting
projects, although there are offshoots of each one.
Capital investment projects consider the following factors:
1. The Net Investment (net cost) of Investment

- It is the difference between the initial cost or initial cash outflows and the initial savings or
initial cash inflows.
Illustration 1 – Net Cost of Investment
The management of AAA Company is planning to replace an old slimming machine which
was acquired 5 years ago as a cost of 30,000. The old machine has been depreciated to its
salvage value of 4,000. The company has found a buyer who is willing to purchase the old
slimming machine for its salvage value.
The new machine will cost 50,000, incidental costs of installation, freight and insurance
will have to be incurred at a total cost of 10,000.
REQUIRED: Determine the net cost of investment in the new machine for decision making
purposes.
SOLUTION:
Initial Cost or Initial Cash Outflows:
Purchase Price 50,000
Incidental Cost 10,000 60,000
Initial Savings or Cash Inflows:
Proceeds from sale of
old machine (4,000)
NET INVESTMENT P56,000
2. Net Returns
(Net Benefits or Net Savings or Annual After-tax Cash Flows)

- Two concepts of return or income may be considered for purposes of evaluating
investment projects. These returns are:
● Accounting net income; and
● Net cash inflows expected form the proposed project.
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Accounting Net Income

Net Sales xxx
Less: Cost of Sales xxx
Gross Profit xxx
Less: Operating Expenses xxx
Operating Income xxx
Less: Income Tax xxx
Annual Income after Tax xxx
Net Cash Inflow

Net Income (income after tax) xxx
Add: Non-cash expenses xxx
Less: Non-cash Income xxx
Annual After-tax net cash flow xxx
Illustration 2 – Net Returns
AAA Company is contemplating to add a new product to its current operations. The new
product will require a machine which will cost 100,000 and will have a new useful life of 20 years
with no residual value. The following estimates related to the new product are made available:
Net Sales 100,000
Operating Expenses 20,000
(Inclusive of 5,000 depreciation)
Gross Profit Rate 40%
Income Tax Rate 30%
REQUIRED: Determine the amount of the following:
a. Accounting Income
Net Sales 100,000
Less: Cost of Sales (60,000)
Gross Profit 40,000
Less: Operating Expenses (20,000)
Operating Income 20,000
Less: Income Tax (30%) (6,000)
Annual Income after Tax 14,000
b. Net Cash Inflow

Net Income (income after tax) 14,000
Add: Non-cash expenses 5,000
After-tax net cash flow 19,000
3. Terminal Cash Flow

- Terminal value or end-of-life recovery value refers to the net cash proceeds expected to
be realized at the end of the project’s economic life.
8.5 Capital Budgeting Techniques
There are different methods adopted for capital budgeting. The traditional methods or non-
discount methods include: Payback period and Accounting rate of return method. The discounted
cash flow method includes the NPV method, profitability index method and IRR.
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8.5.1. Present Value and Net Present Value Method
This is one of the widely used methods for evaluating capital investment proposals. In this
technique the cash inflow that is expected at different periods of time is discounted at a particular
rate. The present values of the cash inflow are compared to the original investment. If the
difference between them is positive (+) then it is accepted or otherwise rejected. This method
considers the time value of money and is consistent with the objective of maximizing profits for
the owners.
The Present Value - The present value concept explains the current worth of a future sum
of money or stream of cash flows given a specified rate of return. It describes a process of
determining what a cash flow to be received in the future is worth in today’s dollars. Precisely,
the present value of future cash flows is a representation of the amount of money today which, if
invested at a particular interest rate, will grow to the amount of the future cash flow at that time in
the future. We call the process of finding present values, Discounting and the interest rate used
to calculate present values, the Discount rate. When we go forward from present values (PVs) to
future values (FVs), compounding.
EXAMPLE: James has $100 in a bank account that pays a guaranteed 5% interest rate each
year. How much would James have at the end of Year 3?
We can use two approaches to solve the above problem: (1) the step-by-approach; (2) the formula
approach.
1. STEP-BY-APPROACH
FV1 = PV + INT
= PV + PV(I)
= PV (1+I)
Where: FV = Future value; PV = Present value or beginning amount; I = Interest rate earned per
year. (Sometimes a lower case i is used).
Thus, James earns $100 (0.05) = $5 of interest during the first year, so the amount at the end of
Year 1 (or at t=1) is: $100 (1+0.05) = $100 (1.05) = $105
For Year 2, we begin with $105. James earns 0.05 ($105) = $5.25, thereby ending the
year with $110.25. For Year 3, we begin with $110.25. James earns 0.05 ($110.25) = $5.51,
thereby ending the year with a final balance of $115.76. Note that the interest during Year 2 of
$5.25 is higher than the first year’s interest of $5, because James earned $5(0.05) = $0.25
interest on the first year’s interest and the interest during Year 2 of $5.51 is higher than the second
year of $5.25. This is called <compounding,= and interest earned on interest is called
<compounding interest.=
2. FORMULA APPROACH
FVN = PV (1+I)N
Where: N = Number of periods involved in the analysis.
Thus: FV3 = $100 (1.05)3 = $115.76.
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The Net Present Value (NPV) 3 The net present value is defined as the present value of
a project’s cash flows minus the present value of its costs. It includes all cash flows including
initial cash flows such as the cost of purchasing an asset. The net cash flow tells us how much
the project contributes to shareholder wealth. Thus, the larger the NPV, the more value the project
adds and thus the higher the stock’s price.
EXAMPLE: The initial cost of a project is $10,000 and the after-tax , end of year, project cash
flows are as follows: Year 1-$5,000; Year 2 - $4,000; Year 3 - $3,000; Year 4 - $1,000. The
projects are risky, with a risk-adjusted cost of capital or r = 10%
The equation for NPV is as follows:
NPV = CF0 + CF1/(1+r)1 + CF2/(1+r)2 + …+CFN/(1+r)3

N
= ∑ CFt
t=0 (1+r)t
NPVS = -$10,000 + $5000/(1.10)1 + $4000/(1.10)2 + $3000/(1.10)3 + $1,000/(1.10)4

= - $10,000 + $4,545.45 + $3,305.79 + $2,253.94 + $683.01
= $788.20.
In the above, CFt is the expected net cash flow at Time t, r is the project’s risk adjusted
cost of capital (or WACC), and N is its life. Generally, projects require an initial investment, like
developing the product, buying the equipment needed to make it, building a factory, and stocking
inventory. The initial investment, $10,000 is a negative cash flow. This means that the cost -
$10,000 is not discounted because it occurs at t=0. When we sum the PVs of the inflows and
subtract the cost, the result is $788.20, which is the NPV.
8.5.2. Payback Period Method
The payback period evaluates an investment project by focusing on the payback period.
The payback period is expressed in years.
FORMULA = Investment required / Net annual cash inflow
EXAMPLE: Company ABC needs a food processing machine. It is considering two machines -
Machine A and Machine B. Machine A costs $15,000 and will reduce operating cost by
$5,000 per year. Machine B costs only $12,000 but will also reduce costs by $5,000 per
year.
To calculate the payback period and which machine should be purchased according to
the payback method, we solve:
Machine A’s payback period = $15,000/$5000 = 3.0 years.

Machine B’s payback period = $12,000/$5,000 = 2.4 years.
From the above, company ABC should purchase Machine B, since it has a shorter
payback period than Machine A.
EVALUATION
1. The payback period provides an indication of a project’s risk and liquidity.

2. It is easy to calculate and understand.
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3. The payback period method is not a true measure of the profitability of an investment. All
that it tells us is how many years will be required to recover the original investment.
4. A shorter payback period does not necessarily mean that one investment is more
desirable than another.
5. Ignores the Time Value of Money.
6. Ignores cash flows occurring after the payback period.
8.5.3. Discounted Payback Period Method
This method refers to the length of time required to recover the initial cash outflow from
the discounted cash inflows. This is the approach where the present values of cash inflows are
cumulated until they equal the initial investment.
EQUATION:
NPVS = CF1/(1+r)1 + CF2/(1+r)2 + ….+ CFN/(1+r)N
EXAMPLE: Assume a machine purchased by Company ABC for $5,000 yields cash flows
$5,000, $4,000, and $4,000 in years 1, 2 and 3 respectively. The cost of capital is 10%.
Year 1 = $5,000/1.10^1 = $4,545

Year 2 = $4,000/1.10^2 = $3,306
Year 3 = $4,000/1.10^3 = $3,305
For the above project, the payback period (without discounting the future cash flows) is exactly 1
year. However, the discounted payback period is a little over 1 year. This is so because the first-
year discounted cash of $4,545 is not enough to cover the initial investment of $5,000. Thus, the
discounted payback period is 1.14 years: (1 year + ($5,000 - $4,545)/$3,305 = 1 year + .14.
8.5.4. Profitability Index
Profitability index measures the ratio between cash flow to investment. This means that
the higher the ratio the more cash flow to investment. We find the profitability index by dividing
the project’s present value of future cash flows by its initial cost:
FORMULA: Profitability of all future cash flows

Initial Cash Invest
EXAMPLE: There are two properties in New York City, property A and property B. Property A
requires a cash investment of $150,000. James estimates the PV of all its future cash
flows at $160,000. Calculate the profitability index.
$160,000
$150,000
= 1.070
Property B requires a cash investment of $90,000 and James estimates the PV of all its
future cash flows at $99,000.
Calculate the profitability index.
$99,000
$90,000
= 1.10
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Which is the better deal?
Property B is more profitable than property A. A profitability index of 1.0 means that you
have exactly achieved your desired return (i.e. the price you need to pay for the property based
upon its future cash flows discounted at your rate of return is exactly right). An index greater than
1.0 indicates that the investor has exceeded his/her goal. An index less than 1.0 means that the
investor has failed to achieve his/her goal. Thus, an index of 1.0 or better is required for an
investor to meet his/her goal.
8.5.5. Internal Rate of Return (IRR) Method
The internal rate of return method is the discount rate that equates the present value of
the expected future cash inflows and outflows. It measures the rate of return on a project while
assuming that all cash flows can be reinvested at the IRR rate.
FORMULA:
CF0 + CF1/(1+IRR)1 + CF2/(1+1RR)2 + …+CFN/(1+1RR)2 = 0
= N
∑ CFt
t=0 (1+IRR) =0
8.6 Importance and Significance of Capital Budgeting
Capital budgeting is important in:
1) Long term investments involving risks: Capital expenditures are long term
investments which involve more financial risks. That is why proper planning through
capital budgeting is needed.
2) Huge investments and irreversible ones: As the investments are huge but the funds
are limited, proper planning through capital expenditure is a pre-requisite. Also, the
capital investment decisions are irreversible in nature, i.e. once a permanent asset is
purchased its disposal shall incur losses.
3) Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.
In addition, the following are the significance of capital budgeting:
1) Capital budgeting is an essential tool in financial management.

2) Capital budgeting provides a wide scope for financial managers to evaluate different
projects in terms of their viability to be taken up for investments,
3) It helps in exposing the risk and uncertainty of different projects.
4) It helps in keeping a check on over or under investments.
5) The management is provided with an effective control on cost of capital expenditure
projects.
6) Ultimately the fate of a business is decided on how optimally the available resources
are used.
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ASSESSMENT 7
1. Listed below are the costs and benefits of a project for 5 years with a discount rate of 4
percent. All figures are in million pesos.
Year Benefits Cost Net Benefit (B-

C)
0 P 0 P 10000 P -10000
1 2500 500 2000
2 2500 500 2000
3 2500 500 2000
4 3000 500 2500
5 3000 500 2500
Discuss if the project should be accepted or rejected using the NPV.
2. CASE STUDY
Peñamante Co. is considering establishing a corporate fitness programme for its

employees. The firm currently employs 500 workers, mainly managerial and administrative, in a
number of offices in one local area. The type of programme being considered involves subsidizing
employees by paying 50 per cent of any membership fees to a specific fitness centre. This subsidy
represents the cost of operating the programme, while the main benefits expected are in terms of
increased productivity, reduced sickness and absenteeism, and reduced staff turnover costs. The
average salary paid to employees is P240,000 per year, and employees work a forty-hour week
for fifty weeks in the year.
The firm has researched the extent of these costs and benefits and discovered the following
information:
1. 10 per cent of employees can be expected to participate in the programme.

2. The membership fees are 1200 per individual on a group scheme.
3. Workers who do not participate in any fitness programme suffer a drop in productivity of
50 per cent in their last two hours of work each day.
4. The normal sickness/absenteeism rate of eight days lost per year is reduced by 50 per
cent for those workers on a fitness programme.
5. Staff turnover should be reduced from 20 per cent a year to 10 per cent.
6. Each new employee involves a total of twelve hours of hiring time.
7. Each new employee takes five days to train, and training is carried out in teams of five
new employees at a time.
8. Each new employee has a productivity that is 25 per cent lower than average for their first
six weeks at work.
Questions:
1. Estimate the costs of operating the programme described above.

2. Estimate the benefits in terms of increased productivity.
3. Estimate the benefits from reduced sickness and absenteeism.
4. Estimate the benefits from reduced staff turnover.
5. What conclusion can you come to regarding the operation of the programme?
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IM ECON-351 Managerial- Economics BSA BSMA

Managerial Economics (Polytechnic University of the Philippines)

Studocu is not sponsored or endorsed by any college or university

Polytechnic University of the Philippines

INSTRUCTIONAL MATERIAL FOR

Melcah Pascua Monsura

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Chapter 1 THE NATURE, SCOPE, AND PRACTICE

Chapter 2 ECONOMIC DECISION MAKING

Chapter 3 DEMAND ANALYSIS: Estimation and Forecasting

Chapter 4 FORECASTING DEMAND

Chapter 5 THE THEORY OF PRODUCTION AND COST

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5.3 Production Periods…………………………………………………..……………..………56

Chapter 6 OPTIMAL OUTPUT DECISIONS AND PRICING STRATEGIES

Chapter 7 ECONOMIC RISK AND UNCERTAINTY

Chapter 8 Capital Budgeting

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THE NATURE, SCOPE AND PRACTICE OF MANAGERIAL ECONOMICS

1.1 Definition of Managerial Economics and its Nature

Managerial economics is a branch of economics that applies microeconomic concepts,

Specifically, managerial economics deals with microeconomic reasoning on real-world

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1.2 Why Managerial Economics Is Relevant for Managers

1.3 Managerial Economics Is Applicable to Different Types of Organizations

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1.4 Social Responsibility of Business

In modern capitalist economies, business firms contribute significantly to economic

1.5 Social Responsibility of Business and Social Contract2

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4. Obligation towards the Environment:

5. Responsibility to Society in General:

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1. Discuss and integrate microeconomics and macroeconomics in making managerial decisions

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ECONOMIC DECISION MAKING

The Basic Steps in Decision

The process of decision making

Step 1. Define the Problem

Step 2. Determine the Objective

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Step 3. Explore the Alternatives

Step 4. Predict the Consequences

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Key distinction can be drawn between deterministic and probabilistic models. A

Step 5. Make a Choice

Step 6: Perform Sensitivity Analysis

In tackling and solving a decision problem, it is important to understand and be able to

2.1 Public Decisions: Economic View

In government decisions, the question of objectives is much broader than simply an

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Much of economic analysis is built on a description of ultrarational self-interested

2.2 Decision within Firms: Profit-Maximization

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A third issue centers on the social responsibility of business. In modern capitalist

The objective of value maximization implies that management’s primary responsibility is

2.3 Optimal Decision using Marginal Analysis