Chapter 1.

Fundamentals of Managerial Economics

The Manager: A person who directs resources to achieve a stated goal.

Economics: The science of making decisions in the presence of scarce resources.

Managerial Economics Defined: The study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal.

7 Principles of Effective Managerial Decision Making

1. Identify goals and constraints

• Goals must be well-defined

• Firm’s overall goal is to maximize profits

• Constraints make it difficult to achieve goals

2. Recognize the nature and importance of profits

• Accounting profit: Total amount of money taken in from sales (total revenue)
minus the dollar cost of producing goods or services.

• Economic profit: The difference between total revenue and total opportunity
cost.

• The role of profits: Profits are a signal to resource holders where resources
are most highly valued by society.

3. Understand incentives

• Changes in profits provide an incentive to resource holders to alter their use of

resources.
• Within a firm, incentives impact how resources are used and how hard workers
work.

4. Understand markets

• Two sides to every market transaction: buyer and seller

• Bargaining position of consumers and producers is limited by three rivalries in

economic transactions:

1. Consumer-producer rivalry: Consumers attempt to negotiate or locate

low prices, while producers attempt to negotiate high prices.

2. Consumer-consumer rivalry: Limited quantities of goods are available;

consumers will compete with one another for the right to purchase the
available goods.

3. Producer-producer rivalry: producers compete with one another for

the right to service the customers available.
 • Government and the market

5. Recognize the time value of money

Present value: The amount that would have to be invested today at the prevailing
interest rate to generate the given future value.

• Often a gap exists between the time when costs are borne, and when benefits
are received.

𝐹𝑉
𝑃𝑉 =
(1 + 𝑖 )𝑛
Net present value: The present value of the income stream generated by a project
minus the current cost of the project

6. Use marginal analysis

• Marginal benefit 𝑀𝐵(𝑄): The change in total benefits arising from a change in
the managerial control variable, 𝑄.
• Marginal cost 𝑀𝐶(𝑄): The change in the total costs arising from a change in
the managerial control variable, 𝑄.
• Marginal net benefits: 𝑀𝑁𝐵(𝑄)

𝑴𝑵𝑩(𝑸) = 𝑴𝑩(𝑸) − 𝑴𝑪(𝑸)

Marginal principle: To maximize net benefits, the manager should increase the
managerial control variable up to the point where marginal benefits equal marginal
costs. This level of the managerial control variable corresponds to the level at which
marginal net benefits are zero; nothing more can be gained by further changes in that
variable.

7. Make data driven decisions

• How does one obtain information on the demand function?

o Published studies

o Hire a consultant

o Econometric models

o Statistical technique called regression analysis using data on quantity, price,

income and other important variables.
Chapter 2. Market forces: demand and supply

Market demand curve: Illustrates the relationship between the total quantity and price per
unit of a good all consumers are willing and able to purchase, holding other variables
constant.

Change in quantity demanded: Changes in the price of a good lead to a change in the
quantity demanded of that good. This corresponds to a movement along a given demand
curve.

Change in demand: Changes in variables other than the price of a good, such as income or
the price of another good, lead to a change in demand. This corresponds to a shift of the
entire demand curve.

Law of demand

• The quantity of a good consumers is willing and able to purchase increases

(decreases) as the price falls (rises).
• Price and quantity demanded are inversely related.

Changing only price leads to changes in quantity demanded.

• This type of change is graphically represented by a movement along a given demand

curve, holding other factors that impact demand constant.

Changing factors other than price leads to changes in demand.

These types of changes are graphically represented by a shift of the entire demand curve

Demand shifters

1. Income

• Normal good: A good for which an increase (decrease) in income leads to an increase
(decrease) in the demand for that good.
• Inferior good: A good for which an increase (decrease) in income leads to a decrease
(increase) in the demand for that good.

2. Prices of related goods

• Substitute goods: Goods for which an increase (decrease) in the price of one good
leads to an increase (decrease) in the demand for the other good.
• Complement goods: Goods for which an increase (decrease) in the price of one good
leads to a decrease (increase) in the demand for the other good.

3. Advertising and consumer tastes

• Informative advertising

• Persuasive advertising

4. Population
 5. Consumer expectations

6. Other factors

Demand

The demand function: for good X is a mathematical representation describing how many
units will be purchased at different prices for X, the price of a related good Y, income and
other factors that affect the demand for good X.

𝑸𝑿 𝒅 = 𝜶𝟎 + 𝜶𝑿 𝑷𝑿 + 𝜶𝒀 𝑷𝒀 + 𝜶𝑴 𝑴
𝛼𝑋 < 0 by the law of demand;

𝛼𝑌 > 0 if good Y is a substitute for good X;

𝛼𝑀 < 0 if good X is an inferior good.

Linear demand function: A representation of the demand function in which the demand for a
given good is a linear function of prices, income lev els, and other vari ables influencing
demand.

Marketing strategies – like value pricing and price discrimination – rely on understanding
consumer value for products.

• Total consumer value is the sum of the maximum amount a consumer is willing to
pay at different quantities.
• Total expenditure is the per-unit market price times the number of units consumed.
• Consumer surplus is the extra value that consumers derive from a good but do not
pay extra for.

Supply

Market supply curve: A curve indicating the total quantity of a good that all producers in a
competitive market would produce at each price, holding input prices, technology, and other
variables affecting supply constant.

Law of supply: As the price of a good rises (falls), the quantity supplied of the good rises
(falls), holding other factors affecting supply constant.

Changing only price leads to changes in quantity supplied.

• This type of change is graphically represented by a movement along a given supply

curve, holding other factors that impact supply constant.

Changing factors other than price leads to changes in supply.

• These types of changes are graphically represented by a shift of the entire supply
curve.
Supply shifters

1. Input prices

2. Technology or government regulation

3. Number of firms

o Entry
o Exit

4. Substitutes in production

5. Taxes

o Excise tax: a tax on each unit of output sold, where tax revenue is
collected from the supplier
o Ad valorem tax: percentage tax

6. Producer expectations

The supply function: for good X is a mathematical representation describing how many units
will be produced at alternative prices for X, alternative input prices W, and alternative values
of other variables that affect the supply for good X.

𝑸𝑿 𝒔 = 𝜷𝟎 + 𝜷𝑿 𝑷𝑿 + 𝜷𝑾 𝑾 + 𝜷𝒓 𝑷𝒓 + 𝜷𝑯 𝑯
𝑄𝑋 𝑠 is the number of units of good X produced;

𝑃𝑋 is the price of good X;

𝑊 is the price of an input;

𝑃𝑟 is price of technologically related goods;

𝐻 is the value of any other variable affecting supply.

Linear supply function: A representation of the supply function in which the supply of a given
good is a linear function of prices and other variables affecting supply.

Producer surplus: the amount producers receive in excess of the amount necessary to
induce them to produce the good.

Competitive Market Equilibrium

• Determined by the intersection of the market demand and market supply curves.
• A price and quantity such that there is no shortage or surplus in the market.
• Forces that drive market demand and market supply are balanced, and there is no
pressure on prices or quantities to change.
 • The equilibrium price is the price that equates quantity demanded with quantity
supplied

In a competitive market equilibrium, price and quantity freely adjust to the forces of
demand and supply.

At times, government restricts how much prices are permitted to rise or fall.

• Price ceiling: the maximum legal price that can be charged in a market.
• Price floor: the minimum legal price that can be charged in a market.

Comparative static analysis: The study of the movement from one equilibrium to another.

Competitive markets, operating free of price restraints, will be analyzed when:

• Demand changes
• Supply changes
• Demand and supply simultaneously change

Increase in demand only

• Increase equilibrium price

• Increase equilibrium quantity

Decrease in demand only

• Decrease equilibrium price

• Decrease equilibrium quantity

Chapter 3. Quantitative demand analysis

Elasticity: A measure of the responsiveness of one variable to changes in another variable;

the percentage change in one variable that arises due to a given percentage change in another
variable.

Important aspects of the elasticity:

• Sign of the relationship:

o Positive
o Negative
• Absolute value of elasticity magnitude relative to unity:
o |𝑬𝑮,𝑺 | > 𝟏 𝑮 is highly responsive to changes in 𝑺.
o |𝑬𝑮,𝑺 | < 𝟏 𝑮 is slightly responsive to changes in 𝑺.

Own price elasticity of demand: A measure of the responsiveness of the quantity demanded
of a good to a change in the price of that good; the percentage change in quantity demanded
divided by the percentage change in the price of the good.
 %𝜟𝑸𝑿 𝒅
𝑬𝑸 𝒅
,𝑷𝑿
=
𝑿 %𝜟𝑷𝑿
• Sign: negative by law of demand.

• Magnitude of absolute value relative to unity:

o |𝑬𝑸 𝒅
,𝑷𝑿 | > 𝟏: Elastic.
𝑿

o |𝑬𝑸 𝒅
,𝑷𝑿 | < 𝟏: Inelastic.
𝑿

o |𝑬𝑸 𝒅
,𝑷𝑿 | = 𝟏: Unitary elastic.
𝑿

When demand is elastic: A price increase (decrease) leads to a decrease (increase) in total
revenue.

When demand is inelastic: A price increase (decrease) leads to an increase (decrease) in

total revenue.

When demand is unitary elastic: Total revenue is maximized.

Cross-price elasticity: A measure of the responsiveness of the demand for a good to

changes in the price of a related good; the percentage change in the quantity demanded of
one good divided by the percentage change in the price of a related good.

%𝜟𝑸𝑿 𝒅
𝑬𝑸 𝒅
,𝑷𝒀
=
𝑿 %𝜟𝑷𝒀
• If 𝑬𝑸 𝒅
,𝑷𝒀
> 𝟎, then 𝑿 and 𝒀 are substitutes.
𝑿
• If 𝑬𝑸 𝒅
,𝑷𝒀
< 𝟎, then 𝑿 and 𝒀 are complements.
𝑿

Income elasticity: A measure of the responsiveness of the demand for a good to changes in
consumer income; the percentage change in quantity demanded divided by the percentage
change in income.

%𝜟𝑸𝑿 𝒅
𝑬𝑸 𝒅
,𝑴
=
𝑿 %𝜟𝑴
• If 𝑬𝑸 𝒅
,𝑴
> 𝟎, then 𝑿 is a normal good.
𝑿
• If 𝑬𝑸 𝒅
,𝑴
< 𝟎, then 𝑿 is an inferior good.
𝑿

Chapter 4. The theory of individual behavior

Consumer opportunities: Set of possible goods and services consumers can afford to
consume.

Consumer preferences: Determine which set of possible goods and services will be
consumed.

• Property 1- Completeness: For any two bundles of goods either:

o 𝑨 ≻ 𝑩.
o 𝑩 ≻ 𝑨.
o 𝑨 ∼ 𝑩.
• Property 2- More is better
o If bundle 𝑨 has at least as much of every good as bundle 𝑩 and more of
some good, bundle 𝑨 is preferred to bundle 𝑩.
• Property 3- Diminishing marginal rate of substitution
o As a consumer obtains more of good X, the amount of good Y the
individual is willing to give up to obtain another unit of good X
decreases.
• Property 4- Transitivity: For any three bundles, 𝑨, 𝑩, and 𝑪, either:
o If 𝑨 ≻ 𝑩 and 𝑩 ≻ 𝑪, then 𝑨 ≻ 𝑪.
o If 𝑨 ∼ 𝑩 and 𝑩 ∼ 𝑪, then 𝑨 ∼ 𝑪.

Indifference curve: A curve that defines the combinations of two goods that give a consumer
the same level of satisfaction.

Marginal rate of substitution (MRS): The rate at which a consumer is willing to substitute one
good for another good and still maintain the same level of satisfaction.

Budget set: defines the combinations of goods X and Y that are affordable for the consumer.

𝑷𝑿 𝑿 + 𝑷𝒀 𝒀 ≤ 𝑴
Budget line: defines all combinations of goods X and Y that exactly exhauset the consumer’s
income.

𝑷𝑿 𝑿 + 𝑷𝒀 𝒀 = 𝑴
Consumer equilibrium: The equilibrium consumption bundle is the affordable bundle that
yields the greatest satisfaction to the consumer.

• Consumption bundle that is affordable and yields the greatest satisfaction to the
consumer.
• Consumption bundle where the rate a consumer choses (marginal rate of
substitution) to trade between goods X and Y equals the rate at which these goods are
traded in the market (market rate of substitution).
𝑷𝑿
𝑴𝑹𝑺 =
𝑷𝒀
• Price and income changes impact a consumer’s budget set and level of
satisfaction that can be achieved.

o This implies that price and income changes will lead to consumer equilibrium
changes.

• Price increases (decreases) reduce (expand) a consumer’s budget set.

• The new consumer equilibrium resulting from a price change depends on

consumer preferences:

o Goods X and Y are:

▪ Substitutes: when an increase (decrease) in the price of X leads to an

increase (decrease) in the consumption of Y.

▪ Complements: when an increase (decrease) in the price of X leads to

a decrease (increase) in the consumption of Y.

• Income increases (decreases) reduce (expand) a consumer’s budget set.

• The new consumer equilibrium resulting from an income change depends on

consumer preferences:

o Good X is:

▪ a normal good: when an increase (decrease) in income leads to an

increase (decrease) in the consumption of X.

▪ an inferior good: when an increase (decrease) in income leads to a

decrease (increase) in the consumption of X.

• Moving from one equilibrium to another when the price of one good changes can
be broken down into two effects:

o Substitution effect: The movement along a given indifference curve that

results from a change in the relative prices of goods, holding real income
constant.

o Income effect: The movement from one indifference curve to another that
results from the change in real income caused by a price change.