Managerial Economics

Lecture 2: Oct 15, 2023

Muhammad Shuaib Malik

Pareto Improvements
Nazi
r O’
If we start at point A:
• C is a Pareto improvement
A
S3 that makes Mani better off
C
Food
S4
S5 E • D is a Pareto improvement
M3 that makes Nazi better off
D M2
M1 • E is a Pareto improvement
that makes both better off
O s
Mani Clothes
2
Pareto Efficiency
Pareto Efficiency has three requirements
1) Exchange Efficiency
 Goods cannot be traded to make a consumer better off
2) Input Efficiency
 Inputs cannot be rearranged to produce more goods
3) Substitution Efficiency
 Substituting one good for another will not make one consumer
better off without harming another consumer
3
 Contract Curve
Contract curve is the set of all Pareto-optimal allocations.

OB

OA
4
Equilibrium Condition

MU x
MRS xy 
MU y

𝐴
𝑀𝑅𝑆 𝑥𝑦 =¿

5
1) Example: HE and SHE

HE and SHE have the following utilities for books and coffee:
𝑈 𝐻𝐸
=√ 𝐵 𝐻
𝐶 𝐻
,𝑈 𝑆𝐻𝐸
=√ 𝐵 𝐶
𝐶 𝐶

The Exchange Efficiency Condition therefore becomes:

𝐻𝐸 𝑆𝐻𝐸
𝑀𝑅𝑆 =𝑀𝑅𝑆 𝐵𝐶 𝐵𝐶 6
1) MATH – HE and SHE
If there are 10 books, and 4 cups of coffee, then the contract curve is
𝐻𝐸 𝑆𝐻𝐸
expressed as:
𝑀𝑅𝑆 =𝑀𝑅𝑆 ,
𝐵𝐶 𝐵𝐶
If HE has 6 books, an exchange efficient allocation would be:
C / 6  (4  C ) /(10  6)
H H

4C  6(4  C )
H H

10C  24
H

C  2 .4
H
7
1) MATH – HE and SHE

Therefore,
HE would have 6 books and 2.4 cups of coffee, and
SHE would have 4 = (10-6) books and 1.6 = (4-2.4) cups of coffee, for
utilities of:

𝑈 =√ 𝐵 𝐶 =√6(2.4)=3.79
𝐻𝐸 𝐻 𝐻
8
Economic vs. Accounting Profits

Accounting Profits

• Total revenue (sales) minus cost of producing goods or services.

• Reported on the firm’s income statement.

Economic Profits

• Total revenue minus total opportunity cost.

9
Opportunity Cost
Accounting Costs
• The explicit costs of the resources needed to produce goods or services.
• Reported on the firm’s income statement.
Opportunity Cost
• The cost of the explicit and implicit resources foregone when a decision
is made.
Economic Profits
• Total revenue minus total opportunity cost.
10
Profits as a Signal

Profits signal to resource holders where

• Resources are most highly valued by society.

• Resources will flow into industries that are most highly valued by
society.

11
Marginal (Incremental) Analysis

Control Variable Examples:

• Output
• Price
• Product Quality
• Advertising
• R&D
Basic Managerial Question:
How much of the control variable should be used to maximize net benefits?
Net Benefits

Net Benefits = Total Benefits - Total Costs

Profits = Revenue - Costs

13
Marginal Benefit (MB)

Change in total benefits arising from a change in the control variable, Q:

B
MB 
Q

Slope (calculus derivative) of the total benefit curve.

Marginal Cost (MC)

Change in total costs arising from a change in the control variable, Q:

C
MC 
Q

Slope (calculus derivative) of the total cost curve

The Geometry of Optimization: Total Benefit and Cost
Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q 16
The Geometry of Optimization: Net Benefits

Net Benefits

Maximum net benefits

Slope = MNB

Q* Q 17
Marginal Principle

To maximize net benefits, the managerial control variable should

be increased up to the point where MB = MC.

MB > MC means the last unit of the control variable increased

benefits more than it increased costs.

MB < MC means the last unit of the control variable increased

costs more than it increased benefits.
18
Market

I. Market Demand Curve

• The Demand Function
III. Market Equilibrium
• Determinants of Demand

• Consumer Surplus IV. Price Restrictions

II. Market Supply Curve V. Comparative Statics

• The Supply Function

• Supply Shifters

• Producer Surplus
Consumer Decision Making

Every day we make numerous decisions concerning every aspect of our daily
lives

Particularly in our society, we are rarely put in a position where we have no

choices

20
Rational decision-making

In economic theory, consumers are portrayed as making Rational Decisions

Consumers attempt to Maximize Utility continuously within the constraints of limited resources

Consumers must

• Be aware of all available product alternatives

• Be capable of correctly ranking each in terms of benefits and costs

• Be able to identify the one best alternative

21
Reality in decision-making

Consumers are limited in their skills

Consumers are limited by their existing values and goals

Consumers are limited in the extent of their knowledge

Doesn’t take into account the impacts of advertising and marketing

22
Consumer Buying Behavior

Consumer Buying Behavior refers to the buying

behavior of final consumers (individuals & households)
who buy goods and services for personal consumption.
Study consumer behavior to answer:
“How do consumers respond to marketing efforts the
company might use?”

23
Model of Consumer Behavior
Marketing
Marketingand
and
Other Stimuli
Other Stimuli
Economic
Product Technological
Price Political
Place Cultural
Promotion

Buyer’s
Decision Buyer’s
Buyer’s Black
Black Box
Box Characteristics Affecting
Process Consumer Behavior

Purchase Timing
Product Choice
Brand Choice Buyer’s
Buyer’s Response
Response Purchase Amount
Dealer Choice
24
Consumer Surplus

Willingness To Pay: the maximum amount that a buyer

will pay for a good.
It measures how much the buyer values the good or
service.
Consumer Surplus: a buyer’s willingness to pay minus
the amount the buyer actually pays.

25
Willingness to Pay

• Maximum price at which he or she would buy a good

• Individuals won’t buy the good if it costs more than this

among but eager to do so if it cost less

• If the price is just equal to an individual’s willingness to pay,

he or she is indifferent between buying and not buying

26
The Demand Curve for Used Textbooks
Price of book

$59 A Potential Willingness

buyers to pay
A $59
45 B B 45
C 35
35 C D 25
E 10
25 D

10 E

D
0 1 2 3 4 5 Quantity of books

A consumer’s willingness to pay for a good is the maximum price at which he or she would
buy that good.
Willingness to Pay

• Not a smooth curve because it is only

dealing with a small number of

consumers

• Each horizontal segment = how much

one is willing to pay

• What is the quantity demanded at $59?

• What is the quantity demanded at $45?

28
Consumer Surplus in the Used Textbook Market
Price of book
A’s consumer surplus:
$59-$30=$29 The total consumer surplus is given
$59 A
by the entire shaded area - the sum
B’s consumer surplus:
$45-$30=$15 of the individual consumer surpluses
45 B
C’s consumer surplus: of A, B, and C
$35-$30=$5
35 C equal to $29 + $15 + $5 = $49.
30 Price = $30
25 D

10 E

D
0 1 2 3 4 5 Quantity of books
Consumer Surplus
Total consumer surplus generated by
purchases of a good at a given price is
equal to the area below the

demand curve but above that price

30
Thank You

31