Presentation on theme: "Instructor Sandeep Basnyat"— Presentation transcript:
1 Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281 Managerial Economics Ace Institute of Management Executive MBA Program Remainings from Objectives of the FirmInstructorSandeep Basnyat
2 Profit MaximizationIf increase Q by one unit, revenue rises by MR, cost rises by MC.If MR > MC, then increase Q to raise profit.If MR < MC, then reduce Q to raise profit.What Q maximizes the firm’s profit?
3 Firms maximize profit by producing the Quantity until Profit MaximizationQTRTCProfitMRMCProfit = MR – MCAt any Q with MR > MC, increasing Q raises profit.$0453323159$5571–$5$10121086$4–224$611010220At any Q with MR < MC, reducing Q raises profit.1033010440(The table on this slide is similar to Table 2 in the textbook.)For most students, seeing the complete table all at once is too much information. So, the table is animated as follows:Initially, the only columns displayed are the ones students saw at the end of the exercise in Active Learning 1: Q, TR, and MR.Then, TC appears, followed by MC. It might be useful to remind students of the relationship between MC and TC.Then, the Profit column appears. Students should be able to see that, at each value of Q, profit equals TR minus TC.The last column to appear is the change in profit.When the table is complete, we use it to showit is profitable to increase production whenever MR > MC, such as at Q = 0 , 1, or 2.it is profitable to reduce production whenever MC > MR, such as at Q = 5.10550Firms maximize profit by producing the Quantity untilMR = MC
4 Exercise Calculate the profit maximizing output (Q); and Assume a cost function: TC = Q Q2 and a constant marginal revenue $10 per unit for a firm.Calculate the profit maximizing output (Q); andTotal profit if the selling price per unit (P) = MR.Solution:a) MC = dTC /dQ = QProfit maximizing output is at whereMR = MC10 = QTherefore, Profit Maximizing Quantity (Q) = 400 units.b) Profit = TR –TC = [(PxQ) – TC]= [(10x400) – ( (400) (4002)] = $600
5 ExerciseAssume the following functions for a firm Demand : Q = 90 – 2P Total Revenue: TC = Q3 - 8Q2 + 57Q + 2 Find the followings for this firm.Profit maximizing QuantityPrice per unitTotal ProfitQ = 4P = 43π = 6
6 Sales Revenue or Revenue Maximization QPTRARMRSales Revenue Maximization ConditionMR = 0$4.5091074$ 0n.a.14.001.502.002.503.003.50$4.00–1123$423.5033.0042.50When the AR column appears, note that AR = P at every quantity. This, of course, is a tautology.When the MR column appears, note that MR is less than P. This is not as easy to see, because the MR numbers are offset from the rows of the table, just as if you were in an elevator stuck between two floors. But students can still see that MR < P.For example, in the range of output of Q=2 to Q=3, the price ranges from $3.50 to $3.00, but MR is only $2.52.0061.50
7 ExerciseAssume the following functions for a firm Demand : P = 7,500 – 3.75Q Total Cost: TC = 1,012, ,500Q Q2 Find the followings for this firm.Revenue maximizing QuantityPrice per unitTotal RevenueTotal Profit / LossQ = 1000 units.P = 3,750TR = 3,750,000π = - 12,500
8 Exercise Profit Revenue 90 100 i) Maximizing Quantity 2200 2000 Assume the following functions for a firmDemand : P = 4,000 – 20QTotal Cost: TC = QFind the followings for this firm underProfit maximization objectiveRevenue Maximization objective.Profit Revenue1,60,000 1,58,000i) Maximizing Quantityii) Price per unitiii) Total Profit / Loss
9 Numerical Exercise Assume the following functions for a firm: Demand : P = 20 – QTotal Cost: TC = Q2 + 8Q + 2a) Find Price (P), Quantity (Q) and Total Profit (or Loss) for each of the following conditions:Profit maximizationRevenue Maximizationb) Find Price (P), Quantity (Q), Total Revenue (TR) and Total cost (TC) for sales maximization with profit constraint or profit constraint of 8 or higher.P = 17, Q = 3, π = 16P = 10, Q = 10, π = 82 (loss)When Q = 1; P = 19, TR = 19, TC = 11When Q = 5; P = 15, TR = 75, TC = 67Firm should produce Q = 5.
10 Average Total Cost or Average Cost Minimization Related to two important costs: MC and ATCRecall:ATC = AFC + AVC or TC / QMC =∆TC∆Q
11 Marginal Cost ∆TC MC = ∆Q Marginal Cost (MC) is the change in total cost from producing one more unit:$100$701170∆TC∆QMC =50222040326050431070538010064801407620
12 Average Total Cost Curves $0$25$50$75$100$125$150$175$2001234567QCostsQTCATC$100n.a.1170$1702220110326086.67431077.50538076648080762088.57
13 Important Economic Relation: ATC and MC When MC < ATC,ATC is falling.When MC > ATC,ATC is rising.The MC curve crosses the ATC curve at the ATC curve’s minimum.$0$25$50$75$100$125$150$175$2001234567QCostsATCMCThe textbook gives a nice analogy to help students understand this. A student’s GPA is like ATC. The grade she earns in her next course is like MC. If her next grade (MC) is less than her GPA (ATC), then her GPA will fall. If her next grade (MC) is greater than her GPA (ATC), then her GPA will rise.I suggest letting students read the GPA example in the book, and giving them the following example in class:You run a pizza joint. You’re producing 100 pizzas per night, and your cost per pizza (ATC) is $3. The cost of producing one more pizza (MC) is $2. If you produce this pizza, what happens to ATC? Most students will understand immediately that ATC falls (albeit by a small amount). Instead, suppose the cost of producing one more pizza (MC) is $4. Then, producing this additional pizza causes ATC to rise.ATC is minimum where,ATC = MCAVC is minimum where,AVC = MC
14 Exercise Given the cost function: TC = 1000 + 10Q - 0.9Q2 + 0.04Q3 Find Q when AVC is minimum.SolutionWhen AVC is minimum:AVC = MCQ Q2 = Q+ 0.12Q2Or, Q Q = 0Or, Q(- 0.08Q+ 0.9) = 0Or, Q =0 and Q+ 0.9 = 0 i.e, Q = (Minimum AVC)
15 ExerciseAssume the following functions for a firm Demand : P = 7,500 – 3.75Q Total Cost: TC = 1,012, ,500Q Q2 Find the followings for this firm if your objective is to minimize average cost.a) Qb) Price per unitc) Total Revenued) Total ProfitQ = 900P = 4,125TR = 3,712,500π = 337,500
16 Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281 Managerial Economics Ace Institute of Management Executive MBA Program Session 2: Supply, Demand and ElasticityInstructorSandeep Basnyat
17 Demand Demand comes from the behavior of buyers. Demand comes from the behavior of buyers.The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal.
18 The Market Demand Curve for Orange PQd (Market)$0.00241.00212.00183.00154.00125.0096.006PQ
19 Demand Curve Shifters: Non-price Determinants of Demand PriceNumber of buyersIncome levelEffect on normal goodsEffect on inferior goodPrices of other goodsSubstitute goodsComplement goodsTaste or PreferenceExpectationQtyPriceQty
20 Q = 10,000 – 200 P + 0.03POp + 0.6I + 0.2 A Numerical exercise The ABC Marketing consulting firm found that a particular brand of portable stereo has the following demand curve for a certain region:Q = 10,000 – 200 P POp + 0.6I AWhere,Q = quantity per monthP = Price in $Pop = PopulationI = Disposable incomeA = Advertising expenditure in $Determine the demand curve for the company in a market in which P = 300, Pop = 1,000,000, I = 30,000, and A = 15000b) Calculate the quantity demanded at prices of $200c) Calculate the price necessary to sell 45,000 units.(Ans.: Q = 61,000 – 200P)(Ans.: 21000)(Ans.: $80)
21 Supply Supply comes from the behavior of sellers. Supply comes from the behavior of sellers.The quantity supplied of any good is the amount that sellers are willing and able to sell.Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal
22 Market Supply Schedule & Curve Market Supply Schedule & CurvePrice of lattesQuantity of lattes supplied$0.001.0032.0063.0094.00125.00156.0018PQ
23 Shift supply curve left or right Supply Curve ShiftersShift supply curve left or rightNumber of sellersInput pricesTechnologyExpectationAgain, the animation here is carefully designed to help make clear that a shift in the supply curve means that there is a change in the quantity supplied at each possible price. If it seems tedious, you can turn it off. In any case, be assured that, by the end of this chapter, the animation of curve shifts will be streamlined and simplified.
24 Supply and Demand Together Supply and Demand TogetherPQEquilibrium Price and QuantitySDWe now return to the latte example to illustrate the concepts of equilibrium, shortage and surplus.
25 Numerical Problem on Demand and Supply 1) Suppose:Demand eqn. for a product: Qd = 286 − 20pSupply eqn. For a product: Qs = pFind Equilibrium Quantity and Price:Solution:Qd = Qs286 − 20p = p60p = 198P = $3.30Q = 286 – 20(3.3) = 220
26 Comparative Static Analysis Sensitivity analysis or “what-if” analysis.The role of factors influencing demand is analyzed while holding supply conditions constant.Or, the role of factors influencing supply is analyzed by studying changes in supply while holding demand conditions constantShort and Long run analysesShort: Price adjustment to stabilize equilibriumLong: Reallocation of resources
27 when quantity supplied is greater than quantity demanded Surplus:when quantity supplied is greater than quantity demandedPQExample: If P = $5,SDSurplusthen QD = 9and QS = 25resulting in a surplus of 16 units
28 Short-run market change: Rationing Mechanism of Price: Surplus case PQFacing a surplus, sellers try to increase sales by cutting the price.SDSurplusThis causes QD to riseand QS to fall……which reduces the surplus.
29 Short-run market change: Rationing Mechanism of Price: Surplus case PQFacing a surplus, sellers try to increase sales by cutting the price.SDSurplusFalling prices cause QD to rise and QS to fall.Prices continue to fall until market reaches equilibrium.
30 What happens if the market price is lower than equilibrium price? ShortageWhat happens if the market price is lower than equilibrium price?PQExample: If P = $1,SDthen QD = 21 lattesand QS = 5 lattesresulting in a shortage of 16 lattesShortage
31 Short-run market change: Rationing Mechanism of Price: Shortage case PQFacing a shortage, sellers raise the price,SDcausing QD to falland QS to rise,…which reduces the shortage.Shortage
32 Short-run market change: Rationing Mechanism of Price: Shortage case Facing a shortage, sellers raise the price,PQcausing QD to fallSDand QS to rise.Prices continue to rise until market reaches equilibrium.Rationing Mechanism: Price adjustment to balance demand and supply in marketShortage
33 Long run analysis: Guiding or Allocating Mechanism: Market for Hybrid Cars EVENTS: 1. Price of gas rises2.New technology reduces production costsPQS1S2D2D1P2P3Q3Short-run AnalysisP1Q1Long-run AnalysisQ2
34 Increase in D> Increase in S. What about others? PQPQS1S2S1S2D2D2D1D1P2P3Q3P1Q1P1Q1P2Q2Q2
36 Price Elasticity of Demand Price elasticity of demand=Percentage change in QdPercentage change in PPrice elasticity of demand measures how much Qd responds to a change in P.
37 Price Elasticity of Demand Price elasticity of demand=Percentage change in QdPercentage change in PPQExample:DP rises by 10%Price elasticity of demand equalsP2Q2P1Q115%10%= 1.5Q falls by 15%What does elasticity = 1.5 mean?
38 Calculating Percentage Changes Standard method of computing the percentage (%) change:Calculate Price Elasticity of Demandend value – start valuestart valuex 100%PQ250010BD200015A
39 Calculating Percentage Changes Demand for your guidingProblem:From A to B, P rises 25%, Q falls 33.33%, elasticity = 33.33/25 = -1.33From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 =PQ250010BD200015AHow to solve this confusion?
40 Calculating Percentage Changes So, we instead use the midpoint method:end value – start valuemidpointx 100%The midpoint is the number halfway between the start & end values, also the average of those values.It doesn’t matter which value you use as the “start” and which as the “end” – you get the same answer either way!What is PED using midpoint method?
41 Calculating Percentage Changes Using the midpoint method, the % change in P equals2500 – 20002250x 100%= 22.2%The % change in Q equals10 – 1512.5x 100%= %These calculations are based on the example shown a few slides back: points A and B on the website demand curve.The price elasticity of demand equals40/22.2 =
42 A C T I V E L E A R N I N G 1: Calculate an elasticity Use the following information to calculate the price elasticity of demand for hotel rooms using midpoint method:if P = $70, Qd = 5000if P = $90, Qd = 300042
43 A C T I V E L E A R N I N G 1: Answers Use midpoint method to calculate % change in Qd(5000 – 3000)/4000 = 50%% change in P($70 – $90)/$80 = - 25%The price elasticity of demand equals50%25%=43
45 Numerical exampleConsider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows:Price($) Demand (millions)60 2280 20Calculate the price elasticity of demand when the price is $80.
46 Solution to Numerical example From the above question, with each price increase of $20, the quantity demanded decreases by 2. Therefore,At P = 80, quantity demanded equals 20 and
47 Calculating Price Elasticity of Demand The estimated linear demand function for pork is:Q = pwhere Q is the quantity of pork demanded in million kg per year and p is the price of pork in $ per year.At the equilibrium point of p = $3.30 and Q = 220 Find the elasticity of demand for pork:
48 Calculating Price Elasticity of Demand The estimated linear demand function for pork is:Q = pwhere Q is the quantity of pork demanded in million kg per year and p is the price of pork in $ per year.At the equilibrium point of p = $3.30 and Q = 220 the elasticity of demand for pork:
49 Numerical Example Demand for a publisher’s book is given as: Qx = 12,000 – 5,000Px + 5I + 500PcPx = Price of the book = $5I = Income per capita = $10,000Pc = Price of the books from competing publishers = $6Find Price elasticity of demand for the book.
50 Solution to Numerical Example Substituting the values of I and PcQx = 12,000 – 5,000Px + 5(10000) + 500(6)Or, Qx = 65,000 – 5,000PxWhen Px = $5 (given), Qx = 40,000Now, dQx/dPx =Therefore, E p = x (5 / 40000) =
51 The Determinants of Price Elasticity The price elasticity of demand depends on:the extent to which close substitutes are availablewhether the good is a necessity or a luxuryhow broadly or narrowly the good is definedthe time horizon: elasticity is higher in the long run than the short run.This slide is a convenience for your students, and replicates a similar table from the text.If you’re pressed for time, it is probably safe to omit this slide from your presentation.
52 The Variety of Demand Curves Economists classify demand curves according to their elasticity.The price elasticity of demand is closely related to the slope of the demand curve.Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.The next 5 slides present the different classifications, from least to most elastic.
53 “Perfectly inelastic demand” (one extreme case) Price elasticity of demand=% change in Q% change in P0%= 010%D curve:PQDverticalQ1P1Consumers’ price sensitivity:P2If Q doesn’t change, then the percentage change in Q equals zero, and thus elasticity equals zero.It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently large price increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health insurance.However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate.P falls by 10%Elasticity:Q changes by 0%
54 Price elasticity of demand “Inelastic demand”Price elasticity of demand=% change in Q% change in P< 10%< 110%DD curve:PQrelatively steepQ1P1Consumers’ price sensitivity:P2Q2relatively lowAn example: student demand for textbooks that their professors have required for their courses.Here, it’s a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class.Another example: gasoline in the short run.P falls by 10%Elasticity:< 1Q rises less than 10%
55 Price elasticity of demand “Unit elastic demand”Price elasticity of demand=% change in Q% change in P10%= 110%DD curve:PQintermediate slopeQ1P1Consumers’ price sensitivity:P2Q2intermediateThis is the intermediate case: the demand curve is neither relatively steep nor relatively flat. Buyers are neither relatively price-sensitive nor relatively insensitive to price.This is also the case where price changes have no effect on revenue.P falls by 10%Elasticity:1Q rises by 10%
56 Price elasticity of demand “Elastic demand”Price elasticity of demand=% change in Q% change in P> 10%> 110%DD curve:PQrelatively flatQ1P1Consumers’ price sensitivity:P2Q2relatively highA good example here would be Rice Krispies, or nearly anything with readily available substitutes.An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve).P falls by 10%Elasticity:> 1Q rises more than 10%
57 “Perfectly elastic demand” (the other extreme) Price elasticity of demand=% change in Q% change in Pany %= infinity0%D curve:PQhorizontalP2 =P1DConsumers’ price sensitivity:Q1Q2extreme“Extreme price sensitivity” means the tiniest price increase causes demand to fall to zero.“Q changes by any %” – when the D curve is horizontal, the quantity is indeterminant. Consumers might demand Q1 units one month, Q2 units another month, and some other quantity later. Q can change by any amount, but P always “changes by 0%” (i.e. doesn’t change).If perfectly inelastic is one extreme, this (perfectly elastic) is the other.Here’s a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. Suppose you run a small family farm in Iowa. Your main crop is wheat. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of wheat. Suppose that price is $5/bushel.Now consider the demand curve facing you, the individual wheat farmer. If you charge a price of $5, you can sell as much or as little as you want. If you charge a price even just a little higher than $5, demand for YOUR wheat will fall to zero: Buyers would not be willing to pay you more than $5 when they could get the same wheat elsewhere for $5. Similarly, if you drop your price below $5, then demand for YOUR wheat will become enormous (not literally infinite, but “almost infinite”): if other wheat farmers are charging $5 and you charge less, then EVERY buyer will want to buy wheat from you.Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell.P changes by 0%Elasticity:infinityQ changes by any %