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Finance 30210: Managerial Economics Introduction.

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Presentation on theme: "Finance 30210: Managerial Economics Introduction."— Presentation transcript:

1 Finance 30210: Managerial Economics Introduction

2 “Economics deals with the Allocation of scarce resources to satisfy unlimited wants”

3 “You can’t always get what you want…” - Mick Jagger Consumers have limited incomes to spend on a wide variety of goods and services (both now and in the future) Workers have a finite number of hours in the day to work, relax, go to school, etc Firms have finite capacity and limited financial resources, to produce goods and services Microeconomics is all about making the most of these limits

4 Efficiency vs. Equity An allocation of resources that maximum total welfare An allocation of resources provides a “fair” distribution of welfare Under certain circumstances, the market process guarantees this Can we trust markets to produce a desirable outcome? If we can’t have everything we want, so we need to decide what to do with the limited resources we do have.

5 When thinking about efficiency, think about the impact on individuals! VS. Suppose that Exxon acquires drilling rights within a remote area where there will be negligible environmental damage in the traditional sense The Sierra club files a lawsuit to block the drilling (Their personal serenity has been threatened by the knowledge that the oil is being removed from it’s natural habitat) If you are the judge, who should prevail?

6 If Exxon Wins: Exxon stockholders gain Workers gain from added jobs Motorists see falling gasoline prices If Exxon Wins: Sierra club members lay awake at night screaming $10M -$5M VS. A ruling against Exxon in this example would be inefficient – a missed opportunity to make everyone better off.

7 Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace "Greed captures the essence of the evolutionary spirit." -Gordon Gekko

8 Introducing homo economicus….also known as “Economic Man” Economic man is a RATIONAL being

9 The Fundamental Rule of Economics: Individuals are rational beings and therefore respond to incentives Economic Incentive = (Expected) Benefit – Opportunity Cost Opportunity cost = Direct (Money) Costs + Indirect Costs In other words, think about opportunity cost as the value of ALL the resources that have been consumed

10 Example: Do you have an incentive to be here? Costs Tuition & Fees: $39,920 Room & Board: $10,870 Books/Supplies: $1,000 Other Expenses: $900 Transportation: $500 Lost Salary: $26,000 Total: $67,820 X 4 = $271,280 Benefits (Mendoza Grads) Median Salary: $56,000 - HS Grad Salary: $26,000 Difference: $30,000/yr Think of the salary differential as interest being collected from an initial investment $30,000/yr $271,280 =.011 (11.0%)

11 Competitive markets will yield efficient outcomes (that is, maximize total gains), but not necessarily equitable outcomes. Many producers/consumers Homogeneous product No taxes, subsidies, tariffs, quotas, etc. Perfect information No externalities The average consumer/producer stands to gain very little Producers with the lowest costs stand to gain the most Consumers with the highest values stand to gain the most This is where the equity issues arise!

12 Manufacturing 4 units/hr5 units/hr Agriculture 5 units/hr4 units/hr MexicoUSA Note: Assume that wages are equal across sectors Markets are all about taking advantage of differences in opportunity cost. Consider the following example. Two countries (the US and Mexico) producing two different goods (Agriculture and Manufacturing).

13 Everything we do involves a cost (Time, money, or both). Opportunity cost measures all the costs involved with an activity. In this example, the cost of manufacturing in Mexico is the time spent. We need to value that time. Manufacturing 4 units/hr Agriculture 5 units/hr Mexico 1 Unit of manufactured goods ¼ hour of time spent 5/4 units of agriculture lost 5 units of agriculture per hour 4 units of manufacturing per hour 1.25 units of agriculture per unit of manufacturing

14 We could work this the other way and figure the opportunity cost for Mexico of producing agriculture. Manufacturing 4 units/hr Agriculture 5 units/hr Mexico 1 Unit of agriculture 1/5 hour of time spent 4/5 units of manufacturing lost 4 units of manufacturing per hour 5 units of agriculture per hour.80 units of manufacturing per unit of agriculture

15 Manufacturing 1.25 Units of Agriculture.80 Units of Agriculture Agriculture.80 Units of Manufacturing 1.25 Units of Manufacturing MexicoUSA In terms of opportunity cost, Mexico has the lower cost of agriculture (in terms of lost manufacturing) and the US has a lower cost of Manufacturing (in terms of lost agriculture). We would say that Mexico has a comparative advantage in agriculture while the US has a comparative advantage in manufacturing

16 Suppose that both the US and Mexico had 40 hrs per week available to produce both goods: Slope = 1.25Slope =.80 For every unit of agriculture produced, the US gives up 1.25 units of manufactured products For every unit of agriculture produced, Mexico gives up.80 units of manufactured products If the US devoted half its resources to each sector, it could have 80 units of agriculture and 100 units of manufacturing If Mexico devoted half its resources to each sector, it could have 100 units of agriculture and 80 units of manufacturing

17 Prices will determine what actually gets produced in each country: Manufacturing 5 units/hr Agriculture 4 units/hr USA Suppose that the wage rate in the US is $10/hr 1 unit = 1/5 hr $2 unit cost 1 unit = 1/4 hr $2.50 unit cost Lets look at the profitability of each industry in the US With a wage of $10/hr, the price of agriculture has to be at least $2.50/unit while manufacturing has to be at least $2 to be profitable

18 A unit of manufacturing sells for $2.00 A unit of agriculture sells for $2.50 The relative price of agriculture (in terms of manufacturing) is $2.50 $2.00 = 1.25 (Units of manufacturing per unit of agriculture) Why should we only be interested in relative prices? How do markets provide efficient outcomes? PRICES!!

19 Profit from producing agriculture (in terms of manufactured goods) Relative price of agriculture (in terms of manufactured goods) Relative cost of agriculture (in terms of manufactured goods) (equals 1.25) If the relative price of agriculture is below 1.25, labor in the US is dedicated to manufacturing If the relative price of agriculture is above 1.25, labor in the US is dedicated to agriculture

20 In Mexico, the relative cost of agriculture is.80 If the relative price of agriculture is below.80, labor in Mexico is dedicated to manufacturing If the relative price of agriculture is above.80, labor in Mexico is dedicated to agriculture We get similar results in Mexico

21 For any relative price of agriculture between.80 and 1.25, Mexico will specialize in agriculture and the US will specialize in manufacturing. Suppose the price of agriculture is one (each agricultural item is traded for one manufactured item) With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 100 units of agriculture Gain = 20 Agricultural Goods With trade, Mexico specializes in agriculture (produces 200 units) and then sells 100 units of them for 100 units of manufacturing Gain = 20 Manufactured Goods Production point Consumption point Production point Consumption point

22 Suppose the agreed upon price of agriculture is.80 (each agricultural item is traded for.80 manufactured items With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 125 units of agriculture Gain = 45 Agricultural Goods With trade, Mexico specializes in agriculture (produces 200 units) and then sells 125 units of them for 100 units of manufacturing Gain = 0

23 Suppose the agreed upon price of agriculture is 1.25 (each agricultural item is traded for 1.25 manufactured items With trade, The US specializes in manufacturing (produces 200 units) and then sells 100 units of them for 80 units of agriculture Gain = With trade, Mexico specializes in agriculture (produces 200 units) and then sells 80 units of them for 100 units of manufacturing Gain = 20 Agriculture, 20 Manufacturing

24 How do we know what price will actually be? For prices below.80, neither country produces agriculture For prices between.80 and 1.25, both countries are completely specialized (US in manufacturing, Mexico in Agriculture) For prices above 1.25, both countries specialize in agriculture But supply is only half the story!!

25 The location of the demand curve will determine the price!! In equilibrium, demand must equal supply. In this case, 200 units of agriculture are produces (all in Mexico) and are sold at a relative price of 1.15 Note: We would get a similar picture for Manufacturing

26 Manufacturing 4 units/hr10 units/hr Agriculture 5 units/hr8 units/hr MexicoUSA Suppose we change this example slightly. Now, the US has an absolute advantage in everything. However, Mexico still has a comparative advantage in agriculture. 1 Unit of agriculture 1/8 hour of time spent 10/8 = 1.25 units of manufacturing lost 1 Unit of agriculture 1/5 hour of time spent 4/5 =.80 units of manufacturing lost

27 Multiple Producers/Consumers Suppose that you have been elected president of the US. Your job is to find the most efficient production/consumption pattern for wheat. You know that different consumers/producers have different values/costs Note: All values are relative to some general price index ProducerUnit CostCapacity #16200 #24100 #33400 #45300 ConsumerReservation Price Demand #13200 #25100 #34400 #46200 ConsumersProducers However, you can’t tell them apart! What do you do?

28 400 5 Competitive markets provide the efficient solution The Supply curve sorts potential producers by cost The Demand curve sorts potential buyers by value What should the equilibrium price be?

29 500 Competitive markets provide the efficient solution 4 ProducerProductionProfit #1 (C = 6)00 #2 (C = 4)1000 #3 (C = 3)400 #4 (C = 5)00 ConsumerConsumption“Profit” #1 (V = 3)00 #2 (V = 5)100 #3 (V = 4)2000 #4 (V = 6) #4 #3 # Note that the gains are not distributed equally!! Total “Profit” = 900

30 The Average Shopping cart in the US today is approximately three times as big as its 1975 counterpart Ralph Nader has argued that this is a prime example of consumers being manipulated by unscrupulous capitalists – bigger carts shame consumers into bigger purchases. What’s wrong with this argument?

31 Microsoft’s new Xbox 360 gaming console was released in North America on November 22, 2005 at a retail price of $ Available supply sold out almost immediately as Christmas shoppers stood in line for this year’s hot item. (Microsoft has increased its sales target from 3M units to 6M units). What’s odd about this??

32 In the years following a divorce, statistics show that the woman’s living standard falls 27% while the man’s living standard rises by 10% Feminists such as Patricia Ireland (NOW) would argue that this proves divorce is unfair to women Couldn’t you just as easily argue that marriage is unfair to men?

33 On December 22, 2001, Richard Reid was arrested trying to blow up an American Airlines flight from Paris to Miami with a bomb hidden in his shoes. Many human rights groups have fought heavily against the practice of racial profiling by airline security Isn’t there a better way to secure the safety of our airplanes? (Hint: could we create a marketplace?)

34 Paul “Freck” Morgan started a website in 2001 offering a $20 Pay Per View event…..to watch him cut off his feet with a homemade guillotine. Note: The site turned out to be a hoax…Paul never actually went through with it! How should we feel about this entrepreneurial effort? (i.e. could we/should we repress this market?)


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