1. 1 SENIOR OUTCOMES SEMINAR (BU385) ECONOMICS

2. 2 BASIC CONCEPTS IN ECONOMICS I Opportunity costs Equilibrium of supply (Q S ) and demand (Q D ) Price elasticity of demand Marginal costs, revenues, and profits Economies of scale and scope

3. 3 BASIC CONCEPTS IN ECONOMICS I Sunk costs and entry barriers Profit maximization by a competitive firm Profit maximization by a monopoly and oligopoly Pricing policies Externalities

4. 4 A rational (reasonable) decision suits interests of the decision maker. The opportunity cost of the rational decision is the value of the next best alternative that is sacrificed because of this decision

5. 5 Essence of the opportunity cost: Under scarcity, no gains without pains, i.e. each gain involves some loss The value of the gain is determined by a ratio between its market price and the market price of the sacrificed next best alternative option.

6. 6 Illustrative example: P(gain)=absolute market price of gain in $$ P(loss)=absolute market price of sacrificed best alternative option in $$ RATIO P(gain)/P(loss) IS A RELATIVE PRICE WHICH DETERMINES THE TRUE VALUE OF THE GAINS

7. 7 Equilibrium of Q S and Q D is a price P* such that Q S (P*)=Q D (P*) Follows from Q S =g(P*) & Q D =f(P*) Prices are information signals that push Q S and Q D towards equality

8. 8 Equilibrium of Q S and Q D is a price P* such that Q S (P*)=Q D (P*) P Q D, Q S P1P1 P2P2 Surplus at P 1 Deficit at P 2

9. 9 Shifts of DD curves P Q D, Q S Rightward: Population up Incomes up Leftward: Population down Incomes down

10. 10 Shifts of SS curves P Q D, Q S Rightward: Size of industry up Tech progress up Relative prices of inputs down Leftward: Size of industry down Relative prices of Tech progress down inputs up

11. 11 Elasticity of demand with respect to changes in prices: η = ΔQ D /Q D : ΔP/P = ΔQ D /ΔP × P/Q D, ΔQD/QD percentage changes ΔP/P percentage changes η is the key measure of sensitivity of demand to changes in prices

12. 12 Elastic demand curve: η>1 Inelastic demand curve: η<1 Unit-elastic demand curve: η=1 P QDQD 45 0 η>1 (luxury) η=1 η<1 (necessities)

13. 13 P QDQD P1P1 At P 1, η=0 QDQD P At any P, η=∞

14. 14 Marginal costs (MC) are costs of producing an additional unit of output Suppose 50 units are already produced TC:= Total cost MC (of the 51th unit)= TC (of 51 units)- TC (of 50 units)

15. 15 In certain business environments, volume of production at MC=AC is an optimum position MC Volume MC AC MC=AC ?

16. 16 Fixed costs (FC) are incurred no matter how much units are produced Variable costs (VC) increase as a volume of production increases This distinction is the key to understanding why some firms are better off after M&A and other are better off without M&A

17. 17 Scale = volumes of produced homogeneous (the same type) output Scale + Scope = volumes of produced homogeneous and heterogeneous outputs Scope = volumes of produced heterogeneous (different types) outputs

18. 18 Economies of scale (ES) are changes in efficiency due to changes in volumes of output Decreasing EC Scale AC Constant ES Increasing ES

19. 19 Increasing ES: costs of additional units of output go down due to rationalization of operations fixed costs per unit decrease Decreasing ES: costs of additional units of output go up due to increasing difficulties of managing added operations

20. 20 Sunk costs are costs that cannot be recouped Barriers to entry into an industry or market are costs that outsiders should incur to become insiders Higher barriers to entry Bigger market power of insiders

21. 21 Economic profit = accounting profit – profit from the next best alternative use of capital Bigger market power of insiders Higher economic profits of insiders

22. 22 Zero economic profit at time t: there does not exist an alternative investment option that will lead to a higher accounting profit at time t In an industry with zero economic profit, insider firms prefer to stay put since nowhere they could get a higher profit

23. 23 Numerous firms are price takers: their individual decisions to change volumes of outputs have no influence on prices. Such (small) firms have horizontal DD curves Such firms can sell any quantities of their outputs at going market prices Perfect competition is idealized model = benchmark:

24. 24 Perfect competition: The firm should stop increasing/ decreasing its outputs when its economic profit becomes zero, i.e. MC = MR = P, where MR is marginal revenue. Any firm can freely exit or enter the industry

25. 25 Monopoly: A firm that can influence prevailing market prices by changing its outputs Such firm has a downward-sloping DD curve Creates entry barriers for potential competitors

26. 26 Essence of monopoly: Chooses levels of outputs such that its economic profit is greater than zero: MC = MR < P. Economic profit from production of additional unit of output is MC = P – MC.

27. 27 Two types of monopoly Pure monopoly : a one-firm industry whose product has no close substitutes Natural monopoly : a one-firm industry because this firm has enormous economies of scale (ES). Such ES need gigantic size=scale.

28. 28 Freedom of exit and entry Monopolistic competition: Numerous small firms Each firm produces slightly different product. Apart of this difference, the product has many close substitutes

29. 29 Monopolistic competition: Economic profit slightly higher than zero MC=MR <P higher: a firm exercises small market power due to unique distinction in its product slightly: many close substitutes, i.e. tough competition

30. 30 A bulk of the business in industry carried by a few large firms Oligopoly: Products are close substitutes so competition is tough May have economic profit slightly higher than zero MC=MR <P

31. 31 Pricing policies Cost-based pricing : cost +target profit. Not enough flexibility to speedily adjust to changes in market situations. Utility-based pricing : a firm adjusts prices to attract maximum consumers and then ruthlessly cut cost to make sales profitable.

32. 32 Pricing policies Price discrimination : different prices to different customers for the same products Price leadership : one firm sets the price for the industry and the other follow. Premium-based pricing : extracting additional payment for unique qualities of a product

33. 33 Externalities are any costs or benefits generated by one firm/person that affect another firm/person Imposition of external costs detrimental externality Imposition of external benefits beneficial externality

34. 34 Examples of externalities Private goods are products and services whose consumption is excludable and rival, e.g. good food at graduation party Public goods are products and services whose consumption is nonexcludable and nonrival, e.g. national defense

35. 35 Examples of externalities Mixed goods: Excludable but nonrival consumption, e.g. cable TV. Nonexcludable but rival consumption, e.g. public park.