L9

Managerial Economics (MBA ZC416)
Session 11: Mid - Review

Instructor
Monika Gupta
Assistant Professor
Economics and Finance Department
monika.gupta@pilani.bits-pilani.ac.in
Announcements
Quiz 1
• Quiz one is open now, you can attempt till 4th sem
• 5% weightage, 10 questions, no negative marks, attempt all questions
• MCQs
• Syllabus – Module 1 to 4
• Go for course MBA ZC 416, not the courseware
• Feedback (Anonymous)
https://docs.google.com/spreadsheets/d/1PvS7dG6Lzki_rrcF_mmeOtvvQ7b4j
MROcHG0gJuGwQA/edit?usp=sharing
(Anonymous)
2/27/2018 MBA ZC416, Managerial Economics, Monika Gupta 2

A quick Recap…
• Different Types of Costs
• Short Run Cost Function
• Long Run Cost Function
• Economies of Scope
• Economies of Scale
• Learning Curve

Queries from the previous session
• To understand basic Calculus please check the following links
• https://www.youtube.com/watch?v=rRphiUtRKcY
• http://www-math.mit.edu/~djk/calculus_beginners/
• MRP
• Marginal revenue product of labour (MRPL) is the extra revenue generated when an
additional worker is employed
• Incremental costs - If a company's total costs increase from $320,000 to
$360,000 as the result of increasing its machine hours from 8,000 to
10,000, the incremental cost of the 2,000 machine hours is $40,000. The
incremental cost is also referred to as the differential cost. The incremental
cost is the relevant cost for making a short run decision between two
alternatives.

Queries from the previous session
• Sunk costs –
• The depreciation is a sunk cost. The equipment has no resale value or
alternative use, so the equipment and the depreciation expense associated
with it are irrelevant to the decision.
• Other examples
• R&D
• Training
• Marketing study
• Survey
• Hiring bonus

Mid-semester Exam
Syllabus
• Live lectures (contact hours)– 1 to 11
• Book chapter – 1 to 6 (Please read the book for details)
• Prerecorded videos – 1 to 6
Type - closed book, prepare for every type of questions
• Marks - 30
• Weightage – 30%
• Duration – 2 hours
• Date - 23/09/2017 (FN) 10 AM – 12 Noon
• For other details please see course handout

Syllabus for mid-sem
• Module 1: Introduction
• Session 1:
• Introduction to Economics, Economic Terminology
• What is managerial economics
• Basic economic concepts
• Ten principles for managers
• Module 2: Theory of the firm and demand analysis - I

• Session 2:
• Theory of the firm: neoclassical and others
• How markets operate
• TR, AR and MR
• Indifference curve
• Basics of demand, Determinants of demand

• Module 3: Demand Analysis – II and Elasticities
• Session 3:
• Price Elasticity of Demand
• Income Elasticity of Demand
• Cross Elasticity of Demand
• Economic Forecasting
• Module 4: Economic Forecasting

• Session 4:
• Why forecasting
• Various forecasting methods
• Trend projection and constant growth models
• Moving averages and exponential smoothing

• Module 5: Production Analysis
• Session 5:
• The Production Function in the Long Run
• Marginal Product of an Input
• Isoquants and MRTS
• Least Cost Combination of Inputs and Economic Region of Production, Expansion Path
• Module 6: Cost of Production

• Session 6:
• Types of Costs
• Costs in the Long Run
• Costs in the Short Run

How to prepare for exams -
• Listen the pre-recorded and live sessions
• You may prepare notes of important topics
• Read the important topics in detail from the book
• Try to solve the given examples in the book and live classes
• Try to solve the questions given at the end of the chapters

Revision of few concepts

Consumer Theory vs. Producer Theory
Consumer Theory Producer Theory
Indifference Curve Isoquant Curve
Budget Constraint Isocost
MRS MRTS
Slope - MUX1/MUX2 Slope - MPL/MPK
Equilibrium Condition -MUX1/MUX2 = PX / PY. MPL/MPK = PL / PK.

Indifference Curve
• Indifference curve shows the combination of set of commodities
yielding the same level of satisfaction
• MRS - Rate at which one good can be substituted for another while
holding utility constant
• Slope of an indifference curve
• dQx2/dQX1 = -MUX1/MUX2

The Budget Constraint
Y The Opportunity Set
• The limits imposed on household
choices by income, wealth, and
product prices. Budget Line
• Opportunity Set M/PY

Y = M/PY – (PX/PY)X
• The set of consumption bundles that are
affordable.
• PxX + PyY  M.
• Budget Line
• The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution M/PX
• The slope of the budget line X
• -Px / Py

Consumer Equilibrium
• The equilibrium consumption Y
bundle is the affordable bundle
Consumer
that yields the highest level of M/PY
Equilibrium
satisfaction.
• Consumer equilibrium occurs at a point
where
MRS = PX / PY.
• Equivalently, the slope of the indifference
curve equals the budget line. III.
-MUX1/MUX2 = PX / PY. II.
• I.
M/PX
X
The Utility-maximizing Rule
• In general, utility-maximizing consumers spread out their
expenditures until the following condition holds:
MU X MU Y
utility - maximizing rule :  for all pairs of goods
PX PY
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Indifference Curves
Perfect Perfect
Complements Substitutes
QY QY
QX QX
The Impact Of A Price Change
• Economists often separate the impact of a price change into two components:
• the substitution effect; and
• the income effect.
• The substitution effect involves the substitution of good x1 for good x2 or vice-
versa due to a change in relative prices of the two goods.
• When the price of something we buy falls, we are better off. When the price of
something we buy rises, we are worse off.
• The income effect results from an increase or decrease in the consumer’s real
income or purchasing power as a result of the price change.
• The sum of these two effects is called the price effect.

The Substitution Effect
• Both the income and the substitution effects imply a negative relationship
between price and quantity demanded—in other words, downward-sloping
demand.
• When the price of something falls, ceteris paribus, we are better off, and we are
likely to buy more of that good and other goods (income effect). Because lower
price also means “less expensive relative to substitutes,” we are likely to buy
more of the good (substitution effect).
• When the price of something rises, we are worse off, and we will buy less of it
(income effect). Higher price also means “more expensive relative to
substitutes,” and we are likely to buy less of it and more of other goods
(substitution effect).
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Decomposing the Income and Substitution Effects
• Initially, bundle A is consumed. A Y
decrease in the price of good X expands
the consumer’s opportunity set.
• Income effect of a price change
• The substitution effect (SE) causes the
consumer to move from bundle A to B. C
• A higher “real income” allows the A

consumer to achieve a higher indifference II
curve.
B
• The movement from bundle B to C
represents the income effect (IE). The
new equilibrium is achieved at point C. I
IE X
0
SE
The case study of The Times
Newspaper

ELASTICITY AND ITS APPLICATION:
A Case Study of The Times Newspaper
There are four major national newspapers in UK: The Times, Guardian,
Daily Telegraph, and Independent.
 They sell around 2.5 million copies daily.
 In September 1993, The Times unilaterally lowered its price by one-
third from 45 pence to 30 pence.
 Initially all the major competing newspapers kept their prices constant as if
nothing had happened. Only later did a price war break out.

Changes in the demand for newspapers
Price Avg. daily sales Percentage
(in pence) change (mid-point
Pre-Sept. Post-Sept. Pre-Sept. Post-Sept. formula)
93 93 93 93 Price Sales
The Times 45 30 376836 448962 -40=(30- +17.5
45)*100/((45
+30)/2)
Guardian 45 45 420154 401705 0 -4.5
Daily Telegraph 45 45 1037375 1017326 0 -1.95
Independent 50 50 362099 311046 0 -15.2
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MBA ZC416, Managerial Economics, Monika Gupta 23
• price elasticity of demand of The Times = -17.5/40 = -0.44

• What will happen to the revenue of The Times after price reduction?
• It’ll obviously go down (inelastic demand). Daily sales revenue of The Times
fell from £ 169,576 to £ 134,689.
• Remember, revenue will increase with reduction in price only when absolute
value of price elasticity of demand is greater than 1.
The competing papers suffered, and the Independent suffered most
(15.2% loss of sales).
Independent was the closest substitute for the The Times (cross elasticity of
demand = +0.38).

Applying demand and supply concepts

• Each newspaper sells all the copies that are demanded at the price
that it sets.
• So, supply curve for each newspaper is horizontal (the elasticity of supply is
effectively infinite at the set price).
What will be the effect of The Times’ price cut both on The Times
and on the Independent?
Note: Since each newspaper is a distinct product, there is no industry supply
curve. Each supplier simply sets a price and lets demand determine its sales.

Demand for The Times and the Independent
Movement along the curve Shift of the curve

• Since demand is inelastic for newspapers in the UK, it was a good strategy for
rival newspapers not to reduce their prices.
• Although the Independent suffered a daily loss of revenue a little over £ 25000, it
would have lost more by cutting its price.
• But, why The Times persisted with its price drop?
Increase in advertising revenue (which depends on circulation) could be one of
the important reasons.
Increase in daily advertising revenue should be more than £ 35000 (which is drop in
sales revenue) to make price cut profitable.

• Predatory pricing (charge a low price to force the rivals out of business) could be
another reason.
• The Independent was indeed in financial difficulty before The Times’ price cut announcement.
• Since Independent was the closest substitute, predatory pricing can’t be ruled out.
• However, the Independent was taken over by the Mirror group, which had more financial
resources. Later it was sold to an Irish newspaper group.
• Therefore, if The Times had been following a predatory pricing strategy, it failed.
Another possibility – The Times’ manager might have expected that its demand
elasticity would increase over time (that is, sales will increase at greater rate in
the long-run).

• Indeed, The Times did continue to increase its market share.

• In June 1994 the Telegraph reacted to The Times’ growing market
share by cutting its price, and the Independent followed.
• The Times reduced its price further, although prices settled down at
slightly higher levels soon after.
• By July 1998 The Times’ price was 35p while other three major papers were at
45p.
• By July 1998 The Times’ sales were 800,000, almost double what was in early
1994. In contrast, the Independent’s sales were just 210,000, less than 60%
…(long run elasticity ...)

• Market share of major newspapers was virtually unchanged during

the next 5 years.
• During mid-2002, sales of The Times were running just over 700,000
daily, the Guardian at just under 400,000, the Independent at about
220,000 and the Telegraph just over 1 million.
• From 2002 onwards, The Times’ has to compete not only with other
newspapers but also with the internet and 24 hours news channels.

• Now, strategy to gain market share may be different than just price cut (value
added services, bundling and tying, etc.).
• However, the aggressive pricing strategy adopted by The Times in the early 1990s
does appear to have had a very long lasting effect on the sales pattern of the UK
newspapers.
• The changes in the sales pattern established in the mid-1990s are still evident,
even though the price war is over. (In early 2007, The Times was priced at 65p
while others at 70p.)
• Think of a network good; once you gain the market, you can continue to be
market leader (unless product becomes obsolete).

Few Problems

Few Problems

All the best!

Plan of the next session
• I will start post mid-sem syllabus - Break even Analysis and
Incremental Profit Analysis, Perfect Competition and Monopoly
• Please read the chapter 7.
• Replay prerecorded video 7.1.

Acknowledgements
• All slides in this presentation have been prepared by the instructor
herself. Any omission of references is unintentional. I acknowledge the
assistance of my guide Prof. Sanjay K. Singh for the A Case Study of
The Times Newspaper.

Thank you

Back up slides..

How does a firm decide if it is profitable to hire another worker
(or another unit of capital)?
• Productivity is the amount of output produced per unit of that input

• If the additional revenue from the output of hiring another worker (Marginal
Revenue Product of Labor - MRPL) is greater than its cost (wage rate - w), hire
more workers.
• So, MRPL = additional output obtained from an additional unit of labor 
additional revenue from an extra unit of output = MPL (marginal product of labor)
 MR (marginal revenue)
• Inputs can be complementary and substitutable

How MRPL = (MPL).(MR)?
R
MRPL  where R is revenue and L is labor
L
Q R
MPL  and MR 
L Q
R R  Q 
  
L Q  L 
MRPL  ( MPL )( MR )

Marginal Revenue Product
• In a competitive market, MR = P
• This means, for a competitive market
MRPL  ( MPL )( P)
• So, graphically, MRPL falls as L increases since MPL falls as L increases

Marginal Revenue Product
represents demand for labor
Price of
labor
Competitive Output Market (P = MR)
MRPL = MPLx P
Monopolistic
Output Market MRPL = MPL x MR
(MR < P)
Hours of Work
Examples of Sunk costs
• Marketing study. A company spends $50,000 on a marketing study to see if its new auburn widget
will succeed in the marketplace. The study concludes that the widget will not be profitable. At this
point, the $50,000 is a sunk cost. The company should not continue with further investments in
the widget project, despite the size of the earlier investment.
• Research and development. A company invests $2,000,000 over several years to develop a left-
handed smoke shifter. Once created, the market is indifferent, and buys no units. The $2,000,000
development cost is a sunk cost, and so should not be considered in any decision to continue or
terminate the product.
• Training. A company spends $20,000 to train its sales staff in the use of new tablet computers,
which they will use to take customer orders. The computers prove to be unreliable, and the sales
manager wants to discontinue their use. The training is a sunk cost, and so should not be
considered in any decision regarding the computers.
• Hiring bonus. A company pays a new recruit $10,000 to join the organization. If the person proves
to be unreliable, the $10,000 payment should be considered a sunk cost when deciding whether
the individual's employment should be terminated.
Source - https://www.accountingtools.com/articles/what-is-a-sunk-cost.html

An Indifference Curve properties
Consumer Preference Ordering Properties –
• Completeness
• More is Better - Monotonicity
• Diminishing Marginal Rate of Substitution – Convex shape
• Transitivity

Complete Preferences
• Completeness Property Good Y
• Consumer is capable of expressing III.
preferences (or indifference) between all
possible bundles. (“I don’t know” is II.
NOT an option!) I.
• If the only bundles available to a A B
consumer are A, B, and C, then the
consumer
• is indifferent between A and C (they are
on the same indifference curve). C
• will prefer B to A.
• will prefer B to C.
Good X

More Is Better!
• More Is Better Property Good Y
• Bundles that have at least as much of III.

every good and more of some good II.
are preferred to other bundles. I.
• Bundle B is preferred to A since B
contains at least as much of good Y and A B
strictly more of good X. 100
• Bundle B is also preferred to C since B

contains at least as much of good X and
C
strictly more of good Y. 33.33
• More generally, all bundles on ICIII are
preferred to bundles on ICII or ICI. And all
bundles on ICII are preferred to ICI. 1 3
Good X

Diminishing Marginal Rate of Substitution
• Marginal Rate of Substitution Good Y
• The amount of good Y the consumer is willing
to give up to maintain the same satisfaction III.
level decreases as more of good X is acquired. II.
• The rate at which a consumer is willing to
substitute one good for another and maintain I.
the same satisfaction level. A
100
• To go from consumption bundle A to B the
consumer must give up 50 units of Y to get one
B
additional unit of X. 50
• To go from consumption bundle B to C the 33.33 C
D
consumer must give up 16.67 units of Y to get one 25
additional unit of X.
• To go from consumption bundle C to D the
consumer must give up only 8.33 units of Y to get 1 2 3 4 Good X
one additional unit of X.
Consistent Bundle Orderings
• Transitivity Property Good Y
• For the three bundles A, B, and C, the III.
transitivity property implies that if C  B
and B  A, then C  A. II.
• Transitive preferences along with the more- I.
is-better property imply that 100 A
• indifference curves will not intersect. C
75
• the consumer will not get caught in a B
perpetual cycle of indecision. 50
1 2 5 7 Good X

THE BASIS OF CHOICE: UTILITY
ALLOCATING INCOME TO MAXIMIZE UTILITY
Allocation of Fixed Expenditure per Week Between Two Alternatives
(1) (3) (5)
TRIPS (2) MARGINAL (4) MARGINAL UTILITY
TO CLUB TOTAL UTILITY PRICE PER DOLLAR
PER WEEK UTILITY (MU) (P) (MU/P)
1 12 12 $3.00 4.0
2 22 10 3.00 3.3
3 28 6 3.00 2.0
4 32 4 3.00 1.3
5 34 2 3.00 0.7
6 34 0 3.00 0
(1) (3) (5)
BASKETBALL (2) MARGINAL (4) MARGINAL UTILITY
GAMES TOTAL UTILITY PRICE PER DOLLAR
PER WEEK UTILITY (MU) (P) (MU/P)
1 21 21 $6.00 3.5
2 33 12 6.00 2.0
3 42 9 6.00 1.5
4 48 6 6.00 1.0
5 51 3 6.00 .5
6 51 0 6.00 0
49 of 40
Consumer Surplus
• The difference between the maximum amount a person is willing to
pay for a good and its current market price.

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Managerial Economics (MBA ZC416)

Session 11: Mid - Review

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• Module 2: Theory of the firm and demand analysis - I

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• Module 4: Economic Forecasting

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• Module 6: Cost of Production

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Indifference Curve Isoquant Curve

Budget Constraint Isocost

Slope - MUX1/MUX2 Slope - MPL/MPK

Equilibrium Condition -MUX1/MUX2 = PX / PY. MPL/MPK = PL / PK.

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• Opportunity Set M/PY

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• A higher “real income” allows the A

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Guardian 45 45 420154 401705 0 -4.5

Daily Telegraph 45 45 1037375 1017326 0 -1.95

Independent 50 50 362099 311046 0 -15.2

2/27/2018 2196464 2179039

• price elasticity of demand of The Times = -17.5/40 = -0.44

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Applying demand and supply concepts

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Movement along the curve Shift of the curve

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• Indeed, The Times did continue to increase its market share.

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• Market share of major newspapers was virtually unchanged during

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• Productivity is the amount of output produced per unit of that input

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Competitive Output Market (P = MR)

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Consumer Preference Ordering Properties –

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• Bundles that have at least as much of III.

• Bundle B is also preferred to C since B

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