Managerial Economics 2013 Block Course by MFZ,TUT CH 3& 4 in your text book. Please you need text book okay??

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1 CH 3& 4 in your text book. Please you need text book okay??

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17 !* % 89 % " 869 % (a) Holding SS conditions constant, DD will vary with changing interest rates. DD increases with a fall in interest rates; DD falls as interest rates rise. [why?]

18 (b) Holding DD conditions constant, SS will vary with changing interest rates. SS falls with with a rise in interest rates; SS rises as interest rates decline. [why?]

19 Real-World Factors That Cause Shifts 1-19

20 Class Work NOTE: I reward those who give me answers in five minutes! 5marks in 5 minutes Solving for Equilibrium Algebraically 1. Suppose the demand for take-out pizzas in a modest-size city is represented by the following question: Qd=64,000-3,000P and the equation for the supply curve's: Qs= -20,000+4,000P a. What does the slopes of the above two equations tells us? Does it confirms the law of supply and demand? b. Calculate the equilibrium price and quantity? c. Calculate the surplus if price is fixed at P=$15. d. Calculate the shortage if price is fixed at P=$10. e. Do you think these shortage and surplus persist in the market for the long duration? Why?

21 Utility Theory Assumptions About Consumer Preferences More is better. Consumers rank-order desirability of products. Utility functions relate well-being to consumption. Marginal utility shows added benefit of a small increase in consumption. Marginal utility is usually positive, MU>0. Law of Diminishing Marginal Utility Marginal utility eventually declines for everything.

22 Indifference Curves Basic Characteristics Higher indifference curves are better. Indifference curves do not intersect. Indifference curves slope downward. Indifference curves are concave to origin. Perfect substitutes are products that satisfy the same need, e.g., car models. Perfect complements are products consumed together, e.g., cars and tires.

23 Figure: Indifference curves show mkt baskets of goods and services that provide the same utility Managerial Economics 2013 Block Course by MFZ,TUT

24 Figure: Prefect Substitutes and Perfect Complements

25 Budget Constraints Basic Characteristics Show affordable combinations of X and Y. Slope of P X /P Y reflects relative prices. Effects of Changing Income and Prices Budget increase (decrease) causes parallel outward (inward) shift. Relative price change alters budget slope. Income and Substitution Effects Income effect changes overall consumption. Substitution effect alters relative consumption.

26 Figure: Consumption Effects of Changes in Budget and Relative Prices (a) An increase in budget results in a parallel outward shift in the budget constraint. (b) A price cut allows purchase of a greater quantity with a given budget

27 Fig: Income and Substitution Effects Following a Reduction in the Price of Goods (a) A price change will result in both income and substitution effects Managerial Economics 2013 Block Course by MFZ,TUT

28 Individual Demand Price-consumption curve shows consumption impact of price changes. Reflects movement along demand curve. Income-consumption curve shows consumption impact of income changes. Reflects shift from one demand curve to another. Engle curves plot income and consumption. Normal good consumption rises with income. Inferior good consumption falls with income (rare).

29 Fig: Price-Consumption Curve Show How Changing Prices Affect Optimal Consumption (a) Market baskets that maximize utility for various service prices trace cut the price-consumption curve. (b) Part (b) illustrates the individual demand curve for services Managerial Economics 2013 Block Course by MFZ,TUT

30 Fig: Engle Curves Plot Income and Consumption

31 Fig: Income-Consumption Curves show How Changing Income affects Optimal Consumption

32 Optimal Consumption Marginal Rate of Substitution (MRS) MRS XY = -MU X /MU Y and equals indifference curve slope. MRS XY shows tradeoff between X and Y consumption, holding utility constant. MRS XY diminishes as substitution of X for Y increases. Utility maximization requires: -P X /P Y = MU X /MU Y, or -MU X /P X =- MU Y /P Y. Slope of an Indifference Curve= slope of a budget constraint

33 Fig: Optimal Market Basket for Consumption The optimal path for consumption is found when Px/Py=MUx/MUy

34 Elasticity Elasticity of demand is the responsiveness of buyers (in terms of buying decisions) to changes in the price of the product Elasticity coefficient: Percentage Change in Quantity Demanded Percentage Change in Price If demand is elastic: Coefficient will have an absolute value greater than 1 Any percentage change in price causes a larger percentage change in quantity demanded If demand is inelastic: Coefficient s absolute value will be some fraction less than 1 Any percentage change in price causes a smaller percentage change in quantity demanded 2-34

35 Elastic and Inelastic If the market price for gasoline was to rise from $1.25 to $2.00, the quantity demanded in the market decreases insignificantly (from 8 to 7 units). If the market price for tacos rises from $1.25 to $2.00, the quantity demanded in the market decreases significantly (from 8 to 1 unit). Taco demand is highly sensitive to price changes and can be described as elastic; gasoline demand is relatively insensitive to price changes and can be described as inelastic Demand Curves Gasol ine Tacos

36 Elastic and Inelastic If the market price for motor oil was to rise from $1.25 to $2.00, the quantity supplied in the market increases insignificantly (from 7 to 8 units). If the market price for burgers rises from $1.25 to $2.00, the quantity supplied in the market increases substantially (from 1 to 8 units). Burger supply is highly sensitive to price changes and can be described as elastic; motor oil supply is relatively insensitive to price changes and can be described as inelastic Supply Curves

37 Elasticity measures sensitivity. Point elasticity shows sensitivity of Y to small changes in X. X = Y/Y X/X. Arc elasticity shows sensitivity of Y to big changes in X. E X = (Y 2 Y 1 )/(Y 2 +Y 1 ) (X 2 -X 1 )/(X 2 +X 1 ).

38 Price Elasticity Formula Point price elasticity, P = Q/Q P/P. In all cases, P < 0. P Price Elasticity and Total Revenue Price cut increases revenue if P > 1. Revenue constant if P = 1. Price cut decreases revenue if P < 1.

39 Elasticity Varies along Demand Curve As price rises, so too does P. As price falls, so too does P. Price Elasticity and Price Changes MR > 0 if P > 1. MR = 0 if P = 1. MR < 0 if P < 1. P Managerial Economics 2013 Block Course by MFZ,TUT

40 Fig: Price Elasticity of Demand Varies Along a Linear Demand Curve

41 Fig: Relation Among Price Elasticity and Marginal,Average,and Total Revenue In the range in which demand is elastic with respect to price, marginal revenue is positive and total revenue increases with a reduction in price. In the inelastic range,marginal revenue is negative and total revenue decreases with price reductions.

42 Optimal Price Formula MR and P are directly related. MR = P/[1+(1/ P)]. Optimal P* = MC/[1+(1/ P )]. Determinants of Price Elasticity Essential goods have low P. Nonessential goods have high P.

43 Cross-price elasticity shows demand sensitivity to changes in other prices. PX = Q Y /Q Y P X /P X. Substitutes have PX > 0. E.g., Coke demand and Pepsi prices. Complements have PX < 0. E.g., Coke demand and Fritos prices. Independent goods have PX = 0. E.g., Coke demand and car prices.

44 Income Elasticity of Demand Income elasticity shows demand sensitivity to changes in income. I = Q/Q I/I. Normal goods have I > 0. Noncyclical normal goods have 0 < I < 1, e.g., candy. Cyclical normal goods have I > 1, e.g., housing. Inferior goods have I < 0. Very rare. Managerial Economics 2013 Block Course by MFZ,TUT

45 demand direct demand utility derived demand demand function demand curve change in the quantity demanded shift in demand Supply KEY CONCEPTS supply function supply curve change in the quantity supplied shift in supply equilibrium market equilibrium price surplus shortage comparative statics analysis

46 KEY CONCEPTS cont d Utility Theory Indifference Curves Budget Constraints Individual Demand Optimal Consumption Demand Sensitivity Analysis: Elasticity Price Elasticity of Demand Price Elasticity and Marginal Revenue Price Elasticity and Optimal Pricing Policy Cross-price Elasticity of Demand Income Elasticity of Demand VIP: Attempt all the questions at the end of CH3&4 in your text book

47 Additional Questions for Exercise -VIP 1. Determine which of two investment projects a manager should choose if the discount rate of the firm is 10 Percent. The first project promises a profit of $100,000 in each of the next for years, while the second project promises a profit of $ 75,000 in each of the next six years. [Hint use PV formula] 2. The cost of attending a private college for one year is $6,000 for tuition,$2000 for room,$1,500 for meals, and $500 for books and supplies. The student could also have earned $15,000 by getting a job instead of going to college and 10 percent interest on expenses he or she incurs at the beginning of the year. Calculate the explicit, implicit, and total economic costs of attending college. 3. A woman managing a photocopying establishment for $25,000 per year decides to open her own duplicating place. Her revenue during the first year of operation is $120,000,and her expenses are as follows: Salaries to hired help $45,000 Calculate: a) The explicit costs b) The implicit costs c) The business profit d) The economic profit, and Supplies 15,000 Rent 10,000 Utilities 1,000 Interest on bank loan 10,000 e) The normal return on investment in this business. 4. Explain what mean by constrained optimization. (b) Indicate the importance of this in managerial economics.

48 Additional Questions for Exercise -VIP 5. Given the following total revenue function: = 9 Q Q MR a) Derive the total,average,and marginal revenue schedules from Q=0 to Q= 6 by 1 s. b) What output (Q) level maximize total revenue? Why? TR 2, and = 9-2Q 6. Given the following total cost schedule: a) Derive AC and MC schedules. b) What is the amount of fixed cost in this case? Why? 6. Using a diagram explain the behavior of the Total Revenue curve when demand is Inelastic, Unitary Elastic and Elastic for successive increase in price of a given commodity. 7.Given: d Qx =10 Px Q s x = 2 + p a) Determine the equilibrium price & quantity. b) Draw the graph on the same set of axis. Q TC c) Calculate price elasticity of demand & supply at the equilibrium price. d) Graphically show the new equilibrium price and quantity if the demand function for X increases from 10-P x to 20-2P x, cet. par, while supply function remaining constant. e) Based on question "d" above what will happen in the market for commodity X after the increase in demand, holding other things constant. 8. If a business man wishes to increase his total revenue by decreasing his output price, what must be the elasticity of demand for his product? Why? 9. Repeated past studies showed that the price elasticity of demand for coffee is 3.5 consistently. If price of coffee is to increase by 10% this year, what will the percentage reduction in demand for coffee be? 10. Why is scarcity a key economic concept, even in an affluent economy?

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