Managerial Economics

Instructor In-charge
Dr. Arun Kumar
Contact Details:
6068-G, Department of Management
arunagariya@pilani.bits-pilani.ac.in
Chamber Consultation Hours:
5-6 PM
The Production Process

production The process by which inputs are

combined, transformed, and turned into outputs.

Production Is Not Limited to Firms

firm An organization that comes into being when a

person or a group of people decides to produce a
good or service to meet a perceived demand. Most
firms exist to make a profit.
The Behavior of Profit-Maximizing Firms

All firms must make several basic decisions to

achieve what we assume to be their primary
objectivemaximum profits.

The Three Decisions That All Firms Must Make

The Behavior of Profit-Maximizing Firms

Profits

profit (economic profit) The difference between

total revenue and total cost.

profit = total revenue - total cost

total revenue The amount received from the sale

of the product (q x P).
Short-Run Versus Long-Run Decisions

short run The period of time for which two

conditions hold: The firm is operating under a
fixed scale (fixed factor) of production, and firms
can neither enter nor exit an industry.

long run That period of time for which there are no

fixed factors of production: Firms can increase or
decrease the scale of operation, and new firms
can enter and existing firms can exit the industry.
The Bases of Decisions: Market Price of Outputs, Available
Technology, and Input Prices

In the language of economics, I need to know

three things:

1. The market price of output

2. The techniques of production that are available
3. The prices of inputs

Output price determines potential revenues. The

techniques available tell me how much of each
input I need, and input prices tell me how much
they will cost. Together, the available production
techniques and the prices of inputs determine
costs.
The Bases of Decisions: Market Price of Outputs, Available
Technology, and Input Prices

Determining the Optimal Method of Production

The Production Process

production technology The quantitative

relationship between inputs and outputs.

labor-intensive technology Technology that relies

heavily on human labor instead of capital.

capital-intensive technology Technology that relies

heavily on capital instead of human labor.
The Production Process

Production Functions: Total Product, Marginal Product, And Average

Product

production function or total product function A

numerical or mathematical expression of a
relationship between inputs and outputs. It shows
units of total product as a function of units of
inputs.

TABLE 7.2 Production Function

(1) Labor Units (2) Total Product (3) Marginal Product (4) Average Product of Labor
(Employees) (Sandwiches per Hour) of Labor (Total Product + Labor Units)
0 0 - -
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4
6 42 0 7.0
The Production Process

Production Functions: Total Product, Marginal Product, And Average

Product
The Production Process

Production Functions: Total Product, Marginal Product, And Average

Product

Marginal Product and the Law of Diminishing Returns

marginal product The additional output that can

be produced by adding one more unit of a specific
input, ceteris paribus.

law of diminishing returns When additional units of

a variable input are added to fixed inputs after a
certain point, the marginal product of the variable
input declines.

Diminishing returns always apply in the short run,

and in the short run every firm will face diminishing
returns. This means that every firm finds it
progressively more difficult to increase its output as
it approaches capacity production.
 The Production Process

Production Functions: Total Product, Marginal Product, And Average

Product

Marginal Product Versus Average Product

average product The average amount produced

by each unit of a variable factor of production.

total product
average product of labor
total units of labor

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The Production Process

Production Functions: Total

Product, Marginal Product, And
Average Product
Marginal Product Versus
Average Product
Choice of Technology

TABLE 7.3 Inputs Required to Produce 100 Diapers Using Alternative Technologies
Technology Units of Capital (K) Units of Labor (L)
A 2 10
B 3 6
C 4 4
D 6 3
E 10 2

TABLE 7.4 Cost-Minimizing Choice Among Alternative Technologies (100 Diapers)

(4) (5)
(2) (3) Cost = (L X PL) + (K X PK)
(1) Units of Units of PL= $1 PL = $5
Technology Capital (K) Labor (L) PK = $1 PK = $1
A 2 10 $12 $52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20
 Exercise-1
Presto Products, Inc., manufactures small electrical
appliances and has recently introduced an innovative
new dessert maker for frozen yogurt and tofu that has
the clear potential to offset the weak pricing and
sluggish volume growth experienced during recent
periods.
Monthly demand and cost relations for Prestos frozen
dessert maker are as follows:

15 Managerial Economics
 Questions
1) Set up a table or spreadsheet for Presto output (Q), price (P),
total revenue (TR), marginal revenue (MR), total cost (TC),
marginal cost (MC), total profit (), and marginal profit (M).
Establish a range for Q from 0 to 10,000 in increments of 1,000
(i.e., 0, 1,000, 2,000, . . . ,10,000).

2) Using the Presto table or spreadsheet, create a graph with TR,

TC, and as dependent variables, and units of output (Q) as
the independent variable. At what price/output combination is
total profit maximized? Why? At what price/output
combination is total revenue maximized? Why?
16 Managerial Economics
 Questions
3) Determine these profit-maximizing and revenue-
maximizing price/output combinations analytically. In
other words, use Prestos profit and revenue equations to
confirm your answers to part B.

4) Compare the profit-maximizing and revenue-

maximizing price/output combinations, and discuss any
differences. When will short-run revenue maximization
lead to long-run profit maximization?

17 Managerial Economics
18 Managerial Economics
 Q.4
Given downward-sloping demand and marginal revenue
curves, and positive marginal costs, the profit-maximizing
price/output combination is always at a higher price and lower
production level than the revenue-maximizing price/output
combination. This stems from the fact that profit is
maximized when MR = MC, whereas revenue is maximized
when MR = 0. It follows that profits and revenue are only
maximized at the same price/output combination in the
unlikely event that MC = 0.

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 Q.4
In pursuing a short-run revenue rather than profit-
maximizing strategy, Presto can expect to gain a number of
important advantages, including enhanced product awareness
among consumers, increased customer loyalty, potential
economies of scale in marketing and promotion, and possible
limitations in competitor entry and growth.
To be consistent with long-run profit maximization, these
advantages of short-run revenue maximization must be at
least worth Prestos short-run sacrifice of $5,500 (=
$37,500 $32,000) in monthly profits.

20 Managerial Economics
 Exercise-2
Pharmed Caplets, Inc., is an international manufacturer of bulk
antibiotics for the animal feed market. Dr. Indiana Jones, head of
marketing and research, seeks your advice on an appropriate
pricing strategy for Pharmed Caplets, an antibiotic for sale to the
veterinarian and feedlot-operator market. This product has been
successfully launched during the past few months in a number of
test markets, and reliable data are now available for the first time.
The marketing and accounting departments have provided you with
the following monthly total revenue and total cost information:

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 Questions
1) Set up a table or spreadsheet for Pharmed Caplets output
(Q), price (P), total revenue (TR), marginal revenue (MR),
total cost (TC), marginal cost (MC), average cost (AC), total
profit (), and marginal profit (M). Establish a range for Q
from 0 to 1,000 in increments of 100 (i.e., 0, 100, 200, . . . ,
1,000).
2) Using the Pharmed Caplets table or spreadsheet, create a
graph with AC and MC as dependent variables and units of
output (Q) as the independent variable. At what price/output
combination is total profit maximized? Why? At what
price/output combination is average cost minimized? Why?

22 Managerial Economics
 Questions
3) Determine these profit-maximizing and average-cost
minimizing price/output combinations analytically. In
other words, use Pharmed Caplets revenue and cost
equations to confirm your answers to part B.

4) Compare the profit-maximizing and average-cost

minimizing price/output combinations, and discuss
any differences. When will average-cost minimization
lead to long-run profit maximization?

23 Managerial Economics
24 Managerial Economics
 Q.4
Given downward-sloping demand and marginal revenue
curves, and a U-shaped or quadratic AC function, the profit-
maximizing price/output combination will often be at a
different price and production level than the average-cost
minimizing price/output combination. This stems from the
fact that profit is maximized when MR = MC, whereas
average cost is minimized when MC = AC. Profits are
maximized at the same price/output combination as where
average costs are minimized in the unlikely event that MR
= MC and MC = AC and, therefore, MR = MC = AC.

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 Q.4
It is often true that the profit-maximizing output level differs from
the average-cost minimizing activity level. In this instance,
expansion beyond Q = 300, the average-cost minimizing activity
level, can be justified because the added gain in revenue more than
compensates for the added costs. Note that total costs rise by
$240,000, from $132,000 to $372,000 as output expands from Q =
300 to Q = 700, as average cost rises from $440 to $531.43.
Nevertheless, profits rise by $80,000, from $129,000 to $209,000,
because total revenue rises by $320,000, from $261,000 to
$581,000. The profit-maximizing activity level can be less than,
greater than, or equal to the average-cost minimizing activity level
depending on the shape of relevant demand and cost relations.

26 Managerial Economics
 Exercise
The following relations describe demand and supply conditions in the lumber-
forest products industry.

Q is quantity measured in thousands of board feet and P is price in dollars.

Set up a spreadsheet to illustrate the effect of price (P), on the quantity supplied
(Qs), quantity demanded (QD), and the resulting surplus (+) or shortage (-) as
represented by the difference between the quantity supplied and the quantity
demanded at various price levels. Calculate the value for each respective
variable based on a range for P from $1.00 to $3.50 in increments of 10c (i.e.,
$1.00, $1.10, $1.20,..., $3.50).

Plot the demand and supply curves for the lumber-forest products industry over
the range of prices indicated previously.

27 Managerial Economics
 Exercise
Information Technology, Inc., is a supplier of math coprocessors (computer
chips) used to speed the processing of data for analysis on personal computers.
Based on an analysis of monthly cost and output data, the company has
estimated the following relation between the marginal cost of production and
monthly output:

MC = $ 100 + $0.004Q

1) Calculate the marginal cost of production at 2500, 5000, and 7500 units of
output.
2) Express output as a function of marginal cost. Calculate the level of
output when MC = $100, $125, and $150.
3) Calculate the profit-maximizing level of output if wholesale prices are
stable in the industry at $150 per chip.
4) Derive the company's supply curve for chips. Express price as a
function of quantity and quantity as a function of price.
28 Managerial Economics
 Question
Manchester United in the Premier League offered
20 off the 200 regular price of reserved seats,
and sales spurted from 32000 to 40000 seats per
game.
Manchester United's inverse demand curve
equation

29 Managerial Economics
 Manchester United could use this curve to estimate
the quantity demanded for ticket prices in the
range from 180 to 200 per ticket. It should not
be used to estimate the number of tickets that
might be sold at exceptionally low prices like
100, or at exceedingly high prices, like 300. The
estimated linear market demand curve should not
be presumed far outside the range of experience.

30 Managerial Economics
 This is a ticket-revenue-maximizing level of output
because total ticket revenue is decreasing for
output beyond Q > 56000. If total costs are fixed,
this revenue-maximizing price will also result in
maximum profits.
In the sports world, it is worth mentioning that
even promotionally priced tickets can result in high
profits if the added customers are big buyers of
high profit margin parking services, and high
margin concessions like soda pop, beer, candy, and
hot dogs. In such instances, revenue per unit must
include direct and indirect receipts.
31 Managerial Economics
 Exercise
Distinctive Designs, Inc., imports and
distributes dress and sports watches. At the
end of the companys fiscal year, brand
manager J. Peterman has asked you to
evaluate sales of the sports watch line using
the following data:

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33 Managerial Economics
 Indicate whether there was or was not a change in each respective
independent variable for each month pair during the past year.

34 Managerial Economics
 Calculate and interpret the average advertising arc elasticity
of demand for sports watches.

Calculate and interpret the average arc price elasticity of

demand for sports watches.

Calculate and interpret the average arc cross-price elasticity

of demand between sports and dress watches.

35 Managerial Economics
36 Managerial Economics
37 Managerial Economics
 The difference in these two areas is illustrated
in Figure as the two shaded rectangles. The
horizontal shaded rectangle is the loss of
revenue caused by the price reduction (P P )
2 1

over the previous units sold Q . The vertical

1

shaded rectangle is the gain in revenue from

selling (Q Q ) additional units at the new
2 1

price P . 2

38 Managerial Economics
39 Managerial Economics
 $34 pair of Lee jeans with a E = 1.33 would
D

have a marginal revenue from lowering price

to achieve one more unit sale equal to $8.50:

For unitary elastic:

40 Managerial Economics