MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter12
Chapter

DEMAND THEORY
INTRODUCTION
 OBJECTIVES

• Provide a guide to making good managerial decisions.

• Use formal models to analyze the effects of managerial
decisions on measures of a firm’s success.
 MANAGERIAL ECONOMICS

• Managerial Economics is the science of directing scarce

resources to manage cost effectively.

• Managerial Economics is the study of choices firms’

managers make, the way the choices of consumers and
the choices of firms interact in the markets, the influence of
governments.
 MANAGERIAL ECONOMICS

• Differs from Microeconomics

• Microeconomics focuses on description (describe how
the economy works, not how it should operate).
• Managerial Economics is prescriptive (provide powerful
tools and framework to guide managers to better
decision).
 MANAGERIAL ECONOMICS

• Is an integrative course
• Brings the various functional areas of business together
in a single analytical framework
• Marketing (demand and elasticity, pricing policy)
• Strategic planning (market structures)
• Finance/Accounting (cost, opportunity cost, break-even
analysis)
• Management Science (cost control, plant layout,
inventory policies)
 MANAGERIAL ECONOMICS

• Is an integrative course
• Brings the various functional areas of business together
in a single analytical framework

Marketing Finance
Demand, Price elasticity Capital budgeting, Break-even analysis,
Opportunity cost, Economic value added

Managerial Economics

Managerial Accounting Strategy Management Science

Relevant cost, Break-even analysis Types of competition, Linear programming,
Incremental cost analysis, Structure-product- Regression analysis,
Opportunity cost performance analysis Forecasting
 THE THEORY OF THE FIRM

• We do not have a well-developed theory of firm

• To apply Managerial Economics to business
management, we need a theory of firm
• According to the theory accepted by most
managerial economists, the firm tries to maximize
its value, defined as the present value of its
expected future cash flows (profits).
 WHAT IS PROFIT?

• Two Measures of Profit

• Accounting Profit
• Historical costs
• Legal compliance
• Reporting requirements
• Economic Profit
• Market value
• Opportunity, or implicit cost
• More useful measure for managerial decision making
 WHAT IS PROFIT?

• Profit (economic profit, not accounting profit)

• When economists speak of profit, they mean profit over
and above what the owner’s labor and capital employed
in the business could earn elsewhere.
• Opportunity cost
• The opportunity cost of something is the highest valued
alternative that we must give up to get it.
• 为得而失去的 (highest valued alternative forgone).
• Opportunity costs of production
is the sum of cost of using resources bought in markets,
owned by the firm, and supplied by the owner of the firm
 WHAT IS PROFIT?

• Example 1
Suppose your firm bought some raw materials 10 years
ago. The price was $10. The current market price is $20.
These raw materials are used in the production of a
product. How to value them, or how to calculate real
economic cost?
 WHAT IS PROFIT?

• Example 2
• Lee is a computer programmer who earned $35,000 in 2015. But on January 1, 2016,
Lee opened a body board manufacturing business. At the end of the first year of
operation, he submitted the following information to his accountant:
• He stopped renting out his cottage for $3,500 a year and used it as his factory. The
market value of the cottage increased from $70,000 to $71,000.
• He spent $50,000 on materials, phone, etc.
• He leased machines for $10,000 a year.
• He paid $15,000 in wages.
• He used $10,000 from his savings account, which earns 5 percent a year interest.
• He borrowed $40,000 at 10 percent a year.
• He sold $160,000 worth of body boards.
• Normal profit is $25,000 a year.
• Calculate Lee’s opportunity cost of production and his economic profit.
• Lee’s accountant recorded the depreciation on his cottage during 2016 as $7,000.
According to the accountant, what profit did Lee make?
 PROFIT

• Measures the quality of managers’ decision-making skills

• Encourages good management decisions by linkage with
incentives
 SOURCES OF PROFIT

• Innovation
• Producing products that are better than existing
products in terms of functionality, technology, and style
• Risk Taking
• Future outcomes and their likelihoods are unknown, as
are the reactions of rivals.
• Exploiting Market Inefficiencies
• Building barriers to entry, employing sophisticated
pricing strategies, diversifying, and making good
strategic production decisions
 DEMAND AND SUPPLY: A FIRST LOOK

• Market
• A group of firms and individuals that interact with each
other to buy or sell a good
• Part of an economy’s infrastructure
• A social institution that exists to facilitate economic
exchange
• Relies on binding, enforceable contracts
 DEMAND AND SUPPLY: A FIRST LOOK

• Demand Function
• Quantity demanded relative to price, holding other possible
influences constant
• Negative slope
• Period of time
• Shifts in demand
• Other Influences (held constant)
• Income
• Prices of substitutes and complements
• Advertising expenditures
• Product quality
• Government fiat
 THE DEMAND SIDE OF THE MARKET

• Market demand=
F(price of the product,
advertising,
quality,
price of substitute products,
price of complementary products,
state of the economy,
disposable personal income,
people’s taste,
government regulations)
 THE DEMAND SIDE OF THE MARKET

• Total Revenue Function

• A firm’s total revenue (TR) for a given time period is
equal to the price charged (P) times the quantity sold
(Q) during that time period.
• TR = P x Q
• The demand function reflects the effect of changes in P
on quantity demanded (Q) per time period and, hence,
the effect of changes in P on TR.
THE MARKET DEMAND CURVE FOR COPPER,
WORLD MARKET
 THE SUPPLY SIDE OF A MARKET

• Supply Function
• Quantity supplied relative to price, holding other
possible influences constant
• Positive slope
• Period of time
• Shifts in supply
• Other influences (held constant)
• Technology
• Cost of production inputs (Land, Labor, Capital)
 THE SUPPLY SIDE OF A MARKET

• Market supply=
G(price of the product,
price of factors of production,
price of substitute products,
price of complementary products,
expected future prices,
the number of suppliers,
technology,
the state of the nature)
THE SUPPLY SIDE OF A MARKET
 EQUILIBRIUM PRICE

• Disequilibrium
• Price is too high
• Excess supply
• Surplus
• Causes price to fall
• Price is too low
• Excess demand
• Shortage
• Causes price to rise
 EQUILIBRIUM PRICE

• Equilibrium Price
• Quantity demanded is equal to quantity supplied.
• Price is stable.
• The market is in balance because everyone who wants
to purchase the good can, and every seller who wants
to sell the good can.
EQUILIBRIUM PRICE OF COPPER, WORLD
MARKET
 ACTUAL PRICE

• Invisible Hand
• No governmental agency is needed to induce producers to drop or
increase their prices.
• If actual price is above equilibrium price, there will be a
surplus that puts downward pressure on the actual price.
• If actual price is below equilibrium price, there will be a
shortage that puts upward pressure on the actual price.
• If actual price is equal to equilibrium price, then there will
be neither a shortage nor a surplus and price will be stable.
 WHAT IF THE DEMAND CURVE SHIFTS?

• Increase in Demand
• Represented by a rightward or upward shift in the
demand curve
• Result of a change that makes buyers willing to
purchase a larger quantity of a good at the current price
and/or to pay a higher price for the current quantity
• Will create a shortage and cause the equilibrium price to
increase
 WHAT IF THE DEMAND CURVE SHIFTS?

• Decrease in Demand
• Represented by a leftward or downward shift in the
demand curve
• Result of a change that makes buyers purchase a
smaller quantity of a good at the current price and/or
continue to buy the current quantity only if the price is
reduced
• Will create a surplus and cause the equilibrium price to
decrease
EFFECTS OF LEFTWARD AND RIGHTWARD SHIFTS OF THE
DEMAND CURVE ON THE EQUILIBRIUM PRICE OF COPPER
 WHAT IF THE SUPPLY CURVE SHIFTS

• Increase in Supply
• Represented by a rightward or downward shift in the
supply curve
• Result of a change that makes sellers willing to offer a
larger quantity of a good at the current price and/or to
offer the current quantity at a lower price
• Will create a surplus and cause the equilibrium price to
decrease
 WHAT IF THE SUPPLY CURVE SHIFTS

• Decrease in Supply
• Represented by a leftward or upward shift in the supply
curve
• Result of a change that makes sellers willing to offer a
smaller quantity of a good at the current price and/or to
offer the current quantity at a higher price
• Will create a shortage and cause the equilibrium price to
increase
EFFECTS OF LEFTWARD AND RIGHTWARD SHIFTS OF THE
SUPPLY CURVE ON THE EQUILIBRIUM PRICE OF COPPER
 EXERCISE

• The following events occur one at a time:

(i) The price of crude oil rises.
(ii) The price of a car rises.
(iii) All speed limits on highways are abolished.
(iv) Robots cut car production costs.
Which of these events will increase or decrease
a. The demand for gasoline?
b. The supply of gasoline?
c. The quantity of gasoline demanded?
d. The quantity of gasoline supplied?
 EXERCISE

• Oil soars to new record over $135

The price of oil hit a record high above $135 a barrel on
Thursday—more than twice what it cost a year ago ...
OPEC has so far blamed price rises on speculators and
says there is no shortage of oil (BBC News, May 22,
2008)
a. Explain how the price of oil can rise even though there is no shortage
of oil.
b. If OPEC is correct, what factors might have changed demand and/or
supply and shifted the demand curve and/or the supply curve to cause
the price to rise?
LIFE DURING A MARKET MOVEMENT