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Fundamental
Economic Concepts
Chapter 2
Fundamental Economic Concepts
 Demand, Supply, and Equilibrium Review
 Total, Average, and Marginal Analysis
 Finding the Optimum Point
 Present Value, Discounting & Net Present
Value
 Risk and Expected Value
 Probability Distributions
 Standard Deviation & Coefficient of Variation
 Normal Distributions and using the z-value
 The Relationship Between Risk & Return
Law of Demand
 A decrease in the price of a good, all other
things held constant, will cause an increase in
the quantity demanded of the good.
 An increase in the price of a good, all other
things held constant, will cause a decrease in
the quantity demanded of the good.
Change in Quantity Demanded
Price
An increase in price
causes a decrease in
quantity demanded.
P1
P0
Q1
Q0
Quantity
Change in Quantity Demanded
Price
A decrease in price
causes an increase in
quantity demanded.
P0
P1
Q0
Q1
Quantity
Demand Curves
 Individual Demand
Curve the greatest
quantity of a good
demanded at each
price the consumers
are willing to buy,
holding other
influences constant
$/Q
$5
20
Q /time unit
Sam
+
Diane
=
Market
 The Market
Demand Curve is
the horizontal sum
of the individual
demand curves.
4
3
7
 The Demand
Function includes Q = f( P, Ps, Pc, Y, N PE)
- +
? + +
all variables that
influence the
P is price of the good
S is the price of substitute goods
P
quantity demanded C
P is the price of complementary goods
Y is income, N is population,
PE is the expected future price
Determinants of the
Quantity Demanded
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
xi.
x.
price, P
price of substitute goods, Ps
price of complementary goods, Pc
income, Y
advertising, A
advertising by competitors, Ac
size of population, N,
expected future prices, Pe
adjustment time period, Ta
taxes or subsidies, T/S
 The list of
variables that
could likely affect
the quantity
demand varies
for different
industries and
products.
 The ones on the
left are tend to
be significant.
Change in Demand
An increase in demand refers
to a rightward shift in the
market demand curve.
Price
P0
Q0
Q1
Quantity
Change in Demand
A decrease in demand refers to
a leftward shift in the market
demand curve.
Price
P0
Q1
Q0
Quantity
Figure 2.3 Shifts in Demand
Law of Supply
 A decrease in the price of a good, all other
things held constant, will cause a decrease in
the quantity supplied of the good.
 An increase in the price of a good, all other
things held constant, will cause an increase in
the quantity supplied of the good.
Change in Quantity Supplied
A decrease in price
causes a decrease in
quantity supplied.
Price
P0
P1
Q1
Q0
Quantity
Change in Quantity Supplied
An increase in price
causes an increase in
quantity supplied.
Price
P1
P0
Q0
Q1
Quantity
Supply Curves
 Firm Supply Curve -
the greatest quantity
of a good supplied at
each price the firm is
profitably able to
supply, holding other
things constant.
$/Q
Q/time unit
 The Market
Supply Curve is
the horizontal sum
of the firm supply
curves.
 The Supply
Function includes
all variables that
influence the
quantity supplied
Acme Inc. + Universal Ltd. = Market
4
3
7
Q = g( P, PI, RC, T, T/S)
+
-
-
+
?
Determinants of the Supply Function
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
price, P
input prices, PI, e.g., sheet metal
Price of unused substitute inputs, PUI, such as fiberglass
technological improvements, T
entry or exit of other auto sellers, EE
Accidental supply interruptions from fires, floods, etc., F
Costs of regulatory compliance, RC
Expected future changes in price, PE
Adjustment time period, TA
taxes or subsidies, T/S
Note: Anything that shifts supply can be included and varies for
different industries or products.
Change in Supply
An increase in supply refers to a
rightward shift in the market
supply curve.
Price
P0
Q0
Q1
Quantity
Change in Supply
A decrease in supply refers to a
leftward shift in the market
supply curve.
Price
P0
Q1
Q0
Quantity
Market Equilibrium
 Market equilibrium is determined at
the intersection of the market
demand curve and the market
supply curve.
 The equilibrium price causes
quantity demanded to be equal to
quantity supplied.
Equilibrium: No Tendency to Change
S
 Superimpose
P
demand and supply
Willing
 If No Excess
& Able
Demand and No in crosshatched
Excess Supply . . .
 Then no tendency to
Pe
change at the
equilibrium price, Pe
D
Q
Dynamics of Supply and Demand
 If quantity demanded is greater than quantity
supplied at a price, prices tend to rise.
 The larger is the difference between quantity
supplied and demanded at a price, the greater is
the pressure for prices to change.
 When the quantity demanded and supplied at a
price are equal at a price, prices have no
tendency to change.
Equilibrium Price Movements
 Suppose there is an
P
S
P1
e1
D
Q
increase in income
this year and
assume the good is
a “normal” good
 Does Demand or
Supply Shift?
 Suppose wages
rose, what then?
Comparative Statics
& the supply-demand model
P
 Suppose that
e2
e1
S
D’
D
Q
demand Shifts to
D’ later this fall…
 We expect prices
to rise
 We expect
quantity to rise
as well
Market Equilibrium
Price
D0
D1
S0
An increase in demand will
cause the market
equilibrium price and
quantity to increase.
P1
P0
Q0
Q1
Quantity
Market Equilibrium
Price
D1
D0
S0
A decrease in demand will
cause the market
equilibrium price and
quantity to decrease.
P0
P1
Q1
Q0
Quantity
Market Equilibrium
Price
D0
S0
P0
S1
An increase in
supply will
cause the
market
equilibrium
price to
decrease and
quantity to
increase.
P1
Q0
Q1
Quantity
Market Equilibrium
Price
D0
S1
P1
S0
A decrease in
supply will
cause the
market
equilibrium
price to
increase and
quantity to
decrease.
P0
Q1
Q0
Quantity
Break Decisions Into Smaller Units:
How Much to Produce ?
 Graph of output and
profit
GLOBAL
MAX
profit
 Possible Rule:


Expand output until
profits turn down
But problem of
local maxima vs.
global maximum
MAX
A
quantity B
Average Profit = Profit / Q
PROFITS
 Slope of ray from the origin
MAX


C
Rise / Run
Profit / Q = average profit
 Maximizing average profit
doesn’t maximize total
profit
B
profits
Q
quantity
Marginal Profits = /Q
 Q1 is breakeven (zero profit)
 maximum marginal profits occur at the
inflection point (Q2)
 Max average profit at Q3
 Max total profit at Q4 where marginal
profit is zero
 So the best place to produce is where
marginal profits = 0.
FIGURE 2.8 Total, Average, and
Marginal Profit Functions
Present Value
 Present
value recognizes that a dollar received
in the future is worth less than a dollar in hand
today.
 To compare monies in the future with today,
the future dollars must be discounted by a
present value interest factor, PVIF=1/(1+i),
where i is the interest compensation for
postponing receiving cash one period.
 For dollars received in n periods, the discount
factor is PVIFn =[1/(1+i)]n
Net Present Value (NPV)

Most business decisions are long term




capital budgeting, product assortment, etc.
Objective: Maximize the present value of profits
NPV = PV of future returns - Initial Outlay
NPV = t=0 NCFt / ( 1 + rt )t

where NCFt is the net cash flow in period t
 NPV Rule: Do all projects that have positive net
present values. By doing this, the manager maximizes
shareholder wealth.
 Good projects tend to have:
1.
2.
3.
high expected future net cash flows
low initial outlays
low rates of discount
Sources of Positive NPVs
Brand preferences 5.
for established
brands
6.
2. Ownership control
over distribution
7.
3. Patent control over
products or
techniques
4. Exclusive ownership
over natural
resources
1.
Inability of new firms to acquire
factors of production
Superior access to financial
resources
Economies of large scale or
size from either:
a. Capital intensive processes,
or
b. High start up costs
Appendix 2A
Differential Calculus Techniques in
Management
 A function with one decision variable,
X, can be written as Y = f(X)
 The marginal value of Y, with a small
increase of X, is My = Y/X
 For a very small change in X, the
derivative is written:
dY/dX = limit Y/X
X  B
Marginal = Slope = Derivative
 The slope of line C-D
is Y/X
 The marginal at point
C is My is Y/X
 The slope at point C is
the rise (Y) over the
run (X)
 The derivative at point
C is also this slope
D
Y
Y
X
C
X
 Finding the maximum flying range for
the Stealth
Bomber is an optimization problem.
 Calculus teaches that when the first derivative is zero,
the solution is at an optimum.
 The original Stealth Bomber study showed that a
controversial flying V-wing design optimized the
bomber's range, but the original researchers failed to
find that their solution in fact minimized the range.
 It is critical that managers make decision that
maximize, not minimize, profit potential!
Quick Differentiation Review
Name
Function
 Constant Y = c
Derivative
dY/dX = 0
Y=5
dY/dX = 0
dY/dX = c
Y = 5•X
dY/dX = 5
Functions
 A Line
Y = c•X
 Power Y = cXb
Functions
Example
dY/dX = b•c•X b-1 Y = 5•X2
dY/dX = 10•X
Quick Differentiation Review
 Sum of Y = G(X) + H(X)
Functions
example Y = 5•X + 5•X2
 Product of
dY/dX = dG/dX + dH/dX
dY/dX = 5 + 10•X
Y = G(X)•H(X)
Two Functions
dY/dX = (dG/dX)H +
(dH/dX)G
example Y = (5•X)(5•X2 )
dY/dX = 5(5•X2 ) + (10•X)(5•X) = 75•X2
Quick Differentiation Review
 Quotient of Two
Y = G(X) / H(X)
Functions
dY/dX = (dG/dX)•H - (dH/dX)•G
H2
Y = (5•X) / (5•X2) dY/dX = 5(5•X2) -(10•X)(5•X)
(5•X2)2
= -25X2 / 25•X4 = - X-2
 Chain Rule
Y = G [ H(X) ]
dY/dX = (dG/dH)•(dH/dX) Y = (5 + 5•X)2
dY/dX = 2(5 + 5•X)1(5) = 50 + 50•X
Applications of Calculus in
Managerial Economics
 maximization problem: A profit function might
look like an arch, rising to a peak and then declining at even
larger outputs. A firm might sell huge amounts at very low
prices, but discover that profits are low or negative.
 At the maximum, the slope of the profit function is zero. The
first order condition for a maximum is that the derivative at
that point is zero.
 If  = 50·Q - Q2, then d/dQ = 50 - 2·Q, using the rules of
differentiation.
 Hence, Q = 25 will maximize profits where 50 - 2•Q = 0.
More Applications of Calculus
 minimization problem: Cost minimization supposes that
there is a least cost point to produce. An average cost curve
might have a U-shape. At the least cost point, the slope of the
cost function is zero.
 The first order condition for a minimum is that the derivative at
that point is zero.
 If C = 5·Q2 - 60·Q, then dC/dQ = 10·Q - 60.
 Hence, Q = 6 will minimize cost where 10•Q - 60 = 0.
More Examples
 Competitive Firm: Maximize Profits



where  = TR - TC = P•Q - TC(Q)
Use our first order condition:
d/dQ = P - dTC/dQ = 0.
TC a function of Q
Decision Rule: P = MC.
Problem 1
l
Max = 100•Q - Q2
100 -2•Q = 0 implies
Q = 50 and  = 2,500
Problem 2
l
Max= 50 + 5•X2
So, 10•X = 0 implies
Q = 0 and= 50
Second Derivatives and the
Second Order Condition:
One Variable
 If the second derivative is negative, then it’s
a maximum
 If the second derivative is positive, then it’s a
minimum
Problem 1
lMax
= 100•Q -
Problem 2
Q2
100 -2•Q = 0
second derivative is: -2 implies Q
=50 is a MAX
lMax=
50 + 5•X2
10•X = 0
second derivative is: 10 implies Q
= 0 is a MIN
Partial Differentiation
 Economic relationships usually involve several
independent variables.
 A partial derivative is like a controlled
experiment -- it holds the “other” variables
constant
 Suppose price is increased, holding the
disposable income of the economy constant
as in Q = f (P, I ), then Q/P holds income
constant.
Example
 Sales are a function of advertising in
newspapers and magazines ( X, Y)
 Max S = 200X + 100Y -10X2 -20Y2 +20XY
 Differentiate with respect to X and Y and set
equal to zero.
S/X = 200 - 20X + 20Y= 0
S/Y = 100 - 40Y + 20X = 0
 solve for X & Y and Sales
Solution: 2 equations & 2 unknowns
 200 - 20X + 20Y= 0
 100 - 40Y + 20X = 0
 Adding them, the -20X and +20X cancel, so
we get 300 - 20Y = 0, or Y =15
 Plug into one of them:
200 - 20X + 300 = 0, hence X = 25
 To find Sales, plug into equation:
S = 200X + 100Y -10X2 -20Y2 +20XY = 3,250
 Most decisions involve a gamble
 Probabilities can be known or unknown, and
outcomes possibilities can be known or unknown
 Risk -- exists when:
Possible outcomes and probabilities are known
Examples: Roulette Wheel or Dice
 We generally know the probabilities
 We generally know the payouts

Uncertainty if probabilities and/or payouts are unknown
Concepts of Risk
 When probabilities are known, we can analyze risk
using probability distributions

Assign a probability to each state of nature, and be
exhaustive, so that pi
Strategy
States of Nature
Recession
p = .30
Expand Plant
Don’t Expand
=1
- 40
- 10
Economic Boom
p = .70
100
50
Payoff Matrix
 Payoff Matrix shows payoffs for each state of nature,
for each strategy
 Expected Value =
r = ri
pi
_
 r = ri pi = (-40)(.30) + (100)(.70) = 58 if Expand
_
 r = ri pi = (-10)(.30) + (50)(.70) = 32 if Don’t
Expand
 Standard Deviation = =
  (r
i
-
r )- 2. pi
Example of
Finding Standard Deviations
expand = SQRT{ (-40 - 58)2(.3) + (100-58)2(.7)}
= SQRT{(-98)2(.3)+(42)2 (.7)}
= SQRT{ 4116} = 64.16
don’t = SQRT{(-10 - 32)2 (.3)+(50 - 32)2 (.7)}
= SQRT{(-42)2 (.3)+(18)2 (.7) }
= SQRT{ 756 } = 27.50
Expanding has a greater standard deviation (64.16),
but also has the higher expected return (58).
FIGURE 2.9 A Sample Illustration of Areas
under the Normal Probability Distribution
Curve
Coefficients of Variation
or Relative Risk
 Coefficient of Variation (C.V.) =

/ r.
_
C.V. is a measure of risk per dollar of expected return.
 Project T has a large standard deviation of $20,000
and expected value of $100,000.
 Project S has a smaller standard deviation of $2,000
and an expected value of $4,000.
 CVT = 20,000/100,000 = .2
 CVS = 2,000/4,000 = .5

Project T is relatively less risky.
Projects of Different Sizes:
If double the size, the C.V. is not changed!!!
Coefficient of Variation is good for comparing
projects of different sizes
Example of Two Gambles
A:
Prob
.5
.5
X }
10
20
B:
Prob
.5
.5
X
20
40
R = 15
}
 = SQRT{(10-15)2(.5)+(20-15)2(.5)]
}
= SQRT{25} = 5
C.V. = 5 / 15 = .333
}
R = 30
}
 = SQRT{(20-30)2 ((.5)+(40-30)2(.5)]
}
= SQRT{100} = 10
C.V. = 10 / 30 = .333
What Went Wrong at LTCM?
 Long Term Capital Management was a ‘hedge
fund’ run by some top-notch finance experts
(1993-1998)
 LTCM looked for small pricing deviations
between interest rates and derivatives, such as
bond futures.
 They earned 45% returns -- but that may be due
to high risks in their type of arbitrage activity.
 The Russian default in 1998 changed the risk
level of government debt, and LTCM lost $2
billion
Table 2.10 Realized Rates of Returns and Risk
 Which had the highest return? Why?