Download Powerpoint Slides #1

MSU Weekend MBA
Program – April 28, 2012
Marginal Analysis -Chapter 1
Demand – Chapter 2, , pgs 35-45
Elasticities – Chapter 3
Profit Maximization - Ch. 8, pgs 264-265, pgs 277-300
1
I. Marginal Analysis - Definitions


Marginal Benefit – the change in total
benefits arising from a change in the
managerial control variable, Q (OR the
change in total benefits arising from a given
choice).
Marginal Cost – the change in total costs
arising from a change in the managerial
control variable, Q (OR the change in total
costs arising from a given choice).
2
Marginal Analysis for Profit
Maximizing Firm

Note first that firms maximize Economic Profits
not Accounting Profits
Accounting Profits= Total RevenueAccounting Costs
Economic Profits= Total RevenueEconomic Costs
where Economic Costs include opportunity costs
3
Opportunity Cost - Definition
The cost of the explicit and implicit
resources that are foregone when a
decision is made OR the cost of
using resources for a certain
purpose in terms of the benefit given
up by using them in their best
alternative way.
4
Marginal Analysis for Profit
Maximizing Firm
Marginal Benefit of a firm’s decision is the
change in Total Revenue attributable to
that decision.
 Marginal Cost of a firm’s decision is the
change in Economic Costs attributable to
that decision.

5
Example 1: Coffee Shop

Steve Mason works as a lawyer in Chicago and
owns a two-story Brownstone. He currently lives
on the second story of his Brownstone and
leases the first floor out to a travel agency.
Steve makes $60,000 per year as a lawyer, pays
$80,000 per year in mortgage payments on the
Brownstone and leases the first floor for
$100,000 per year.
6
Example 1 (cont.): Coffee Shop

Steve is deciding whether to quit is job and open
a coffee shop on the first floor of his Brownstone
(instead of leasing the space to the travel
agency). Steve expects the coffee shop’s labor
costs to be $40,000 per year and supplies to
cost $50,000 per year. What is the minimum
expected revenue the coffee shop must
generate in order for Steve to quit his job as a
lawyer? What assumptions do you need to
make?
7
Example 2: NBA Finals

Suppose you plan to attend game 7 of the NBA
Finals game at United Center in slightly over a
month – Kevin Durant versus Derrick Rose. You
have purchased a plane ticket for $600, bought
a ticket for $300 and booked a hotel room for
$500. You are standing in the parking lot of the
United Center right before tip-off and someone
offers you $1200 for your ticket. Do you take it?
What does it depend on?
8
United Center – Home of YOUR
Chicago Bulls
Isiah Thomas is here
Michael Jordan is here
Here you are!
9
III. Marginal Analysis and the Time
Value of Money

Often, some of the benefits and costs
associated with a given decision/action
occur in the future.
10
Time Value of Money

What is the Present Value (PV) of $100 in
T years if the interest rate is i?
PV=100/(1+i)T

What is the PV of $100 in T years and
$150 in Z years if the interest rate is i?
PV=100/(1+i)T+150/(1+i)Z
11
Example 3: Skaneateles Bar

Sherwood Inn is a bar on Skaneateles Lake (one of the
Finger Lakes in Upstate New York). The manager of
Sherwood is deciding whether to buy a large tent for the
4th of July (when the town has fireworks over the lake).
The manager would use the tent each 4th of July for a
beer garden and expects the tent to last three years.
The manager also expects that he would be able to
increase the number of drinks sold each July 4th by
2,000. Suppose the price of a drink is $3, the cost of the
ingredients in each drink is $1 and that the manager
would have $1,000 more in labor costs if he has the beer
garden. If the annual interest rate is 10%, what is the
maximum the manager is willing to pay for the tent?
12
Example 4: My Mom

My mom owns a house in the Chicago suburbs which is
currently worth $200,000. If she sells the house, she
would rent another place in the suburbs for $15,000 a
year which she has to pay at the beginning of the year.
Suppose that the expected appreciation on the house is
5% annually. Let the interest rate be 10% annually and
assume my mom is indifferent between living in her
current house or renting (except for the cost issue).
What is the maximum annual maintenance cost on the
house my mom should be willing to pay? If the annual
maintenance cost is greater than this amount, my mom
would choose to rent. Assume the maintenance cost is
paid at the end of the year.
13
Demand analysis - intuition
Marginal Cost/Marginal Benefit analysis of
consumers
If Marginal Benefit > Marginal Cost, buy it
If Marginal Benefit < Marginal Cost, don’t buy it

Marginal Benefit is reflected by what consumer is
willing to pay. Marginal Cost is price of item.
Individual’s Demand for Gasoline’s
(based on individual’s willingness to pay)
Depends on,
 Individual’s Income
 Price of Gasoline
 Prices of Related Goods (automobiles,
bus ticket, etc.)
 Individual’s Tastes/Preferences
 Individual’s expectation of future prices
Market Demand for Gasoline
Obtained by summing all individual
demands.
Depends on,
 All factors that affect individuals’ demands
 Number of Individuals (population)
Graphing Demand
Schedule:
Price
10
9
8
7
6
5
4
3
2
1
0
Quantity
Demanded
0
1
2
3
4
5
6
7
8
9
10
Gasoline Market
10
9
8
7
6
5
4
3
2
1
0
D
0
1
2
3
4
5
6
7
8
9 10
Q=Quantity of Gas
Market Demand for Gasoline
(sum of individual demand curves)
18
Demand for Adam Humphrey’s Visa
Service (based on individuals’ willingness to pay)
Depends on,
 Price of Service
 Individual’s Income
 Price Associated with Doing it at Burger King
 How much does the person really want to go
to China or how big a hassle is it to come
back.
 Number of Individuals going to Chinese
Consulate for visa.
Demand for Adam Humphrey’s Visa Service
Law of Demand

Is the relationship between price and
quantity demanded positive or negative?
Negative (Price and quantity demand
move in opposite directions)

Law of demand
More of a good will be demanded, the
lower its price.
Change in quantity demanded
results from a change in price, all else
equal
 shown as a movement along the demand
curve

Change in demand
results from a change in a factor other
than price
 shown as a shift of the entire demand
curve

Notation
D=Demand
 QD=Quantity Demanded

Example of Change in Demand
due to income change




Income Increases
At every price, do people
want to buy more or less?
For Gasoline, More!
Demand increases
Shifts right
Gasoline Market
12
Price/Gallon of Gas = P

10
8
6
D1
4
2
D0
0
0
1
2
3
4
5
6
7
8
9 10
Quantity of Gas = Q
Normal Good
A good for which demand increases when
income increases
 Examples:
Premium Beers and wine
Disneyland
Gasoline
Lego Robotic
Income Increases for an Inferior Good
Inferior goods are goods where
demand decreases when income
increases.
 Examples:
Pabst Blue Ribbon Beer
Certain Products at Wal-Mart
Generic Diapers
Income Increases for an Inferior Good
Income
Increases
 At every price,
do people want
to buy more or
less?
 Less!
 Demand
decreases
 Shifts left

P
D1
D0
Q
Change in demand due to change in
the price of a related good
 Substitutes
Two goods that satisfy similar needs
or desires
 Examples:
Diet Pepsi and Diet Coke
Strawberries and Raspberries
Gasoline and Manual Lawn Mowers
Change in demand due to change in the price
of a related good: Substitutes



Price of a
substitute good
decreases
Demand
Decreases
Shifts Left
P
D1
D0
Q
Change in demand due to change in the price
of a related good: Substitutes

What happens if the price of a substitute
increases?
Demand Increases/Shifts Right
Change in demand due to change in
the price of a related good:

Complements
Two goods that are used jointly in
consumption.

Examples:
Tires and Gasoline
Tires and Automobiles
Beer and Pizza
Change in demand due to change in the price
of a related good: Complements



Price of a
complementary
good decreases
Demand
Increases
Shifts right
P
D1
D0
Q
Change in demand due to change in the price
of a related good: Complements

What happens if the price of a complement
increases?
Demand decreases/Shifts left
Change in demand due to...
Tastes
Consumer Report indicates that Lexus SUV
rolls and is unsafe.
 Population
Out migration from Michigan
 Expectation of Future Prices
Fill up gas tank before Memorial Weekend

Change in demand
results from a change in a factor other
than price
 shown as a shift of the entire demand
curve
 change in anything other than price

Demand = Willingness to Pay
Gasoline Market
10
9
8
7
P= 6
5
4
3
2
1
0
Consumer Surplus
(The value
consumers get from a
good but do not have
to pay for.)
D
0
1
2
3
4
5
6
7
8
9 10
Q=Quantity of Gas
Types of Elasticities
1.
2.
3.
Own Price Elasticity of Demand
Income Elasticity of Demand
Cross Price Elasticity of
Demand
Own Price Elasticity of Demand
Defined
How sensitive quantity demanded is to
price
 More formally:

D
% DQ XD

% DPX
Where D means “change”
Example
What is the own price elasticity of demand
for cigarettes?
 -0.4
 Interpret this number:
 A 1% increase in the price of cigarettes
will lower the quantity demanded by 0.4 %

Example

If the government wanted to decrease smoking
by 10 percent, by how much would the
government have to increase the price of
tobacco?
% DQ

% DP
D
 .10
 0.4 
%DP
 .10 = .25 = 25%
%DP 
 0.4
What determines relative price
elasticity?









Number of substitutes
The more substitutes or the closer the substitutes, the…
Ex. Diet Coke
more elastic
Time interval
The longer time interval the…
Ex. Gasoline
more elastic
Share of budget
The larger share of the budget the …
more elastic
Ex. Salt
Own Price Elasticity of Demand

1.
2.
Why do we care?
Tells us what affect a D in P will have on
revenue
Tells us what affect a D in P will have on
Q (ex: taxes)
Own Price Elasticity of Demand
D
% DQ XD

% DPX
What sign does it have?
 Negative, Why?
 Law of Demand

Calculating Own Price Elasticity of Demand
At a single point, small changes in P and Q
DQ
%DQ
D 
%DPX
D
X

DP
P

Q
P
Q  DQ * P DQ

*
Q DP
DP
DP Q
D
D
D
P
D
DQ
D
D
P ($/Q)
P

D
D
Q
P
1

*
slope
Q slope
D
D
12 A
11
10
9
8
7
6
5
4
3
2
1
0
0
B
C
D
E
F
G
1
2
3
Q
4
5
6
Own Price Elasticity and demand


The equation for
the demand curve
below is P = 12-2Q
The slope of the
demand curve is -2
P ($/Q)
along a linear demand curve
12
11
10
9
8
7
6
5
4
3
2
1
0
A
B
C
D
E
F
G
0 1 2 3 4 5 6
Q
Calculating Own Price Elasticity of
P
Demand @ B
 
Q
0
1
2
3
4
5
6
P
d
12 -∞
10 -5
-2
8
-1
6
4 -1/2
2 -1/5
0
0
P ($/Q)
Point
A
B
C
D
E
F
G
D
P 1  10 1 =-5
 D (point B) 
Q slope 1  2
1
Q slope
12 A
11
B
10
9
C
8
7
D
6
5
E
4
F
3
2
G
1
0
0 1 2 3 4 5 6
Q
Own Price Elasticity of Demand
%DQ

 d <-1 (further from 0) is Elastic
%DP
D
% change in QD > % change in P

d>-1 (closer to 0) is Inelastic
% change in QD < % change in P
Calculating Own Price Elasticity of
P 1
 
Demand
Q slope
D
Q
0
1
2
3
4
5
6
P
12
10
8
6
4
2
0
d

-
-5
-2
-1
-½
-1/5
0
P ($/Q)
Point
A
B
C
D
E
F
G
d<-1: Elastic
12 A
11
B
10
9
C
d>-1:
8
7
D Inelastic
6
5
E
4
F
3
2
G
1
0
0 1 2 3 4 5 6
Q
Extremes
Perfectly Inelastic
 completely unresponsive to changes in
price

P
D
Ex. Insulin
5
4
Q
5
Extremes
Perfectly Elastic
 completely responsive to changes in
price

Ex. Farmer Joe’s Corn
P
5
D
4
Q
5
Elasticity and Total Revenue
 Total
revenue is
 the amount received by sellers of a good.
 Computed as:
TR = P X Q
Intuition Check

If an item goes on sale (lower price), what
will happen to the total revenue on that
item?
Elasticity and Total Revenue
 Marginal
Revenue is
 the additional revenue from selling one
more of a good.
 Computed as:
MR = DTR/DQ
B
C
D
E
F
3
4
5
6
6
2
5
1
4
G
2
3
Q
1
0
-1
-2
-3
-4
-5
-6
-7
-8
-9
-10
-11
-12
-13
-14
-15
-16
-17
-18
-19
-20
-21
-22
1
P d TR
12 -∞
10 -5
8
-2
6
-1
4 -1/2
2 -1/5
0
0
0
Q
0
1
2
3
4
5
6
P ($/Q)
Pt
A
B
C
D
E
F
G
Elasticity
Own Price Elasticity of
Demand
12 A
11
10
9
8
7
6
5
4
3
2
1
0
0
Q
4
4
-1/2
F
5
2
-1/5
10
G
6
0
0
0
10
2
-2
-6
-10
G
1
2
3
4
5
6
6
E
18
16
1
F
5
-1
B
E
4
6
12
D
Q
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
3
3
0
C
2
D
A
B
1
8
P
0
2
Q
P ($/Q)
C
d TR MR
0
-∞
10
10
-5
6
16
-2
Pt
TR=TE
Own Price Elasticity of
Demand
12 A
11
10
9
8
7
6
5
4
3
2
1
0
0
Q
Income Elasticity of Demand
Defined
How sensitive quantity demanded is to
income
 More formally:
D
%DQX
M 
%DM

Where M means “income”
Interpreting Income Elasticity
%DQ
M 
%DM
D
X



Suppose Income
elasticity is 2
A 1 percent increase
in income leads to a...
2 percent increase in
quantity demanded
Sign of Income Elasticity
Ex. Great
Positive
 Normal Good Harvest Bread
 Negative
M
 Inferior Good


Ex. Spam
%DQ

%DM
D
X
Cross-price Elasticity of
Demand Defined
How sensitive quantity demanded of X is
to a change in the price of Y
 More formally:
%DQXD
 XY 
%DPY

Where PY means “price of Y”
Sign of Cross Price Elasticity
Positive
Ex. Accord and Taurus ,
 substitutes Diet Coke and Diet Pepsi
 XY
 Negative
 complements
Ex. Pizza and Beer,

gasoline and SUVs,
software and hardware
%DQ

%DPY
D
X
Words of Caution

There are many complicated issues
associated with estimating elasticities. To
accurately estimate these elasticities, one
needs detailed knowledge of the
product/industry, sophisticated statistical
techniques, reasonable variation in
prices/quantities and precise data.
Costs and Profit Maximization
assuming:
1.
2.
Firm must charge every consumer the
same price (i.e., no price discrimination)
No Strategic Interaction among Firms
Think Monopoly 
Firm’sQ Costs
FC
VC
0
100
0
TC
AFC
AVC
100
-
-
Fixed costs do not
vary with output
1
ATC
MC
(150-100)/1= 50
100
50
150
100
50
Variable costs increase by 50 from 0 to 1 unit
of output and increases by 30 from 1 to 2
2
100
80
180
50
40
units.
150
30
90
20
Average Fixed Costs (AFC) = Average Variable Costs (AVC)
3
33.3
33.33
66.7 so at an
Costs/Q
Fixed Costs/Q
so100at an100
output200 = Variable
output of 2, AVC=80/2=40.
of 2, AFC=100/2=50.
10
4
5
100
110
210
25
27.5
52.5
Average Total Costs (ATC) = Total
Costs/Q so at an output of 2,
ATC=180/2=90
100
130
230 or AFC+ATC.
20
26
46
20
64
Costs Q
FC
VC
TC
AFC
AVC
ATC
5
100
130
230
20
26
46
MC
30
6
100
160
260
16.7
26.67
43.3
40
7
100
200
300
14.3
28.57
42.9
50
8
100
250
350
12.5
31.25
43.8
60
9
100
310
410
11.1
34.44
45.6
70
10
100
380
480
10
38
48
65
What output maximizes profits if the marginal revenue (MR)
for each unit the firm sells is $55? What are these profits?
8
MC
55*8-43.75*8=90
50
150.00
100
30
90.00
20
33.33
33.33
66.67
10
5
6
25.00
20.00
16.67
27.50
26.00
26.67
46.00
20
50
30
40
43.33
40
7
8
9
14.29
12.50
11.11
28.57
31.25
34.44
10.00
38.00
ATC
AVC
30
20
42.86
50
10
60
0
43.75
AFC
45.56
70
10
MC
70
60
52.50
$/Q
4
80
48.00
Q
10
3
90
9
40.00
8
50.00
7
2
2
50.00
1
100.00
0
1
6
ATC
-
5
AVC
-
4
AFC
-
3
Q
0
What output maximizes profits if the marginal revenue for
each unit the firm sells is $35? What are these profits?
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
7
8
16.67
14.29
12.50
26.67
28.57
31.25
11.11
34.44
10.00
38.00
10
50
0
42.86
43.75
45.56
48.00
30
40
70
10
AVC
20
43.33
60
9
40
AFC
Q
Produce an output of 6 in shortrun if fixed costs are sunk.
10
27.50
ATC
50
9
25.00
$/Q
10
4
MC
8
33.33
30
7
33.33
40.00
90
150.00
6
3
50.00
50.00
35*6-43.33*6=-50
5
2
100.00
100
4
1
6
MC
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
What output maximizes profits if the marginal revenue for
each unit the firm sells is $25? What are these profits?
MC
50
80
20
70
90.00
66.67
60
52.50
20
5
20.00
26.00
46.00
30
6
7
8
16.67
14.29
12.50
26.67
28.57
31.25
11.11
34.44
10.00
38.00
10
50
0
42.86
43.75
45.56
48.00
30
40
70
10
AVC
20
43.33
60
9
40
AFC
Q
Better off producing 0 so
profits=-FC=-100
10
27.50
ATC
50
9
25.00
$/Q
10
4
MC
8
33.33
30
7
33.33
40.00
90
150.00
6
3
50.00
50.00
25*5-46*5=-105
5
2
100.00
5?
4
1
100
3
ATC
-
2
AVC
-
1
AFC
-
0
Q
0
Short-Run Profit Maximizing Rule
 Produce
at an Output where
Marginal Revenue = Marginal Cost
(MR)
(MC)
if Total Revenue > Variable Cost
[When the firm cannot price discriminate, this is
the same thing as saying as long as
Price > AVC (from P*Q > AVC*Q) ]
Monopoly Characteristics
1.
2.
3.
There is a single seller
There are no close substitutes
for the good
There are extremely high
barriers to entry
Monopolist Marginal Revenue
DTR
(with no price discrimination) MR 
DQ
P
Q TR MR
10
0
+9
1 9
+7
2 16
+5
3 21
+3
4
3
D
2
1
11
10
9
8
7
MR
Note that Marginal Revenue for a given
unit is plotted at the midpoint of that unit.
12
Q
0
6
+1
-1
-3
-5
-7
-9
5
0
5
4
10
6
3
0
7
2
24
25
24
21
16
9
8
1
2
1
4
5
6
7
8
9
5
4
3
9
0
0
9
8
7
6
10
Monopoly



If the firm’s goal were to
maximize total revenue,
where would it produce?
P=$5; D=-1; TR=$25
The elastic and inelastic
portions of the demand
curve are labeled. How do
these relate to MR?
10
Elastic
9
8
7
6
5
Inelastic
4
3
D
2
1

MR
12
11
10
9
8
7
6
5
4
3
2
Q
1

Elastic: MR>0
0
Inelastic: MR<0
Will a monopolist ever produce
on the inelastic portion of the
demand curve? No.
0

4
4
-1/2
F
5
2
-1/5
10
G
6
0
0
0
10
2
-2
-6
-10
G
1
2
3
4
5
6
6
E
18
16
1
F
5
-1
B
E
4
6
12
D
Q
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
3
3
0
C
2
D
A
B
1
8
P
0
2
Q
P ($/Q)
C
d TR MR
0
-∞
10
10
-5
6
16
-2
Pt
TR=TE
Own Price Elasticity of
Demand
12 A
11
10
9
8
7
6
5
4
3
2
1
0
0
Q
Monopoly Maximizing Profits


If the monopolist
maximizes profits, where
would it produce?
At an output where
MR=MC as long as
P>AVC.
10
9
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
4
3
2
0
1
This is at an output of
Q=4 so a price of P=6.
0

Q
MR
Monopoly Maximizing Profits
TR
10
9
Profits
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
3
2
1
0
0
4
At Q=4 and P=6, what
is Total Revenue?
TR=P*Q=6*4=24
 At Q=4, what are Total
Costs?
TC=ATC*Q=4.5*4=18
 At Q=4 and P=6, what
are Profits?
Profits=TR-TC=24-18=6
Or
Profits=P*Q-ATC*Q
=(P-ATC)*Q
=(6-4.5)*4=6

Q
TC
MR
Monopoly Maximizing Profits
Profits
10
MC
9
8
ATC
7
6
AVC
5
4
3
D
2
1
MR
12
11
10
9
8
7
6
5
4
3
2
1
0
0
What is the difference
between these costs
and the costs on the
prior slide? FC are
greater on the costs
depicted to the right.
 If the monopolist
maximizes profits,
where would it
produce?
Q=4 so set P=6.
 Profits would be:
TR-TC=6*4-8*4= -8

Monopolist in Long Run
What should this
monopolist do in the
Long Run assuming
that the monopolist
thinks his costs will not
change and neither will
demand?
Keep producing Q=4 or
change plant size
depending if there is a
plant size that would
result in greater profits.

10
9
Profits
MC
8
7
ATC
6
5
AVC
4
3
2
D
1
12
11
10
9
8
7
6
5
4
3
2
1
0
0
Q
MR
Short Run and Long Run ATCs
Q
Monopolist in Long Run
Profits

What should this
monopolist do in the
Long Run assuming
that the monopolist
thinks his costs will not
change and neither will
demand?
10
MC
9
8
ATC
7
6
AVC
5
4
3
1
MR
12
11
10
9
8
7
6
5
4
3
2
1
0
0
Exit the industry or change
plant size depending if
there is a plant size that
would result in positive
profits given demand
curve.
D
2
Review of Profit Maximization (when setting a single price)
Marginal Revenue from 5th Unit is just the shaded area
below. This area is $11.
20
18
MC
When the MR curve
is linear, the area
under the MR curve
can be obtained by
just taking the MR at
Dthe midpoint of the
quantities – in this
case at 4.5.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
The orange area is the
same as the purple
area.
7
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
Marginal Cost of 5th Unit is just the shaded area below.
This area is $9.
20
18
MC
When the MC curve
is linear, the area
under the MC curve
can be obtained by
taking the MC at
D the midpoint of the
quantities – in this
case at 4.5.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
7
The purple area is the
same as the red area
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
Change in Profits associated with producing
5 Units rather than 4 units.
20
18
MC
Yellow area is
change in profits
associated with
producing 5 units
rather than 4 units.
DThis area is $2.
16
14
ATC
12
$/unit
AVC
10
8
6
4
2
0
0
1
2
3
4
5
6
7
Subtract MC of 5th unit
from MR of 5th unit–
brown area from purple.
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20
Review of Profit Maximization (when setting a single price)
PROFIT MAXIMIZATION
Profits are
maximized at an
output where
MR=MC which is
Q=5. Price is 15
and ATC is 11.2 at
Q=5.
20
18
MC
16
15
14
ATC
12
11.2
$/unit
AVC
10
D
8
Profits are then
15*5-11.2*5=19
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
Q
11
12
13
MR
14
15
16
17
18
19
20