demand supply

63
Basic Economics Basic Economics Principles Principles Demand, Supply, and Demand, Supply, and Market Equilibrium Market Equilibrium By Neelam Tandon By Neelam Tandon

Upload: ankitpatodi11

Post on 18-Nov-2014

648 views

Category:

Documents


3 download

DESCRIPTION

dimand suply

TRANSCRIPT

Page 1: Demand Supply

Basic Economics Principles Basic Economics Principles

Demand, Supply, and Demand, Supply, and Market Equilibrium Market Equilibrium

By Neelam TandonBy Neelam Tandon

Page 2: Demand Supply

Demand and SupplyDemand and Supply

Page 3: Demand Supply

Demand Demand • The amount of a good or service consumers The amount of a good or service consumers

are willing to purchase during a given period are willing to purchase during a given period of time is called quantity demanded.of time is called quantity demanded.

• The six principle variables that influence the The six principle variables that influence the quantity demanded of a good or service are:quantity demanded of a good or service are:

• The price of the good or service, the income The price of the good or service, the income of the consumers, the price of related goods of the consumers, the price of related goods and services, the taste and preference and services, the taste and preference patterns of consumers, the expected price of patterns of consumers, the expected price of the product in future periods and the the product in future periods and the number of consumers in the market ( for number of consumers in the market ( for market demand).market demand).

Page 4: Demand Supply

Generalized demand Generalized demand functionfunction

• Qd = f (P, M, Pr, T, Pe, N)Qd = f (P, M, Pr, T, Pe, N)

• To know the individual effect that To know the individual effect that any one of these six variables has on any one of these six variables has on Qd, we must explain how changing Qd, we must explain how changing that one variable by itself influences that one variable by itself influences Qd. It requires all other variables be Qd. It requires all other variables be held constant.held constant.

Page 5: Demand Supply

Demand functionDemand function

• A table, a graph, or an equation that A table, a graph, or an equation that shows how quantity demanded is related shows how quantity demanded is related to product price, holding constant the five to product price, holding constant the five other variables that influences demand.other variables that influences demand.

• Linear demand function:Linear demand function:

Qd = a+ bP + cM + dPr + eT+ fPeQd = a+ bP + cM + dPr + eT+ fPe

The intercept a shows the value of Qd when The intercept a shows the value of Qd when the variables P, M, Pr , T , Pe are all the variables P, M, Pr , T , Pe are all simultaneously equal to zero.simultaneously equal to zero.

Page 6: Demand Supply

Linear Demand FunctionLinear Demand Function

• QdQd = a+ bP + cM +dPr +eT+fPe = a+ bP + cM +dPr +eT+fPe

• The other parameters, b,c,d,e and f are slope The other parameters, b,c,d,e and f are slope parameters.parameters.

• Slope Parameters- Parameters in a linear Slope Parameters- Parameters in a linear function that measure the effect on the function that measure the effect on the dependent variable (Qd) of changing one of dependent variable (Qd) of changing one of the independent variables (P,M,Pr, T, Pe )while the independent variables (P,M,Pr, T, Pe )while holding rest of these variables constant.holding rest of these variables constant.

Page 7: Demand Supply

Summary Of the Linear Summary Of the Linear Demand FunctionDemand Function

• When the slope parameter of a specific variable When the slope parameter of a specific variable is positive( negative ) in sign, quantity is positive( negative ) in sign, quantity demanded is directly (inversely) related to that demanded is directly (inversely) related to that variable.variable.

• b is negative because the relationship between b is negative because the relationship between price and quantity demanded is inverse.price and quantity demanded is inverse.

• c will be +ve if it is normal good and –ve if the c will be +ve if it is normal good and –ve if the good is inferior. d will +ve for substitute good good is inferior. d will +ve for substitute good and –ve for complement good, e will be +ve for and –ve for complement good, e will be +ve for favourable change and –ve for unfavourable favourable change and –ve for unfavourable change, f will be + always.change, f will be + always.

Page 8: Demand Supply

Example Linear Demand Example Linear Demand EquationEquation

• Qd = 1,800- 20P + 0.6 M – 50 PrQd = 1,800- 20P + 0.6 M – 50 Pr

• Suppose consumer’s income is Rs. Suppose consumer’s income is Rs. 20,000 and the price of related good 20,000 and the price of related good is Rs 250. Find the demand function is Rs 250. Find the demand function and calculate quantity demanded and calculate quantity demanded when price for the good is Rs.50, Rs. when price for the good is Rs.50, Rs. 40 and Rs.30.40 and Rs.30.

Page 9: Demand Supply

SupplySupply• The amount of a good or service offered for sale The amount of a good or service offered for sale

during a given period of time.during a given period of time.

• It depends on : It depends on :

• The price of the good itself.The price of the good itself.

• The price of factor inputs used to produce the The price of factor inputs used to produce the goodgood

• The level of technology.The level of technology.

• The price of goods related in productionThe price of goods related in production

• Expectations of producer concerning the future Expectations of producer concerning the future price of the goodprice of the good

• Number of firms.Number of firms.

Page 10: Demand Supply

SupplySupply Supply Price-The minimum price necessary to Supply Price-The minimum price necessary to induce producers voluntarily to offer a given induce producers voluntarily to offer a given quantity for sale.quantity for sale.

Change in quantity supplied- A movement along a Change in quantity supplied- A movement along a given supply curve that occurs when the price of given supply curve that occurs when the price of the good changes , all else constant.the good changes , all else constant.

Change in supply- A shift in supply curve because Change in supply- A shift in supply curve because of change in other determinants of supply except of change in other determinants of supply except the price of the commodity.the price of the commodity.

Page 11: Demand Supply

Supply ElasticitySupply Elasticity

• The responsiveness of supply to price The responsiveness of supply to price changes.changes.

• ((S/S)/(S/S)/(P/P), proportional change in P/P), proportional change in supply divided by proportional supply divided by proportional change in price.change in price.

• Usually positive.Usually positive.

Page 12: Demand Supply

• How much product should you produce How much product should you produce and what price should you charge for it? and what price should you charge for it?

• How can you best segment your market if How can you best segment your market if there are different types of buyers with there are different types of buyers with different demand characteristics (e.g., different demand characteristics (e.g., business travelers vs. vacation travelers, business travelers vs. vacation travelers, home PC buyers vs. corporate buyers)? home PC buyers vs. corporate buyers)?

• What are the types of pricing schemes What are the types of pricing schemes available (e.g., bundling, promotional available (e.g., bundling, promotional offers, loyalty bonuses, volume offers, loyalty bonuses, volume discounts)?discounts)?

PricingPricing

Page 13: Demand Supply

• Aim: to understand key aspects of Aim: to understand key aspects of markets:markets:

– nature of demands for the productsnature of demands for the products

– closeness or otherwise of competitorscloseness or otherwise of competitors

– structure of costs structure of costs

– dependence of profits on the level of dependence of profits on the level of

outputoutput

Analyzing the Structure of a MarketAnalyzing the Structure of a Market

Page 14: Demand Supply

The Market MechanismThe Market Mechanism

• Characteristics of the equilibrium or Characteristics of the equilibrium or market clearing price:market clearing price:– QQDD = Q = QSS

– No shortageNo shortage– No excess supplyNo excess supply– No pressure on the price to changeNo pressure on the price to change

Page 15: Demand Supply

The Market MechanismThe Market Mechanism

Quantity

D

S

The curves intersect atequilibrium, or market-

clearing, price. At P0 thequantity supplied is equalto the quantity demanded

at Q0 .

P0

Q0

Price(Rs. per unit)

Page 16: Demand Supply

Demand Curve -Income Demand Curve -Income RisesRises

In case of normal goods demand will increase with increase in income

Price

Quantity demanded

Page 17: Demand Supply

Demand ShiftsDemand Shifts

Equilibrium price increases from P1 to P2 with increase in demand while supply remains same.

Price

Quantity demanded

Supply

Initial demand

New demand

Page 18: Demand Supply

Supply shiftsSupply shiftsD

D

S

S1

With increase in supply the equilibrium price decreases and equilibrium quantity increases while demand for the good remains same.

Page 19: Demand Supply

D & S shiftD & S shift

Price

Quantity demanded

Page 20: Demand Supply

SurplusSurplus

D

S

Q1

Assume the price is P1 , then:1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2.3) Producers lower price.4) Quantity supplied decreases

and quantity demanded increases.

5) Equilibrium at P2Q3

P1

Excess Supply

Q2 Quantity

Price(Rs. per unit)

P2

Q3

The Market Mechanism

Page 21: Demand Supply

The Market MechanismThe Market Mechanism

• The market price is above equilibriumThe market price is above equilibrium– There is excess supplyThere is excess supply– Producers lower pricesProducers lower prices– Quantity demanded increases and Quantity demanded increases and

quantity supplied decreasesquantity supplied decreases– The market continues to adjust until the The market continues to adjust until the

equilibrium price is reached.equilibrium price is reached.

Excess Supply Excess Supply

Page 22: Demand Supply

ShortageShortage

D

S

Q1 Q2

P2

Excess Demand

Quantity

Price(Rs. per unit)

Assume the price is P2 , then:1) Qd : Q2 > Qs : Q1

2) Excess Demand is Q1:Q2.3) Producers raise price.

4) Quantity supplied increases and quantity demanded decreases.

5) Equilibrium at P3, Q3

Q3

P3

The Market Mechanism

Page 23: Demand Supply

The Market MechanismThe Market Mechanism

• The market price is below equilibrium:The market price is below equilibrium:– There is a shortageThere is a shortage– Producers raise pricesProducers raise prices– Quantity demanded decreases and Quantity demanded decreases and

quantity supplied increasesquantity supplied increases– The market continues to adjust until the The market continues to adjust until the

new equilibrium price is reached.new equilibrium price is reached.

Excess DemandExcess Demand

Page 24: Demand Supply

The Market MechanismThe Market Mechanism• Market Mechanism - Summary:Market Mechanism - Summary:

1)1) Supply and demand interact to Supply and demand interact to determine the market-clearing price.determine the market-clearing price.

2) When not in equilibrium, the market 2) When not in equilibrium, the market will will adjust to alleviate a shortage or surplus and adjust to alleviate a shortage or surplus and return the market to equilibrium.return the market to equilibrium.

3)3) Markets must be competitive for the Markets must be competitive for the mechanism to be efficient.mechanism to be efficient.

Page 25: Demand Supply

Demand AnalysisDemand Analysis

Page 26: Demand Supply

– Analysis of demand Analysis of demand

•demand curves, demand curves,

•price, income & cross price, income & cross elasticities of demandelasticities of demand

• use of demand use of demand parameters in forecastingparameters in forecasting

Page 27: Demand Supply

Price elasticity of demand:Price elasticity of demand:Measures responsiveness of demand to Measures responsiveness of demand to price.price.

Defined as E = (Defined as E = (Q/Q)/(Q/Q)/(P/P) = P/P) = ((Q/Q/P)*(P/Q)P)*(P/Q)

Why is it defined in proportional terms?Why is it defined in proportional terms?

- Unit free. - Unit free.

- Scale sensitive.- Scale sensitive.

Page 28: Demand Supply

Price

Ed = 0

Price

Quantity Demanded Quantity Demanded

Page 29: Demand Supply

Q = 8 - 2P or P = 4 - 0.5Q

Elasticity = (Elasticity = (Q/Q)/(Q/Q)/(P/P) = (P/P) = (Q/Q/P)*(P/Q) = -P)*(P/Q) = -2*(P/Q)2*(P/Q)

Geometric Method of Calculating Price

Elasticity of Demand

Page 30: Demand Supply

Responsiveness of demand to Responsiveness of demand to changes in incomechanges in income

IED = (IED = (Q/Q)/Q/Q)/I/I) = (I/I) = (Q/Q/I)*(I/Q)I)*(I/Q)

Use to define Use to define necessitiesnecessities and and luxuriesluxuries

Income Elasticity of Income Elasticity of Demand:Demand:

Page 31: Demand Supply

Necessities - IED < 1Necessities - IED < 1

Luxuries - IED > 1Luxuries - IED > 1

Cyclical vs. defensive sectorsCyclical vs. defensive sectors

Cyclical - high IED - foreign travel, Cyclical - high IED - foreign travel, consumer durablesconsumer durables

Defensive - low IED - food, utilitiesDefensive - low IED - food, utilities

Page 32: Demand Supply

The responsiveness of demand for good The responsiveness of demand for good A to change in price of good B:A to change in price of good B:

QQAA/Q/QAA = = QQAA ** P PBB

PPBB/P/PB B PPB B PPAA

Example:Example:

responsiveness of demand for Nokia cell responsiveness of demand for Nokia cell

phone to Motorola cell phone in the phone to Motorola cell phone in the

market.market.

Cross price elasticity of Cross price elasticity of demand:demand:

Page 33: Demand Supply

Cross Price ElasticityCross Price Elasticity

• Cross price elasticity represents whether Cross price elasticity represents whether two goods are substitute or compliment.two goods are substitute or compliment.

• If Ep value is greater than 0, two goods If Ep value is greater than 0, two goods are substitute goods.are substitute goods.

• If Ep value is less than 0 , two goods are If Ep value is less than 0 , two goods are complimentary goods.complimentary goods.

• If Ep value is 0, two goods are If Ep value is 0, two goods are independent goods.independent goods.

Page 34: Demand Supply

Advertising or Promotional Advertising or Promotional Elasticity Of Demand Elasticity Of Demand

• Qd = f (A)Qd = f (A)

• A is advertisement expenditure of the firmA is advertisement expenditure of the firm

• The degree of responsiveness of demand The degree of responsiveness of demand to changes in advertising or promotional to changes in advertising or promotional elasticity of demand is measured;elasticity of demand is measured;

• eA = Percentage change in quantity eA = Percentage change in quantity demanded / percentage change in demanded / percentage change in advertisement expenditureadvertisement expenditure

Page 35: Demand Supply

Arc advertising ElasticityArc advertising Elasticity

• It is used when price- quantity It is used when price- quantity changes are very smallchanges are very small

• eA arc= change in quantity eA arc= change in quantity demanded/ change in advertising demanded/ change in advertising expenditure * Average of advertising expenditure * Average of advertising expenditure / Average of quantity expenditure / Average of quantity demandeddemanded

Page 36: Demand Supply

Critical in understanding oil market, Critical in understanding oil market, energy markets, metal marketsenergy markets, metal markets

Responding to a price movement takes Responding to a price movement takes time - possibly many yearstime - possibly many years

Long-run elasticity measures Long-run elasticity measures totaltotal responseresponseShort-run elasticity measures Short-run elasticity measures immediateimmediate response response

Short-run vs. long-run Short-run vs. long-run elasticitieselasticities

Page 37: Demand Supply

Short-run dropin demand

Long-run drop in demand

Po

P1

Short-rundemand

Long-run demand

Page 38: Demand Supply

Revenue , Elasticity and Revenue , Elasticity and Pricing Pricing • If the demand for the commodity is If the demand for the commodity is

elastic. Total revenue will increase with elastic. Total revenue will increase with decrease in price. decrease in price.

• Total revenue will be maximum when Total revenue will be maximum when demand is unit elastic that will be the demand is unit elastic that will be the optimum price for the producer.optimum price for the producer.

• Total revenue will decrease if the Total revenue will decrease if the demand for the commodity is inelastic demand for the commodity is inelastic even with decrease in price for the good.even with decrease in price for the good.

Page 39: Demand Supply

Marginal RevenueMarginal Revenue

• Increase in revenue from one extra Increase in revenue from one extra salesale

• Rate of change of revenue with Rate of change of revenue with respect to salesrespect to sales

• Typically less than price as demand Typically less than price as demand curve slopes downcurve slopes down

• Depends on PEDDepends on PED

Page 40: Demand Supply

Q = 8 - 2P

or

P = 4 - 0.5Q

so as revenue R is price times quantity

R = 4Q - 0.5Q2

Relationship between Relationship between demand, quantity and demand, quantity and revenue:revenue:

Page 41: Demand Supply

PED = -1 PED = 0

Revenue rises as price rises

Revenue falls as price rises

PED = <1PED=>1

Price

2

Q = 8 - 2P

Page 42: Demand Supply

This is a quadratic pointing up.

The slope of revenue curve is:

R Q

As R= 4Q – 0.5 Q2

MR =4 – 0.5 * 2Q

MR= 4-Q which is zero at Q = 4.

Slope is positive for Q<4 and vice versa.

Maximum revenue comes when Q = 4, therefore P = 2, and max revenue is 8

= 4 - Q

Page 43: Demand Supply

PED when revenue is PED when revenue is maximummaximum

• Revenue is max when Q = 4, P = 2.Revenue is max when Q = 4, P = 2.

• E = (E = (Q/Q)/(Q/Q)/(P/P) = (P/P) = (Q/Q/P)*(P/Q)P)*(P/Q)

• So E = (So E = (Q/Q/P)*(1/2) and P)*(1/2) and

• Q/Q/P = -2 so E = -2 * 1/2 = -1 when P = -2 so E = -2 * 1/2 = -1 when TR is at a maximum. TR is at a maximum.

• PED is price elasticity of demand.PED is price elasticity of demand.

Page 44: Demand Supply

Marginal Revenue & PEDMarginal Revenue & PED• MR = dR/dQMR = dR/dQ• R= P*QR= P*Q• Differentiating both sides of equation with Differentiating both sides of equation with

respect to Q we get – respect to Q we get – • dR/dQ = P* dQ/dQ + Q*dP/dQdR/dQ = P* dQ/dQ + Q*dP/dQ• MR = P + Q*dP/dQMR = P + Q*dP/dQ• MR= P{1 + (Q/P)*dP/dQ}MR= P{1 + (Q/P)*dP/dQ} PED = dQ/dP*P/QPED = dQ/dP*P/Q MR = P{1 - 1/PED} ( IF PED is taken in MR = P{1 - 1/PED} ( IF PED is taken in

absolute terms)absolute terms)• Remember PED < 1 so MR <0. Remember PED < 1 so MR <0. • If PED = 1, then MR = 0. (Top of revenue curve)If PED = 1, then MR = 0. (Top of revenue curve)• If PED <1 , then MR >0.If PED <1 , then MR >0.

Page 45: Demand Supply

Pricing Theater Tickets During Pricing Theater Tickets During Off- Peak Hours Off- Peak Hours

• Suppose you manage a movie theater Suppose you manage a movie theater and want to maximize profits for and want to maximize profits for midweek screenings. Demand is slack midweek screenings. Demand is slack during midweek, and it’s likely to take a during midweek, and it’s likely to take a very low price to fill the theater. As the very low price to fill the theater. As the cost is independent of the number of cost is independent of the number of admissions you sell. Hence you can admissions you sell. Hence you can maximize your profit from the sale of maximize your profit from the sale of tickets when you maximize revenue tickets when you maximize revenue from admissions.from admissions.

Page 46: Demand Supply

Demand and Total RevenueDemand and Total Revenue per per MidweekMidweek

• If the demand for If the demand for admissions to your admissions to your midweek screenings is midweek screenings is linear. Along the linear linear. Along the linear demand curve , each demand curve , each 1 paisa reduction in 1 paisa reduction in ticket prices results in ticket prices results in the sale of two more the sale of two more tickets. The theater’s tickets. The theater’s capacity is 600 capacity is 600 persons.persons.

Price Price (Rs.)(Rs.)

No: of No: of admissionadmissions s demandedemandedd

Total Total revenurevenuee

PEDPED

3.003.00 200200 600600 ElasticElastic

2.502.50 300300 750750 ElasticElastic

2.002.00 400400 800800 Unit Unit ElasticElastic

1.501.50 500500 750750 InelasticInelastic

1.001.00 600600 600600 InelasticInelastic

Page 47: Demand Supply

Elasticity and RevenueElasticity and Revenue

• The demand schedule indicates that if The demand schedule indicates that if you choose a ticket price of Rs. 3, the you choose a ticket price of Rs. 3, the no: of admissions demanded would be no: of admissions demanded would be 200. Total revenue would be Rs. 600 for 200. Total revenue would be Rs. 600 for the evening. Because Rs.3 is relatively the evening. Because Rs.3 is relatively high price , demand for theater high price , demand for theater admissions is elastic at that price. It admissions is elastic at that price. It means if you were to lower price ,total means if you were to lower price ,total revenue would increase. revenue would increase.

Page 48: Demand Supply

• Each paisa reduction in price results in Each paisa reduction in price results in

two more admissions.two more admissions.• Total Revenue will continue to increase Total Revenue will continue to increase

as long as demand remains elastic and as long as demand remains elastic and will begin to decline just at the point at will begin to decline just at the point at which price is reduced to make demand which price is reduced to make demand inelastic.inelastic.

• At a price of Rs 2 , demand is unit At a price of Rs 2 , demand is unit elastic, because if price were reduced elastic, because if price were reduced an additional paisa, to Rs 1.99, an additional paisa, to Rs 1.99, admissions would increase to 402 and admissions would increase to 402 and total revenue would decline to Rs. 750, total revenue would decline to Rs. 750, because demand would be inelastic.because demand would be inelastic.

Page 49: Demand Supply

• The theater could be fill by you if you The theater could be fill by you if you charge Rs.1 for admission but your total charge Rs.1 for admission but your total revenue would be only Rs. 600! revenue would be only Rs. 600!

• To maximize revenue you would choose To maximize revenue you would choose to price your tickets at Rs. 2 and be to price your tickets at Rs. 2 and be content filling only two thirds of your content filling only two thirds of your seating capacity but enjoying Rs. 800 seating capacity but enjoying Rs. 800 revenue for the evening. revenue for the evening.

• Hence if a business wants to maximize Hence if a business wants to maximize revenue, it must choose the price at revenue, it must choose the price at which demand just becomes inelastic. which demand just becomes inelastic. This is the price for which demand is This is the price for which demand is unit elastic. unit elastic.

Page 50: Demand Supply

Marginal Analysis For Optimal Marginal Analysis For Optimal Decisions Decisions

• Making optimal decisions about the Making optimal decisions about the levels of various business activities is levels of various business activities is an essential skill for all managers.an essential skill for all managers.

• It requires managers to analyze It requires managers to analyze benefits and costs to make the best benefits and costs to make the best possible decision under a given set of possible decision under a given set of circumstances.circumstances.

Page 51: Demand Supply

The Analytical TechniqueThe Analytical Technique

• Marginal Analysis forms the foundation of Marginal Analysis forms the foundation of the theories of Profit Maximization, the theories of Profit Maximization, Production, Input- Choice and even Production, Input- Choice and even Consumer Behaviour.Consumer Behaviour.

• It helps to estimate how changing the It helps to estimate how changing the business activity will affect both the business activity will affect both the benefits the firm receives from the activity benefits the firm receives from the activity and costs the firm incurs from engaging in and costs the firm incurs from engaging in the activity.the activity.

Page 52: Demand Supply

ConceptsConcepts

• Objective Function- The function the decision Objective Function- The function the decision maker seeks to maximize or minimize.maker seeks to maximize or minimize.

• Maximization Problem- An optimization problem Maximization Problem- An optimization problem that involves maximizing the Objective Function.that involves maximizing the Objective Function.

• Minimization Problem – An optimization problem Minimization Problem – An optimization problem that involves minimizing the Objective Function.that involves minimizing the Objective Function.

• Activities or choice variables- Variables that Activities or choice variables- Variables that determine the value of the Objective Function. determine the value of the Objective Function.

Page 53: Demand Supply

ConceptsConcepts

• Unconstrained Optimization- An Unconstrained Optimization- An optimization problem in which the decision optimization problem in which the decision maker can choose the level of activity from maker can choose the level of activity from an unrestricted set of values.an unrestricted set of values.

• Constrained Optimization – An optimization Constrained Optimization – An optimization problem in which the decision maker problem in which the decision maker selects values for the choice variables from selects values for the choice variables from a restricted set of values.a restricted set of values.

Page 54: Demand Supply

Optimal Advertising Optimal Advertising ExpendituresExpenditures((An example of Constrained Maximization )An example of Constrained Maximization )• Objective – A manager of small retail firm Objective – A manager of small retail firm

wants to maximize the effectiveness (in total wants to maximize the effectiveness (in total sales) of the firm’s weekly advertising budget sales) of the firm’s weekly advertising budget of Rs 2000.of Rs 2000.

• Choice Variables- He has an option of Choice Variables- He has an option of advertising on the local television station or advertising on the local television station or local FM radio station.local FM radio station.

• Maximization objective – To maximize the Maximization objective – To maximize the number of units sold, thus the total benefits is number of units sold, thus the total benefits is measured by the total number of units sold.measured by the total number of units sold.

Page 55: Demand Supply

Estimates of Increase in Weekly Estimates of Increase in Weekly Sales (MBs) from Increasing Sales (MBs) from Increasing Advertising ExpenditureAdvertising ExpenditureNumber Number of adsof ads

Marginal benefits Marginal benefits from TVfrom TV

Marginal benefits Marginal benefits from Radiofrom Radio

11 400400 360360

22 300300 270270

33 280280 240240

44 260260 225225

55 240240 150150

66 200200 120120

Page 56: Demand Supply

Constraint Advertising Constraint Advertising BudgetBudget• Advertising budget is Rs 2000.Advertising budget is Rs 2000.• If price of ad on TV is Rs 400/ad and on If price of ad on TV is Rs 400/ad and on

radio is Rs. 300/ad.radio is Rs. 300/ad.• The marginal benefit /Rs spent on The marginal benefit /Rs spent on

advertising is the most important thing to advertising is the most important thing to know. It is clear from the schedule TV ads know. It is clear from the schedule TV ads are more powerful than radio ads.are more powerful than radio ads.

• MB(TV) = 400/400 = 1MB(TV) = 400/400 = 1• MB(Radio) = 360/300 = 1.2MB(Radio) = 360/300 = 1.2• MB(Radio) > MB (TV) MB(Radio) > MB (TV)

Page 57: Demand Supply

Allocation of budgetAllocation of budget

• This indicates that sales rise by I unit This indicates that sales rise by I unit per rupee spent on the 1per rupee spent on the 1stst ad and 1.2 ad and 1.2 units on the 1units on the 1stst radio ad. Therefore radio ad. Therefore when the manager is allocating the when the manager is allocating the budget , the first ad she selects will be budget , the first ad she selects will be a radio ad- the activity with the larger a radio ad- the activity with the larger MB per rupee spent. Following the MB per rupee spent. Following the same rule, the Rs. 2000 advertising same rule, the Rs. 2000 advertising budget would be allocated as follows:budget would be allocated as follows:

Page 58: Demand Supply

Budget ScheduleBudget Schedule

DecisionDecision MB/ PriceMB/ Price Ranking of Ranking of MB/PriceMB/Price

Cumulative Cumulative ExpenditureExpenditure

Buy 1st radio Buy 1st radio adad

360/300=1.20360/300=1.20 11 300300

Buy 1st TV adBuy 1st TV ad 400/400=1400/400=1 22 700 =300 +400700 =300 +400

Buy 2nd radio Buy 2nd radio adad

270/300=0.90270/300=0.90 33 1000=700+3001000=700+300

Buy 3rd radio Buy 3rd radio adad

240/300=0.80240/300=0.80 44 1300=1000+301300=1000+3000

Buy 2nd TV adBuy 2nd TV ad 300/400=0.75300/400=0.75 55 1700=1300 + 1700=1300 + 400400

Buy 4th radio Buy 4th radio adad

225/300=0.75225/300=0.75 55 2000=1700+302000=1700+3000

Page 59: Demand Supply

Optimum Allocation Of Optimum Allocation Of BudgetBudget

• By selecting 2 TV ads and 4 Radio By selecting 2 TV ads and 4 Radio ads, the manager of firm has ads, the manager of firm has maximized sales subject to the maximized sales subject to the constraint that only Rs 2000 can be constraint that only Rs 2000 can be spent on advertising activity.spent on advertising activity.

• MB TV/P TV = MB radio/P radio= MB TV/P TV = MB radio/P radio= 0.750.75

Page 60: Demand Supply

Constrained MinimizationConstrained Minimization

• Objective Function- to minimize total Objective Function- to minimize total cost subject to a constraint that the level cost subject to a constraint that the level of activities be chosen such that a given of activities be chosen such that a given level of total benefit is achieved.level of total benefit is achieved.

• A manager has to minimize the total A manager has to minimize the total cost of two activities, A and B, subject to cost of two activities, A and B, subject to the constraint that 3,000 units of the constraint that 3,000 units of benefits to be generated by those benefits to be generated by those activities.activities.

Page 61: Demand Supply

AssumptionsAssumptions

• Price of A/ unit= Rs.5Price of A/ unit= Rs.5

• Price of B / unit = Rs 20Price of B / unit = Rs 20

• If a manager uses 100 units of A and If a manager uses 100 units of A and 60 units of B his total benefit is 3,000 60 units of B his total benefit is 3,000 units.units.

• If MB of last unit of A = 30 and MB of If MB of last unit of A = 30 and MB of last unit of B = 60.last unit of B = 60.

Page 62: Demand Supply

Minimize Total CostMinimize Total Cost

• To choose the level of each activity so To choose the level of each activity so that marginal benefit per rupee spent is that marginal benefit per rupee spent is equal for all activities.equal for all activities.

• MBA/PA = MBB/PB= MBC/PC = ----MBA/PA = MBB/PB= MBC/PC = ----

• MBA/Rupee spent on activity A =30/5= 6MBA/Rupee spent on activity A =30/5= 6

• MBB/Rupee spent on activity B = MBB/Rupee spent on activity B = 60/20=360/20=3

• MBA/PA > MBB/PBMBA/PA > MBB/PB

Page 63: Demand Supply

• Hence manager will substitute B for A. One Hence manager will substitute B for A. One less unit of B means total benefit (TB) to less unit of B means total benefit (TB) to decrease by units reducing cost by Rs 20.decrease by units reducing cost by Rs 20.

• To keep TB constant, 60 units of lost benefit To keep TB constant, 60 units of lost benefit can be made by increasing activity A by 2 can be made by increasing activity A by 2 units with a MB of 30 each. Two additional units with a MB of 30 each. Two additional units of A will increase the cost by Rs 10 (Rs5* units of A will increase the cost by Rs 10 (Rs5* 2units).2units).

• Total cost reduces by Rs 10 (Rs20(B)-Rs10(A))Total cost reduces by Rs 10 (Rs20(B)-Rs10(A))

• As long as MBA/PA > MBB/PB, the manager As long as MBA/PA > MBB/PB, the manager will continue to increase activity A and will continue to increase activity A and decrease activity B at the rate that holds TB decrease activity B at the rate that holds TB constant until MBA/ PA = MBB/PB constant until MBA/ PA = MBB/PB