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Managerial Economics ©Oxford University Press, 2006 All rights reserved
Chapter 1
Foundations of Managerial
Economics
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What is Economics?
•What to produce
•How to produce
•How to distribute
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Definition, scope and functions
Microeconomics Macroeconomics Decision Sciences
Managerial Economics
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The BIG Picture
Product
Market
FirmsHouseholds
Factor
Market
Income spent
Goods demand
Inputs supplied
Income earned
Inputs demand
Factor costs
Goods supplied
R
e
v
e
n
u
e
Revenue earned
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Objective of the Firm• Profit maximization
- economic profit:
total revenue minus total economic
costs
- economic costs are “relevant” costs
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Invisible Hand
Furthering selfish interest
Furthers growth of the Nation
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Problems in Managerial
EconomicsClassified into two broad categories:
• Those requiring „optimal‟ solutions
- Total, Average and Marginal
magnitudes
• Those requiring equilibrium solutions
- Supply – Demand Analysis
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Graphical Solution to Supply- demand
Analysis
P
Q
D
DS
S
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Algebraic Solution
P = 300 – Qd P = 60 + 2Qs
a = 300; b = 1; c = 60; d = 2
300 – Q = 60 + 2Q
Q* = 80 P* = 220
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Total, Average, and Marginal
magnitudesQ P TR MR Q P TR MR
(=AR)
0 10 0 - 6 4 24 -11 9 9 9 7 3 21 -3
2 8 16 7 8 2 16 - 5
3 7 21 5 9 1 9 -7
4 6 24 3
5 5 25 1
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Relation between Total, Average
and Marginal Magnitudes• When Total is rising, Marginal is positive
• When Total is falling, Marginal is negative
• When Total is maximum, Marginal is zero
• When Average falls/rises, Marginal
falls/rises at a faster rate
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Concept of Margin
• Rate of Change
• Derivative- Calculus
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Chapter 2
Household as a Consumer
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The decision making process of
the consumer
Preference set Constraints
Optimal decision
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Assumptions
• Completeness
• Transitivity
• Non satiation
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Utility and Optimization
• Utility:
- reflects a rank ordering of preferences.
- is a magnitude indicating the direction of
preferences
• Optimization:
- Cardinal Approach and OrdinalApproach
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Optimization
The Cardinal Approach• Utility is cardinally measurable and the
objective is to maximize utility
• The Law of Diminishing Marginal Utility
• Optimization Rule 1:
When only one good is consumed and is
available for free, consume till
MUx = 0
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Optimization
• Optimization Rule 2:
When only one good is consumed and is
available for a price:Consume till MUx = Pricex
• Optimization Rule 3:When more than onegood is consumed and the goods‟ prices are
different:
Consume till MUx /Px = MUy /Py = MUz /Pz
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Optimization- The Ordinal approach
• Rank ordering of preferences
• Combinations of goods
Two inputs required to arrive at optimal
combination:
1. Preference set2. Opportunity set
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Preference Set- Indifference
Curves• Indifference Curve:
Combination of goods that yield the same level
of satisfaction.• Properties of Indifference curves:
- Slope downward
- Convex to the origin- Non intersecting
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Shapes of Indifference curves
MRS decreasing MRS Constant=1 One fixed proportion
Normal substitutes perfect substitutes Complements
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Opportunity Set
• Defined by Budget Constraint.
6x + 3y = 60
Given Px = 6 and Py = 3
Graphically,
-Px /Py is the Slope
10
Y
20
X
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Consumer’s Equilibrium- The
Optimal Combination
e
x
y
At „e‟ slope of the budget line is equal to the slope
of the Indifference curve.
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Consumer’s Equilibrium
• Slope of the budget line: - Px /Py
• Slope of Indifference curve: MUx/MUy
• Equilibrium : MUx/MUy = Px /Py
or MUx/Px = MUy/Py
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Chapter 3
Comparative Statics and Demand
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Meaning of “comparative statics”
• The analysis which enables us to arrive at new
optimal decisions when underlying assumptions
change
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Changes in equilibrium when prices
change• Relative price changes get reflected in changes in
slope of the budget line.
• New point of tangency between the indifference
curve and the new budget line
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Changes in equilibrium
• Joining all these points of tangency gives the
Price Consumption Curve. (PCC)
X
Y
PCC
Price of X is falling.
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Derivation of the demand curve
• Data contained in the PCC:
- Optimal level of consumption of X
- Optimal level of consumption of Y- Prices of X and Y
• Demand curve for X requires –
- Price of X.- Quantity consumed of X.
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Demand Curve
• Every point on the PCC gives the price of X and
quantity demanded/consumed of X
Thus,
Qx
Px
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Shifts in and movements along a
Demand Curve
• Effect on demand of changes in its own price
results in movement along the demand curve.
• Effect on demand of changes in other factors
results in shifts in demand curve
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Changes in equilibrium when
income changes• Income changes show up as parallel shifts of the
budget line
• New points of tangency between indifference
curves and the new budget lines
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Changes in equilibrium
• Joining all these points of tangency gives
the Income Consumption Curve (ICC)
X
Y
ICC
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Slope of the ICC
• If the goods are „Superior‟, the ICC is
upward sloping
• If one of the goods is „Inferior‟, the ICC
is downward sloping
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Slope of the PCC
• If the goods are normal, PCC is upward
sloping
• If PCC is downward sloping, then one of them
is a Giffen Good
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Giffen good
Income effect
• Price effect +
Substitution effect• Substitution effect is inversely related to price.
• Income effect can be inversely related to
changes in income – Inferior Good• Income effect can be positively related to
income-Superior good
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Giffen Good
• If income effect is inverse and large enough to
offset the substitution effect, then it is a GiffenGood
• The Demand curve for Giffen Good will have apositive slope
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Elasticity
• Price Elasticity: Proportionate change in
quantity demanded due to a
proportionate change in price- ∆Qx/ ∆Px * Px/Qx
- negative for normal goods
- negative sign is ignored while making
comparisons among normal goods
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Elasticity
• Income Elasticity
∆Qx/∆I * I/Qx
• Could be negative or positive:
Negative for Inferior goods
Positive for Superior goods
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Elasticity
• Cross Price Elasticity:
∆Qx/∆Py * Py/Qx
• Could be negative or positive
- Negative for complements
- Positive for substitutes
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Chapter 4
Demand Estimation and
Forecasting
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Demand Estimation Techniques
Qualitative Quantitative
- consumer Surveys - Statistical estimation
- Market Experiments Techniques- Consumer Clinics - Regression
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Steps in Demand Estimation
Exercise• Identification of variables
• Collection of Data
• Mathematical specification of the relationship• Estimation of the parameters
• Using these estimates to arrive at estimates of
variables
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A Simple Linear Regression Model
• Y = a + BX + u
Where Y is the dependent variable
X is the independent variable„a‟ is the intercept ; „b‟ is the slope ; „u‟ is the
error term.
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Method of Estimation
• Method of Ordinary Least Square( OLS)
- minimizes the sum of the squared deviations of
each of the points from the mean.
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Coefficient of Determination
• Regression Sum of Squares (RSS) /
Total Sum of Squares (TSS) is R2
– Coefficient of Determination
• If R2 = 1, the best fit.
• If R2 = 0.4, 40% of the total deviationsis explained by the regression
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Graphical Representation
R2 = 1 R2 = 0
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Problems in using Regression
• Multicollinearity – where there is dependency
amongst independent variables
• Identification problem• Auto correlation
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Forecasting Techniques
• Opinion polls and market research
• Expert opinion
• Surveys• Economic indicators
• Projection Techniques
• Econometric Models
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Time Series Projection using
Least Square method
• How the dependent variable moveswith time
Yt = f (Tt , St , Ct , Rt ) whereYt is the actual value of the data in time series
Tt is the trend component at time „t‟
St is the seasonal component at time „t‟
Ct is the cyclical component at time „t‟
Rt is the random component at time „t‟
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Chapter 5
Firm as a Producer
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Creation of a firm
• To minimize Transaction costs
• One entity takes the responsibility to bring all
the factors together required for production
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Motive behind existence of a Firm
• Profits
- economic Profits
- total revenue minus total „economic‟ costs
• Economic costs are „relevant‟ costs usingthe principle of opportunity costs
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Marginal Analysis
• Used to arrive at the profit-maximizing output
level
• Uses the concepts of Marginal revenue andMarginal Cost
• Marginal revenue is the change in total
revenue due to an additional unit of output
• Marginal cost is the change in total cost due to
an additional unit of output
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Profit-maximizing Rules
• Rule- The level of output at which MR = MC
• Should this level of output be produced at all?
- Shut Down Rule:If at the optimal level of output, Average
Revenue is less than Average (economic) Cost,
then, SHUT DOWN.
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Do Firms really maximize Profits?
• Satisficing Theory
• Other Objectives:
- provide good products/services tocustomers
- a good work place for employees
- responsibility to society
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Control Mechanisms
• Principal – Agency Cost
Therefore CONTROL MECHANISMS
Internal External
-board of Directors - Takeovers
- ESOPs
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Non- Profit Firms
• No right to accumulate Profits
• Operate with funds from external sources
• Exempt from Corporate Tax
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Public Sector Firms
• Operate in areas where Private sector will not
operate
• Involved in the provision of Public goods
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Chapter 6
Analysis of Production
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Production Function with twovariable inputs
• Q = f (K , L) where K is capital and L is labour
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Isoquants
• Graphical representation of production
function• A curve drawn through the technically feasible
combinations of inputs to produce a target
level of output
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Map of Isoquants
Output 160
Output 200Output 260
K
L
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Properties of Isoquants
• They are downward sloping
• They are convex to the origin
• They do not intersect
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Production function with onevariable input
• Total Product: Q = 30L+20L2-L3
• Average Product : Q /L
• Marginal Product : MP = dQ/dL = 30+40L-L2
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Production Elasticity
• ∆Q / ∆X * X / Q = MPx * 1 / APx
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Three Stages of Production
• Stage 1: AP is increasing, MP is increasing and
Production Elasticity is > 1.
• Stage 2: AP and MP are decreasing andProduction Elasticity is 0 < Prod.Elas < 1
• Stage 3: MP and AP continue to decrease and
Production Elasticity < 0.
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Returns to Scale
• Increasing Returns to Scale When output
increases by a proportion greater than the
proportionate increase in all inputs.
• Decreasing returns to scale
• Constant returns to scale
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Cobb – Douglas ProductionFunction
• Q = A Lα Kβ
Where, α + β indicates Returns to Scale
If > 1, it exhibits Increasing Returns to Scale
If < 1, it exhibits Decreasing Returns to Scale
If = 1, it exhibits Constant Returns to Scale
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Optimal Input Levels
• With one variable input:
Marginal Revenue Product (MRP) = Marginal
Variable Cost.MRP = MP * MR
• With many variable inputs:
MPL
/ PL
= MPK
/ PK
= ……….
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Chapter 7
Analysis and Estimation of
Costs
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Concepts of costs
• Economic costs – Relevant costs definedin terms opportunity costs
• Sunk costs – Expenditures that are
irrelevant for decision making during theconcerned period
• Normal Profit – this is as much acomponent of costs as wages, interest, etc.It is a payment for „entrepreneurship‟
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Long-run total Cost (LRTC)
• Steps to derive:
- select level of output
- find the point of tangency between therelevant isoquant and the isocost line
- repeat the first two steps for differentlevels of output
- the line joining all these points of tangencyis the LRTC
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Short run Total Cost (SRTC)
• The relevant cost is the Short-Run Variable
cost
• Fixed costs are irrelevant in the short run
• The slope of the SRTC varies with the
returns from the variable input
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Average and Marginal Cost Curves
• The LRAC is derived from LRTC ; is U-
shaped reflecting Returns to Scale
• SRAC is derived from SRTC; is U-shapedreflecting variable returns from the variable
input in the short run
• Marginal Cost is derived from LRTC or
SRTC; is U- shaped
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Relationship between Marginaland Average Cost
• When MC is below the AC, the AC falls
• When MC is above the AC, the AC rises
• When AC is at the minimum, MC is rising• MC cuts AC at the minimum of the AC
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Relationship between LRAC andSRAC
• Points on the LRAC gives the lowest cost of
producing a target level of output
• The lowest point on the SRAC gives the level of output at which the AC is lowest in the short
run
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Cost Functions
• Polynomial Function:
- Cubic Fn: TC = a + bQ - cQ2 +dQ3
- Quadratic Fn: TC = a + bQ + cQ2
- Linear Fn: TC = a + bQ
• Logarithmic Function:
- ln TC = a + b ln Q
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Breakeven Analysis
• Qb = TFC / ( P – AVC)
P – AVC is “ Contribution”
• Quantity at which a target profit can beearned:
Q = TFC + Profit Target / Contribution
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Chapter 8
The Competitive and Monopoly
Models
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Optimizing rules in CompetitiveModel
• Marginal Output Rule:
MR = MC
• Shut-down Rule:If P (price) is less than Min AC , then SHUT
DOWN
M i l t t R l d S l C
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Marginal output Rule and Supply CurveGraphical Representation
MC
AEC (Avg Eco. Cost
AR=MR=P
Q
Rs/unit
B
Every point above „B‟ on the MC curve is a pointon the Short run supply curve
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Long Run (LR) Supply curve
• The relevant curves are the Long run MC curve
and the Long run Avg Cost curve.
• Derived from these two curves just as the Short
run supply curve.
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Elasticity of supply
• Ess = % change in quantity supplied / %
change in price
• Flatter the supply curve , larger the elasticity
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Characteristics of a Perfectly
competitive Market
• Large number of sellers. Each seller is
therefore a price taker
•Large number of buyers
• Homogeneous product- hence uniform price
• Perfect information
• Free entry and exit- so no supernormal profits
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N i l i f P f
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Normative analysis of PerfectCompetition
• Total Surplus is maximum
SS
DD
A
B
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Monopoly
• A single firm faces the entire demand - Price
Maker
• No role for strategy
• No substitutes
• No entry
P i i d O d i i f
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Pricing and Output decisions of aMonopolist
• Downward sloping demand curve or AR
curve
• Hence a falling MR curve• MC=MR at E
ARMR
MC
Q
E
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Monopoly Vs Competitive Solution
• Output lower and price higher in a monopoly than
in competition.
• This is because :
MR = P in Competition and MR < P in Monopoly
In competition, MC =MR =P.
In monopoly, MC=MR and MR < P
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Regulation of Monopoly
• Regulation of prices
• Antitrust Policies – to prevent the
monopolist from exercising Monopoly
Power.
• In India , we had the MRTP Act of 1969
• We now have the competition Act 2002
• Patent Policy
R ti l b hi d P i
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Rationale behind PriceDiscrimination
• To transfer as much as possible of the
consumers surplus over to the seller
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Price Discrimination
• Practice of charging different prices in
different markets for the same product
• The seller should be a price maker
• Price elasticity of demand has to be different
for different market segments
• The different market segments should be
insulated
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Chapter 9
Monopolistic Competition and
Oligopoly
F t f li ti
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Features of monopolisticCompetition
• Large number of sellers but each seller is a
Price Maker
• Large number of imperfect substitutes due to
product differentiation
• Large number of uninfluencing buyers – both
informed and uninformed
• Free entry
Eq ilibri m Short r n and Long
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Equilibrium- Short run and Longrun
• In the Short run at MR =MC , the seller
makes Super normal Profits
• In the Long run, „ Free entry‟ squeezesout the Profit
• So at the Long run equilibrium, MR =
MC= AC
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Features of Oligopoly
• Few sellers
• Interdependence
• Intense rivalry• „Strategy‟ plays a dominant role.
• Barriers to entry; Natural and Strategic
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Equilibrium in Oligopoly
• Cournot Equilibrium
• Bertrand Equilibrium
• Stackelberg Equilibrium• The kinked demand model
• Cartel
• Collusion
• Price Leadership
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Game Theory and Oligopoly
• A Pay off Matrix: WIPRO
without remote with
remotewithout areas areas
H remote areas 40,70
35,55
C
L With remote
areas 30,60 45,45
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A Game Tree
Hero
Atlas
Atlas
low
high
Rs 4000,4000
Rs 6000,1000
Rs 1000,6000
Rs 3000,3000
highlow
lowhigh
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Strategies
• Maximin Strategy
• Dominant Strategy
• Dominated Strategy• Pure and mixed Strategy
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Different Games
• Entry Game• Games of imperfect and incomplete
information – Prisoners‟ Dilemma
Games• Sequential Games
• Repeated Games
• Finitely repeated Games
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Chapter 10
Alternative Pricing Practices
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Pricing of Multiple Products
• Products with interdependent
demands but independent production
Optimizing rule:
MCx = MRx
MRx
= dTRx /dQ
x+ dTR
y /dQ
x
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Pricing of Multiple Products
• Products related in production but
independent in demand:
Optimizing rule:
1. MC of Production = MR1 + MR2+….
Eg. Petroleum Products
2. MC = MRt (Total MR)
Eg. Hide and Meat- A Product Package
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Other Pricing Principles
• Fully distributed Cost – based pricing
• Incremental Cost Pricing
• Ramsey Pricing
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Other Pricing Principles (contd…)
• Transfer Pricing:
- a firm with multiple divisions where eachis
treated as an autonomous profit centre.- where Market exists, the rule is:
• Transfer the product at Market Price
- where external market exists, transfer at
P=MC- where external market is imperfect,behave
like a discriminating monopolist
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Other Pricing Principles (contd..)
• Two Part Tariff:
- a lump sum fixed Charge and a Variable component
• Peak Load Pricing:
- where the product is not storable.
- Where demand varies with time.
- Differing price elasticities
- The same facility is being used to meet all the different
demands
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Chapter 11
Market for Factor Inputs
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Competitive Factor Markets
• Demand for a single variable factor:
MRPl = MFCl
( MPl * MR = MRPl )• Demand for several variable factors:
MC = w/MPl = r/MPk
Or MC/MR = w/MRPl
= r/MRPk
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Economic rent
• In the context of factor markets, the excess of
payment over the minimum required to buy
the use of the factor is economic rent.
• Economic Rent earned varies with supply
elasticity
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Monopsony in the factor market
• A single buyer of a factor
• Minimum Wage Law to protect labour from
exploitation by monopsonist
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Factor market with Monopoly Power
• A single seller of a factor
• A classic example is the Labour Union
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Bilateral Monopoly
• A monopolist seller meets a monopsonist buyer
• Each would bargain and the price gets fixed
Ch t 12
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Chapter 12
Long Term Investment and
Risk Analysis
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Evaluation of Capital Expenditure
• Large investments in assets which, once
undertaken, are irreversible
• Revenue occurs in the future
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The Capital Budgeting Process
• Generation of capital investment projects
• Estimation of the cash flows
• Evaluation of the projects
• Ex-post evaluation of projects
Methods of evaluating investment
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Methods of evaluating investmentprojects
• Payback period
• Average return on investment or Accounting
rate of return
• Net Present Value
• Internal rate of Return
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Discounting
• The process of bringing the future stream of
revenues to the present
• Choice of the discount rate is important
• The discount rate should reflect the
opportunity cost of capital to the firm
E i C B fi A l i
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Economic Cost – Benefit Analysis
• Used to evaluate projects where „ profits „ are
not very relevant
• Used in situations:
- with externality
- where distributional impact is important
- of merit goods
Ri k
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Risk
• A decision making situation in which the
possible outcomes can vary and the probability
of occurrence of each outcome is known
I ti f Ri k
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Incorporation of Risk
• Subjective approach
• Utility function approach
• Decision tree approach• Risk adjusted discount rate approach
M i Ri k d U t i t
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Managing Risk and Uncertainty
• Seek more information
• Diversification
• Hedging• Insurance
• Controlling the operating environment
• Restricting use of firm-specific assets
Th C f D l t bl R
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The Case of Depletable Resources
• Cost of Production
• Cost of Depletion
I t t R t
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Interest Rates
• Interest rate is the price of funds
- Prime lending rate
- Commercial paper rate- Discount rate or Bank rate
- T- Bill rate
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Chapter 13
Economics of Information
I f t I f ti
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Imperfect Information
• Incomplete Information
- where both sides to a transaction do not
possess complete information
• Asymmetric Information
- where one of the parties to a transaction has
more information than the other
As mmetric Information ( td )
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Asymmetric Information (contd…)
• Two sources:
- the characteristic (e.g. – quality of a
used car)- a hidden action (e.g. – actions of an
employee such as „shirking‟ work)
Signalling
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Signalling
• Ways of conveying and getting information on
hidden characteristics (e.g. airlines offering
various „Packages‟)
Adverse Selection
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Adverse Selection
• an outcome of asymmetric information
wherein you select precisely the ones you
should not (e.g. – the unhealthy and weak
taking up health insurance)
• this is due to asymmetric information on
some hidden characteristics
Responses to Adverse Selection
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Responses to Adverse Selection
• Market response:
- “the insurance industry makes medical
examination compulsory, higherpremiums”
Government Response:
- “making information mandatory”
Hidden Action
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Hidden Action
Characterized by:
- one side of the transaction not being able to
observe the action taken by the other.
- The unobservable action affects the other side.
- no agreement on whether the action should be
taken or not.
* The result of hidden Action is Moral Hazard
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Moral Hazards in Product Markets
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Moral Hazards in Product Markets
• Brand Name Reputation as Hostages
• Guarantees and Warrantees
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Externalities
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Externalities
• The effect of an economic activity that is not
incorporated into or reflected in the market
price is called an Externality
• Externality if negative, imposes a „cost‟
unaccounted for
• Externality if positive, gives rise to a „benefit‟
not accounted for
Externalities (contd )
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Externalities (contd..)
• Pollution is a negative externality;
development of an area due to industrial
units being set up is a positive externality
• The result is that costs and benefits are
either overestimated or underestimated
Internalizing Externalities
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Internalizing Externalities
• Government‟s response:
- Taxes
- Regulation
- Effluent Fee
- Transferable Emission Permits
- Recycling
Internalizing Externalities
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Internalizing Externalities
• Market‟s Response
- Mergers
- Social Conventions
- Property Rights
Public Goods
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Public Goods
• Public goods are Non Rival
• Public Goods are Non Excludable
• The result: no reason for the consumerto reveal his/her valuation of the good or
service
• HENCE MARKETS FAIL
Provision of Public Goods
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Provision of Public Goods
• Government alone being responsible.
• Public Private Partnerships (P3s)
Public Private Partnerships (PPP)
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Public Private Partnerships (PPP)
• PPPs are contractual arrangements between agovernment and a private party for the provisionof Assets and the delivery of services that havebeen traditionally provided by the public sector
• The central point is the sharing of decisionmaking authority
• The not-so central point is the sharing of rewards and risks
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Chapter 15
Macroeconomic Aggregates
Macro Aggregates
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Macro Aggregates
• Aggregate output levels
• Aggregate Price levels
• Aggregate Investment levels
• Aggregate Consumption levels
• Balance of Payments
Fundamental Identity
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Fundamental Identity
Agg output ≡ Factor Income ≡Expenditure
Measures of Aggregate Output
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Measures of Aggregate Output
At Market Price At Factor Cost
* Gross Domestic Product
* Gross National Product
* Net Domestic Product
* Net National Product
* PPP Gross Domestic ProductNational Income ≡ NNP at Factor Cost
Price Indices
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Price Indices
• CPI (Also called Cost of living Index)
• WPI (Wholesale Price Index)
• GDP Deflator
Price Indices
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Price Indices
• CPI : Weighted Average Retail Price of aspecific basket of goods.
• WPI : Based on wholesale prices of a
specific basket of goods ( different from CPI’sbasket both in composition and in weights).
• GDP Deflator: Ration of Nominal GDP to
Real GDP.
Aggregate Consumption
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Aggregate Consumption
• Keynesian Consumption function
- Concept of Marginal Propensity to
consume
• Irving Fisher‟s Hypothesis
• Life-Cycle Hypothesis
• Duesenberry‟s Hypothesis
• Random walk Hypothesis
Investment
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Investment
• Investment as a function of changes in
income(Y)
- The Accelerator• A relationship between Investment and
the stock market is Tobin‟s Q
• Investment as a function of Real InterestRate
Inflation and Unemployment
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Inflation and Unemployment
Cost-Push
• InflationDemand- Pull
Remedy in the Short Run: SqueezingAggregate Demand
Phillip’s Curve
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Phillip s Curve
• Inflation (Wage rate) and Unemployment are
inversely related
• NAIRU: Non Accelerating Inflation Rate of
Unemployment
w
Unemp rate
W is wage rate
Balance of Payment
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Balance of Payment
• Captures all transactions between any
economy and the rest of the world.
• Current Account
• Capital Account
Balance of Payment
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Balance of Payment
• Items keenly watched:
- ratio of current account Deficit/surplus
to GDP- ratio of Capital Account surplus/deficit
to GDP
- extent of intervention through reserves.
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Chapter 16
Fiscal, Monetary and Exchange
Rate Policies
Business Cycles
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Business Cycles
• Fluctuations in economic activity.
- low level of economic activity: Recession
- Peaking levels of economic activity: Boom
• Economic activity is measured by rate of
change in GDP
• Policy interventions are called for to reduce
the severity of fluctuations and to stabilize theeconomy
Stabilization Policies
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Stab at o o c es
• Reliance on Demand management Policies in
the Short Run.
Fiscal Policies Monetary Policies
Fiscal Policy
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y
• Instruments: Taxes and Government Spending
• These two instruments don‟t work through the
market.
• Both these are reflected in the Budget.
Monetary Policy
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y y
• The central bank of a country is the sole authority.
• Interest Rate is the instrument which is
manipulated by changes in Money supply.
• Interest rate is the price of funds.
Money Supply
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y pp y
• Is primarily determined by the central bank.
• The banking sector plays a key role through the
„fractional reserve system‟ and the „multiple
expansion of deposits‟.
Money Multiplier
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y p
• Given by :
Cu /D + 1
-----------------------------
Cu/D + RR/D + ER/D
Where Cu is the currency, RR is Required reserves
and ER is Excess Reserves.
Exchange Rate Policies
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g
• Fixed Exchange rate Policy
• Market determined Exchange rate Policy
• Between these two, there is a system of “Managed
Floats”
Stability of Exchange Rates
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y g
• Depends on elasticities of imports and exports.
• An elastic import basket and an elastic export
basket results in stable rates.
• An inelastic import basket and a relatively highly
elastic export basket also results in stable rates.
• An inelastic import basket and a not so elastic
export basket results in instability in exchangerates.
Devaluation
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• A reduction in the value of a currency.
• Devaluation is done when:
- a country cannot maintain the Fixed Exchange
rate due to scarcity of Reserves.
- a country chooses to consciously improve trade.
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Relationship between Monetary policies
and Exchange rate Policies
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and Exchange rate Policies
• Fixed Exchange Rate Policy:
monetary Policy‟s role is exclusively to maintain
the fixed rate for which it requires reserves of
foreign and domestic currencies.
Flexible Exchange rate policy gives freedom to use
monetary policies for other purposes.
Chapter 17
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The New Economy
Definition
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• Outcome of the Information Revolution.
• It has 3 distinguishing characteristics:
- it is leaning on intangibles
- it is global
- it is intensely interlinked
The New Economy is thus a „Network‟ Economy.
Information Goods
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• These are digitized information.
Eg. Encyclopedias, Directories
• Characteristics:
- High fixed costs but very low variable costs of
reproduction.
- The above results in non excludability and
market failure.- Pricing is Value based (since MC is near zero)
Network and Network Industries
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• Industries which provide Information goods are
called Network industries.
• A network is a set of connections between nodes.
• Networks could be real or virtual.
• Larger the network size, more viable the
production and usage.
Networks
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• Network Externality: The value to each user
being in the network rises at a rate much higher
than the rate of increase in the size of the network.
Old Economy Industries (OEI) Vs
Network Industries
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Network Industries
• In old eco.Industries (OEI), economies of scaleoccur on the supply side, whereas in the Network industries, they occur on the Demand side.
• In OEIs, demand is downward sloping and this„shifts‟ when factors change. For network industries, demand increase as accumulateddemand increases- a positive feedback chain.
• In OEI, scarcity gives rise to value. In Network industries, abundance gives rise to value.
Rise and Fall of Dot-Coms
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• Dot-Coms emerged to deal with products
and services that used the Internet.
• Focused on „mind share‟(market share) torealize Network externalities.
Ignored the result of the outcome of theabove- a “winner takes all” situation.
Fundamental Laws and Concepts of
Old Economy
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Old Economy
• Profit Maximization
• Economies of scale results in one or few
winners.
• Demand estimation and elasticities are
important.
• Cost estimation is essential.
Ignoring the above led to the demise of Dot-
Coms
Internet Pricing Models
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• Flat – rate Pricing
• Usage sensitive Pricing
• Transaction- based Pricing
• Priority Pricing
• Precedence model
• Smart Market Mechanism Model
Role of Government
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•Public policy to facilitate adoption and adaptation.
•Policy to actively promote innovation.
•Policy to provide education.
•Policy to promote digitization.