Finance 360_ Managerial Economics by hcj

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									Finance 30210: Managerial
Economics

    Supply, Demand, and Equilibrium
When we talk about the market process, we are talking about the
interaction between two groups of people:




Consumers make decisions           Businesses make decisions about
about what to buy, where to        what to produce and how to produce
shop, etc. in order to maximize    to maximize profit – we can
their enjoyment– we can            (sometimes) summarize their
summarize these decisions          decisions with a supply curve
with a demand curve

 When consumers and producers interact in the marketplace, prices are
 determined – therefore, the market price contains a component from
 consumer decisions AND producer decisions
                    Lets start with a very simple question…if you were to buy
                    an ice cream cone right now, how much would you be
                    willing to pay? What factors influence your choice?




        Lets suppose that you would pay up to, but not over $5


      Now, suppose               Price
      that the
      market price
      for ice cream
      is $3                         $5
                                          $2
                                    $3
We refer to the $2 difference
between what you are willing
to pay and what you actually
pay your consumer surplus                                           Quantity
                                                1
                 Now, lets suppose that you just ate the first ice cream.
                 How much would you pay for a second ice cream
                 cone? Why?

                                      Typically, the more you have of
                                      something, the less it is worth to
                                      you at the margin – we call this
Now, at the same market               diminishing marginal utility
price, you would be
willing to buy two ice        Price
cream cones


                                 $5
                                 $4     $2
                                                  $1
                                 $3
With 2 ice cream
cones, you would earn
$3 of consumer                                                     Quantity
surplus                                       1        2
When we say that consumers are making choices to maximize their utility,
what we mean is that consumers are making buying decisions to
maximize their consumer surplus. A demand curve represents the
outcome of this decision


Price              Quantity demanded for       “is a function of”
                   some commodity x


   $5                                 Qx  D Px , I , Py ,... 
                                       Price of X
                                  D                 Income   Prices of other
                                   Quantity                  goods
               1


 Note that a particular demand curve shows the quantity demanded for
 any given price – HOLDING EVERYTHING ELSE CONSTANT!!!
   Demand curves slope down due to diminishing marginal utility. The
   elasticity of demand measures the strength of this effect


                        Qx  D Px , I , Py ,... 
        Price                      -
                                                          % Q x
                                                     D 
          $5                                              % Px
- 20%                                                     100
          $4                                         D        5
                                                           20
                                       D
                                        Quantity
                    1          2

                        100%
 If we know the form of the demand function, there is an easy way to
 calculate elasticity.
                                           Qx
                              %Qx         Qx          Qx Px
                         D                        
                                                 Px P Q
Price                         %Px                       x  x
                                                  Px

                                      Change in demand
                                      with respect to
 $10                                  price
                                                      One particular point
                                  D                   on the demand
                                                      curve
                                  Quantity
                       100

                                Q P        10 
  Q  200 10P                      10       1
                                P Q        100 
Look what happens as we change the point on the
demand curve

                           Q P        15 
                               10    3
                           P Q        50 
     P
$20                            Q  200 10P

$15
                           Q P        5 
                               10        .3
$5
                           P Q        150 

                    D
         50   150       Q
For linear demand curves, elasticity            Q  A  BP
is not constant!




  P
                                       How is knowing the
A/B
           High elasticity             elasticity of demand
                                       useful?



                      Low elasticity


                       D
                              Q
Q  200 10P             Expenditures are maximized at the point on
                         the demand curve where elasticity equals -1

                        3
                      Expenditures = $15*50=$750



     P
$20
                         1
                       Expenditures = $10*100=$1000

$15

$10                               .3
$5                               Expenditures = $5*150=$750

                         D
         50 100 150             Q
     Elasticity and Expenditures
         E  PQ  $10(100)  $1000

     P
                        E  PQ  $5(150)  $750
                          .3
$10
$5                                         %E  %P  %Q
                                                    %P   %P 

                        D                           %P1   
          100 150              Q
              If the elasticity is less than one, the revenues increase – if
              elasticity is greater than negative one, revenues decrease
At least for most goods, we assume that – all else equal – higher income will
increase demand (you buy more of something when you can afford it). The
income elasticity measures the strength of this response



                  Qx  D Px , I , Py ,... 
                                                  Suppose that a 40%
                                                  increase in your
                                                  income (say, from $100
Price                                             per week to $140)
                             +                    induces you to buy an
                                                  additional ice cream at
                                                  the initial $5 price
  $5

                                                           %Qx
                                                      I 
                                  D                         %I
                                                           100
              1          2
                                  Quantity
                                                      I       2.5
                                                            40
                  100%
Your response to other price changes depends on what the other
commodity is. An increase in the price of a substitute typically raises
demand while a rise in the price of a compliment lowers demand – cross
price elasticity measures the strength of this response

                   Qx  D Px , I , Py ,...       Suppose that a 50%
                                                   increase in the price of
Price                                              soda induces you to
                              + or -               buy an additional ice
                                                   cream at the initial $5
                                                   price
  $5

                                                                 %Qx
                                                      p       
                                   D
                                                           y
                                                                 %Py
                                   Quantity                      100
        0      1          2                           p            2
                                                           y
                                                                  50
                   100%
 While each consumer is making purchasing decisions (intensive
 margin), the market demand adds up these decisions across all
 consumers (extensive margin).



                Individual
                                                     Aggregate


 P                       P                       P


$3
                                                                     D
               D1                     D2
          3
                    Q1          2
                                            Q2                   5
                                                                     Q
             Now, suppose that you are an ice cream salesman. At what
             price would you be willing to sell ice cream? What factors
             influence your decision?


       Lets suppose that you would require at least $2 to cover your costs
       of producing that ice cream. We call this cost your marginal cost


      Now, suppose              Price
      that the
      market price
      for ice cream
      is $5                        $5

We refer to the $3 difference            $3
between the market price and
your marginal production           $2
cost your producer surplus
                                                                   Quantity
                                                1
Total Costs vs. Marginal costs vs. Average Costs

Lets suppose that it cost you $100 to set up your ice cream stand.
This is a fixed cost (otherwise known as overhead) because it does
not depend on your level of production

    Quantity         Total Cost      Marginal Cost   Average Cost

    0                $100
    1                $102            $2              $102
    2                $105            $3              $52.50
    3                $109            $4              $36.33
    4                $114            $5              $28.50


          Note that marginal costs are increasing with production
                If we assume that your marginal costs increase with
                production, then at any given market price, your
                surplus at the margin will shrink as your production
                increases




Now, at the same market
price, you would be
willing to sell two ice       Price
cream cones

                                 $5
                                                  $2
                                 $3    $3

With 2 ice cream                 $2
cones, you would earn
$5 of producer surplus                                           Quantity
                                              1        2
When we say that producers are making choices to maximize their profit,
what we mean is that producers are making production decisions to
maximize their producer surplus. A supply curve represents the outcome
of this decision


Price              Quantity supplied for        “is a function of”
                   some commodity x


                                       Qs  S Px , MC x ,... 

   $2                                   Price of X
                                   D                        Marginal Cost of X
                                    Quantity
               1


 Note that a particular supply curve shows the quantity supplied for any
 given price – HOLDING EVERYTHING ELSE CONSTANT!!!
      Supply curves slope up due to diminishing marginal utility. The elasticity
      of supply measures the strength of this effect


                          Qs  S Px , MC x ,... 
      Price

                                     +
                                                                % Qs
         $3                                                s 
50%                                                             % Px
         $2                                                     100
                                         D                 s      2
                                                                 50
                                          Quantity
                      1          2


                          100%
An increase in costs at the margin will lower quantity supplied. The cost
elasticity of supply measures the strength of this effect


                    Qs  S Px , MC x ,... 
                                                           Suppose that
                                                           a 50% rise in
                                                           marginal
Price
                                                           costs lowers
                                 -                         supply from
                                                           2 to one at
                                                           the $3 price
   $3

                                                             %Qs
   $2                                                MC   
                                     D                       % MC x
                                                              50
                1          2
                                     Quantity
                                                     MC          1
                                                              50
                    -50%
     While each producer is making supply decisions (intensive margin), the
     market demand adds up these decisions across all producers (extensive
     margin).



                   Individual
                                                         Aggregate


 P                  S1        P                      P
                                         S2                          S
$5


                                                  $10


              4
                         Q1         2
                                                Q2            6
                                                                         Q
A market equilibrium is defined at a price that clears the
marketplace. That is, at the equilibrium price, every item that is
produced is sold.

                              Qs  QD
  Price
                                        S     At a market price that is to
                                              high, we have excess supply

     $4
                                              At a market price that is to
                                              low, we have excess demand
                                        D
                                              Quantity
             25         100       200
Also, note that every item that is sold is profitable for everyone
involved


                              Qs  QD

                      Price
                                                             S
                         $6
 Consumer Surplus
                         $4
  Producer Surplus
                         $2
     Marginal Cost                                          D

                                                                     Quantity
                                  25         100
 In fact, the market equilibrium maximizes both consumer surplus and
 producer surplus. Therefore, everyone involved has accomplished
 their objectives.

                              Qs  QD

                      Price
     Total                                                S
     Consumer
     Surplus
         Total          $4
         Producer
         Surplus
                                                        D

Total Production                                               Quantity
                                          100
Costs (Less Fixed
Costs)
The market process represents an aggregation of preferences.
Freely adjusting prices give everyone the proper incentives.

     P
                                              Supply curves aggregate
                                     S        the costs of producers




$4

                                               Demand curves aggregate
                                               the preferences of
                                     D         consumers
                                         Q
                    100

An equilibrium is a price that “clears the market” (Supply equals demand).
Therefore, the market price is a combination of producer cost and
consumer value
Suppose that the value of this product to consumers increases…


     P

                                       S




$4

                                                At the initial price, a
                                                temporary shortage
                                       D        exists. Consumers
                                            Q   battle to obtain the
                     100
                                                good – prices get bid
                                                up
 A rising price creates the incentive for
 firms to raise production.
Suppose that the production costs drop…


     P

                                      S
                                              At the initial price, a
                                              temporary surplus
                                              exists. Firms cut
                                              prices to increase
$4                                            sales



                                      D
                                          Q
                     100


 A falling price creates the incentive for
 consumers to increase their purchases.
An Application of Supply and Demand
  What Factors are driving crude oil prices?



  OPEC is limiting production to maintain
  high prices                                            IRAQ


                               Iraqi Oil Production hasn’t
      Nigeria                  picked up as quickly as
                               expected following the gulf war.



Nigerian rebels are
threatening oil production       Venezuela
                                              Venezuela has yet to fully
                                              recover from the strike of
                                              2003
What Factors are driving crude oil prices?

    Economic Growth Rates (Inflation Adjusted): 2004

   Country                    Annualized Growth
   China                      9.1%
   Hong Kong                  7.4%
   India                      6.2%
   United States              4.4%
   Japan                      2.9%
   European Union             2.4%

   As world incomes rise, so does demand!!
          Over the past year, demand has continued to
          increase (relative to long run trends) while supply
          problems have generated a decrease in supply
          (also relative to long run trends).




      P                        S 2006
                                                   Both factors are
                                  S 2004           acting to increase
                                                   price!!
$60


$30

                                     D2006
                                D2004
                    40 60           Q
  Market prices should be a reflection of value…to everybody!

                        Suppose that your 10th hour
                        of work produces $80 worth
  Productivity          of output
  per hour


    $80


    $50


    $20                                              Your 60th hour produces
                                                     much less than the 10th hour
                                         D
                                             Hours
              10       30     60


Generally speaking, the more one works, the less productive they become.
 Market prices should be a reflection of value…to everybody!


  Time
  Value

                                       S
$100
                                              Your 100th hour of work
                                              (your 100th hour of
                                              foregone leisure) is worth
 $25                                          a lot more


 $5

                                           Hours
          4         20          100

          Your 4th hour of work (your 4th hour of
          foregone leisure) is only worth $5 to
          you.
A market equilibrium represents trades that are beneficial to everyone
involved!

                          Every hour worked is profitable for the
                          firm

Wage

                                      S


                                            The worker is
$50                                         compensated by at
                                            least as much as is
                                            required for every
                                            working hour

                                      D
                                          Hours
                     38
 So, why do we see wages rising over time?


Wage
                                               Explanation #1:
                                   S           Individuals are requiring
                                               more compensation
                                               over time


$50

                                                Explanation #2:
                                                Individuals are
                                                becoming more
                                   D
                                                productive over time
                                       Hours
                     38


  So, which is it?
Labor productivity growth has averaged 1-2.5% per year since WWII.
Wages have grown (in real terms) by 2% per year



Wage

                                       S
$55

                                               Suppose that new
$50
                                               technology makes us 10%
                                               more productive across
                                               the board

                                       D
                                           Hours
                      38
     This is generally consistent with what we see in the short term as well.


                    5
                    4
                    3
                    2
Percentage Change




                    1
                    0
                    -1 1980   1984       1988        1992           1996      2000

                    -2
                    -3
                    -4
                    -5
                    -6

                                 Wages    Productivity      Output Per Hour
   However, an anomaly appears at the micro level…


       Salary                                 Salary

$220,000



                                                              Productivity


                      4%/yr
 $46,000


                                                                Age
           21                                          62

 Its an established fact that average wages increase with age almost until
 retirement while average productivity is flat or actually declines with age
 (particularly after the age of 50)
It appears that younger workers are systematically underpaid (Paris
Hilton is a notable exception) while older workers are systematically
overpaid….how can we explain this?



                  Moral Hazard describes situations in
                  which one agent can’t observe the
                  behavior of another



 Its difficult for a corporation to observe the work habits of every
 employee. Therefore, incentives must be put in place to insure hard
 work:
     For young workers, the best incentive is a rising salary
     For older workers, the threat of being laid off is a much stronger
     incentive (being overpaid increases the possibility of being laid off)
                The preservation paradox

    By recycling one ton (2,000 lbs.) of paper, we save: 17 trees;
    6,953 gallons of water; 463 gallons of oil; 587 pounds of air
    pollution; 3.06 cubic yards of landfill space and 4,077 Kilowatt
    hours of energy.

    The average American uses 650 pounds of paper per year.


Lets do a “back of the envelope” calculation here…

        300 million Americans translates into roughly 100
        million tons of paper used per year – if this paper was
        recycled, we could save roughly 1.7 BILLION Trees per
        year!!!
Is it possible for recycling to actually LOWER the
number of trees in the US?


Let’s think about this from the point of view of a logging
company…suppose our logging company owns 100 acres of forest.
Each acre of land produces 50 trees per year, but different terrains have
different logging costs.


                         25 Acres:        20 Acres: $160
                         $150 per         per acre
                         acre



                                               25 Acres: $190
                        30 Acres: $180
                                               per acre
                        per acre
 This logging company must be able to collect at least $190 dollars of
 revenue per acre to maintain all 100 acres of forest. As revenues
 drop, some areas are no longer worthwhile to maintain.

 Revenue per
 acre
                                    S


$190

$180


$160

$150

                                         Number of
                                         Trees supplied
            1250    2250   3750   5000   per year
 For simplicity, lets assume that the demand for paper was high
 enough so that this company could collect $200 in lumber revenues
 per acre of land. All 100 acres of forest will be maintained.
                                                    Now, suppose that
 Revenue per
                                                    recycling programs
 acre                              S                lower the need for
                                                    trees. What
$200                                     D
                                                    happens?
$190

$180
$170                                      D

$160

$150

                                       Number of
                                       Trees supplied
                    2250        5000   per year
Is it possible for recycling to actually LOWER the
number of trees in the US?


Recycling lowers the demand for trees and, hence, the market value of
forest land. Without the incentive to maintain its inventories, the
logging company simply cuts the trees down and lets the land sit
empty!!


                         25 Acres:        20 Acres: $160
                         $150 per         per acre
                         acre




                                     Treeless Land!!


                    I’m not sure this is what conservationists had in mind!!!
Partial vs. General Equilibrium


Recall the example of going to
college


Total Costs: $59,290 X 4 = $237,160

Total Benefits = $20,000/yr for 40 yrs.   $343,181(i = 5%)




            We have three
            markets interacting
            with each other
                      The indifference principle states that the marginal
                      consumer should be indifferent between any two
                      choices!




    Economic Incentive = (Expected) Benefit – Opportunity Cost




                                                  Determined in college
Determined in job markets
                                                  tuition market


      For the marginal consumer, Expected Benefits = Costs!!
                  The indifference principle states that the marginal
                  consumer should be indifferent between any two
                  choices!




     P                P                          P
          S                         S                           S

$30k/yr       $20k/yr                       $32k/yr

              D                         D                           D
                  Q                         Q                           Q
      P                    P                  P
               S                S                           S

$30k/yr              $20k/yr             $32k/yr

                   D                 D                          D
                       Q                 Q                          Q


          Expenses                    Benefits
           $30k/yr Tuition          $12k/yr Higher Salary
           $20k/yr Lost Wages
                                The Present Value of $12K per
          $50k/yr x 4 = $200K
                                year for 40 years (I = 5%) is
                                $200K
      P                           P                          P
                      S                         S                           S

$30k/yr                   $20k/yr                       $50k/yr

                          D                         D                           D
                              Q                         Q                           Q

   Suppose that high education jobs were overvalued. How would
   markets adjust?

      As more people chose to leave unskilled jobs and return to
      school, the supply of unskilled labor would fall (raising unskilled
      wages) while demand for college rises (tuition increases)
An economic riddle…



          It is routine public policy for the government to
          pay farmers to leave portions of their fields
          untended (this lowers the supply and, hence,
          raises the price)




Why doesn’t the government pay hotels to leave
some of their rooms unoccupied (shouldn’t the
reduction in rooms raise the price)?
   Arbitrage

       Generally speaking, properly functioning, competitive markets
       should eliminate any risk free profit opportunities. Therefore, we
       shouldn’t see the same product selling for a different price in two
       locations

                                              Sell in DC
             P
                           S
            $30
            $20
                                                     P       Washington DC

                                                                     S
New York                       D
                                   Q               $40
                                                   $30
                                                                         D
Buy in NY                                                                    Q

   Arbitrage (Buy Low, Sell High) should eliminate any price discrepancies
 Speculation

     Speculation is the same concept as arbitrage. Simply replace
     locations in space with locations in time!!


    P                                 P
                       S                              S
                                    $40
  $20

                      D                                   D
                           Q                                  Q
             Now                             Next Year



The key difference is that we can’t always predict the future!!

								
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