# 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:

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
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
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
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
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

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
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!

of work produces \$80 worth
Productivity          of output
per hour

\$80

\$50

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
foregone leisure) is worth
\$25                                          a lot more

\$5

Hours
4         20          100

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)

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?

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

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

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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