Managerial Economics

Managerial Economics can be defined as amalgamation of economic theory with business practices so as to ease decision-making and future planning by management. Managerial Economics assists the managers of a firm in a rational solution of obstacles faced in the firm’s activities. It makes use of economic theory and concepts. It helps in formulating logical managerial decisions. The key of Managerial Economics is the micro-economic theory of the firm. It lessens the gap between economics in theory and economics in practice. Managerial Economics is a science dealing with effective use of scarce resources. It guides the managers in taking decisions relating to the firm’s customers, competitors, suppliers as well as relating to the internal functioning of a firm. It makes use of statistical and analytical tools to assess economic theories in solving practical business problems.

Study of Managerial Economics helps in enhancement of analytical skills, assists in rational configuration as well as solution of problems. While microeconomics is the study of decisions made regarding the allocation of resources and prices of goods and services, macroeconomics is the field of economics that studies the behavior of the economy as a whole (i.e. entire industries and economies). Managerial Economics applies micro-economic tools to make business decisions. It deals with a firm.

The use of Managerial Economics is not limited to profit-making firms and organizations. But it can also be used to help in decision-making process of non-profit organizations (hospitals, educational institutions, etc). It enables optimum utilization of scarce resources in such organizations as well as helps in achieving the goals in most efficient manner. Managerial Economics is of great help in price analysis, production analysis, capital budgeting, risk analysis and determination of demand.

Managerial economics uses both Economic theory as well as Econometrics for rational managerial decision making. Econometrics is defined as use of statistical tools for assessing economic theories by empirically measuring relationship between economic variables. It uses factual data for solution of economic problems. Managerial Economics is associated with the economic theory which constitutes “Theory of Firm”. Theory of firm states that the primary aim of the firm is to maximize wealth. Decision making in managerial economics generally involves establishment of firm’s objectives, identification of problems involved in achievement of those objectives, development of various alternative solutions, selection of best alternative and finally implementation of the decision.

The Nature Of Managerial Economics

There are a number of issues relevant to businesses that are based on economic thinking or analysis. Examples of questions that managerial economics attempts to answer are: What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service? Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay barely enough to survive? How can the business best motivate the employees of a firm? The issues relevant to managerial economics can be further focused by expanding on the first two of the preceding questions. Let us consider the first question in which a firm (or a would-be firm) is considering entering an industry. For example, what led Frederick W. Smith the founder of Federal Express, to start his overnight mail service? A service of this nature did not exist in any significant form in the United States, and people seemed to be doing just fine without overnight mail service provided by a private corporation. One can also consider why there are now so many overnight mail carriers such as United Parcel Service and Airborne Express. The second example pertains to the exit from an industry, specifically, the airline industry in the United States. Pan Am, a pioneer in public air transportation, is no longer in operation, while some airlines such as TWA (Trans World Airlines) are on the verge of exiting the airlines industry. Why, then, have many airlines that operate on international routes fallen on hard times, while small regional airlines seem to be doing just fine? Managerial economics provides answers to these questions.

In order to answer pertinent questions, managerial economics applies economic theories, tools, and techniques to administrative and business decision-making. The first step in the decision-making process is to collect relevant economic data carefully and to organize the economic information contained in data collected in such a way as to establish a clear basis for managerial decisions. The goals of the particular business organization must then be clearly spelled out. Based on these stated goals, suitable managerial objectives are formulated. The issue of central concern in the decision-making process is that the desired objectives be reached in the best possible manner. The term "best" in the decision-making context primarily refers to achieving the goals in the most efficient manner, with the minimum use of available resources—implying there be no waste of resources. Managerial economics helps the manager to make good decisions by providing information on waste associated with a proposed decision.

Applications Of Managerial Economics

Some examples of managerial decisions have been provided above. The application of managerial economics is, by no means, limited to these examples. Tools of managerial economics can be used to achieve virtually all the goals of a business organization in an efficient manner. Typical managerial decision making may involve one of the following issues:
• Deciding the price of a product and the quantity of the commodity to be produced
• Deciding whether to manufacture a product or to buy from another manufacturer
• Choosing the production technique to be employed in the production of a given product
• Deciding on the level of inventory a firm will maintain of a product or raw material
• Deciding on the advertising media and the intensity of the advertising campaign
• Making employment and training decisions
• Making decisions regarding further business investment and the mode of financing the investment
It should be noted that the application of managerial economics is not limited to profit-seeking business organizations. Tools of managerial economics can be applied equally well to decision problems of nonprofit organizations. Mark Hirschey and James L. Pappas cite the example of a nonprofit hospital. While a nonprofit hospital is not like a typical firm seeking to maximize its profits, a hospital does strive to provide its patients the best medical care possible given its limited staff (doctors, nurses, and support staff), equipment, space, and other resources. The hospital administrator can use the concepts and tools of managerial economics to determine the optimal allocation of the limited resources available to the hospital. In addition to nonprofit business organizations, government agencies and other nonprofit organizations (such as cooperatives, schools, and museums) can use the techniques of managerial decision making to achieve goals in the most efficient manner.
While managerial economics is helpful in making optimal decisions, one should be aware that it only describes the predictable economic consequences of a managerial decision. For example, tools of managerial economics can explain the effects of imposing automobile import quotas on the availability of domestic cars, prices charged for automobiles, and the extent of competition in the auto industry. Analysis of managerial economics will reveal that fewer cars will be available, prices of automobiles will increase, and the extent of competition will be reduced. Managerial economics does not address, however, whether imposing automobile import quotas is good government policy. This latter question encompasses broader political considerations involving what economists call value judgments.

Economic concepts used in managerial Economics

Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-making process. These concepts can be placed in three broad categories: (1) the theory of the firm, which describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate.
THE THEORY OF THE FIRM
Discussing the theory of the firm is an useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed. A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society's scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categories—production and consumption—firms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side.
The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm.
PROFIT MAXIMIZATION AND THE FIRM.
Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm's owner is the manager of the firm, and thus, the firm's owner-manager is assumed to maximize the firm's short-term profits (current profits and profits in the near future). Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today). In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm.
Defining present value of expected profits is based on first defining "value" and then defining "present value." Many concepts of value, such as book value, market value, going-concern value, break-up value, and liquidating value, are encountered in business and economics. The value of the firm is defined as the present value of expected future profits (net cash flows) of the firm. Thus, to obtain an estimate of the present value of expected profits, one must identify the stream of net cash flow in future years. Once this is accomplished, these expected future profit values are converted into present value by discounting these values by an appropriate interest rate. For illustration, assume that a firm expects a profit of $10,000 in one year and $20,000 in the second year it is assumed that the firm earns no profits after two years. Let us assume that the prevailing interest rate is 10 percent per annum. Thus, $10,000 in a year from now is only equal to about $9,091 at the present ([$10,000/(1 +0.1)] = $9,091)—that is, the present value of a $10,000 profit expected in a year from now is about $9,091. Similarly, the present value of an expected profit of $20,000 in two years from now is equal to about $16,529 (since [$20,000/(1 + 0.1)2] = $16,529). Therefore, the present value of future expected profits is $25,620 (equal to the sum of $9,091 and $16,529). The present value of expected profits is a key concept in understanding the theory of the firm, and maximizing this profit is considered the primary goal of a firm in most models.
It should be noted that expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period. Thus, one can, alternatively, find the present value of expected future profits by subtracting the present value of expected future costs from the present value of expected future revenues.
THE CONSTRAINED PROFIT MAXIMIZATION.
Profit maximization is subject to various constraints faced by the firm. These constraints relate to resource scarcity, technology, contractual obligations, and laws and government regulations. In their attempt to maximize the present value of profits, business managers must consider not only the short-term and long-term implications of decisions made within the firm, but also various external constraints that may limit the firm's ability to achieve its organizational goals.
The first external constraint of resource scarcity refers to the limited availability of essential inputs (including skilled labor), key raw materials, energy, specialized machinery and equipment, warehouse space, and other resources. Moreover, managers often face constraints on plant capacity that are exacerbated by limited investment funds available for expansion or modernization. Contractual obligations also constrain managerial decisions. Labor contracts, for example, may constrain managers' flexibility in worker scheduling and work assignment. Labor contracts may also determine the number of workers employed at any time, thereby establishing a floor for minimum labor costs. Finally, laws and regulations have to be observed. The legal restrictions can constrain decisions regarding both production and marketing activities. Examples of laws and regulations that limit managerial flexibility are: the minimum wage, health and safety standards, fuel efficiency requirements, antipollution regulations, and fair pricing and marketing practices.
PROFIT MAXIMIZATION VERSUS OTHER MOTIVATIONS 
BEHIND MANAGERIAL DECISIONS.
The present value maximization criterion as a basis for the study of the firm's behavior has come under severe criticism from some economists. The critics argue that business managers are interested, at least partly, in factors other than the firm's profits. In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society. The act of maximization itself has been criticized; there is a feeling that managers often aim merely to "satisfice" (seek solutions that are considered satisfactory), rather than really try to optimize or maximize (seek to find the best possible solution, given the constraints). This question is often rhetorically posed as: does a manager really try to find the sharpest needle in a haystack or does he or she merely stop upon finding a needle sharp enough for sewing needs?
Under the structure of a modern firm, it is hard to determine the true motives of managers. A modem firm is frequently organized as a corporation in which shareholders are the legal owners of the firm, and the manager acts on their behalf. Under such a structure, it is difficult to determine whether a manager merely tries to satisfy the stockholders of the firm while pursuing other goals, rather than truly attempting to maximize the value (the discounted present value) of the firm. It is, for example, difficult to interpret company support for a charitable organization as an integral part of the firm's long-term value maximization. Similarly, if the firm's size is increasing, but profits are not, can one attribute the manager's decision to expand as being motivated by the increased prestige associated with larger firms, or as an attempt to make the firm more noticeable in the marketplace? As it is virtually impossible to provide definitive answers to these and similar questions, the attempt to analyze these issues has led to the development of alternative theories of firm behavior. Some of the preeminent alternate models assume one of the following: (1) a firm attempts primarily to maximize its size or growth, rather than its present value; (2) the managers of firms aim at maximizing their own personal utility or welfare; and (3) the firm is a collection of individuals with widely divergent goals, rather than a single common, identifiable goal.
While each of the alternative theories of the firm has increased our understanding of how a modern firm behaves, none has been able to completely take the place of the basic profit maximization assumption for several reasons. Numerous academic studies have shown that intense competition in the markets for goods and services of the firm usually forces the manager to make value maximization decisions; if a firm does not decide on the most efficient alternative (implying the need to seek the minimum costs for each output level, given the market price of the commodity the firm is producing), others can outcompete the firm and drive it out of existence. Competition also has its effects through the capital markets. As one would expect, stockholders are primarily interested in their returns on stocks and stock prices, which in turn, are determined by the firm's value (the discounted present value of expected profits). Thus, managers are forced to maximize profits in order to maximize firm value, an important basis for returns on common stocks in the long run. Managers who insist on goals other than maximizing shareholder wealth risk being replaced. An inefficiently managed firm may also be bought out; in almost all such hostile takeovers, managers pursuing their own interests will most likely be replaced. Moreover, a number of academic studies indicate that managerial compensation is closely correlated to the profits generated for the firm. Thus, managers themselves have strong financial incentives to seek profit maximization for their firms.
Before arriving at the decision whether to maximize profits or to satisfice, managers (like other economic entities) have to analyze the costs and benefits of their decisions. Sometimes, when all costs are taken into account, decisions that appear merely aimed at a satisfactory level of performance turn out to be consistent with value-maximizing behavior. Similarly, short-term firm-growth maximization strategies have often been found to be consistent with long-term value maximization behavior, since large firms have advantages in production, distribution, and sales promotion. Thus, many other goals that do not seem to be oriented to maximizing profits may be intimately linked to value or profit maximization—so much so that the value maximization model even provides an insight into a firm's voluntary participation in charity or other socially responsible behavior.

BUSINESS VERSUS ECONOMIC PROFITS.

As discussed above, profits are central to the goals of a firm and managerial decision making. Thus, to understand the theory of firm behavior properly, one must have a clear understanding of profits. While the term profit is very widely used, an economist's definition of profit differs from the one used by accountants (which is also usually used by the general public and the business community). Profit in accounting is defined as the excess of sales revenue over the explicit accounting costs of doing business. This surplus is available to the firm for various purposes.
An economist also defines profit as the difference between sales revenue and costs of doing business, but includes more items in figuring costs, rather than considering only explicit accounting costs. For example, inputs supplied by owners (including labor, capital, and space) are accounted for in determining costs in the definition used by an economist. These costs are sometimes referred to as implicit costs—their value is imputed based on a notion of opportunity costs widely used by economists. In other words, costs of inputs supplied by an owner are based on the values these inputs would have received in the next best alternative activity. For illustration, assume that the owner of the firm works for ten hours a day at his business. If the owner does not receive any salary, an accountant would not consider the owner's effort as a cost item. An economist would, however, value the owner's service to his firm at what his labor would have earned had he worked elsewhere. Thus, to compute the true profit, an economist will subtract the implicit costs from business profit; the resulting profit is often referred to as economic profit. It is this concept of profit that is used by economists to explain the behavior of a firm. The concept of economic profit essentially recognizes that owner-supplied inputs must also be paid for. Thus, the owner of a firm will not be in business in the long run until he recovers the implicit costs (also known as normal profit), in addition to recovering the explicit costs, of doing business.
As pointed out earlier, a given firm attempts to maximize profits. Other firms do the same. Ultimately, profits decline for all firms. If all firms are operating under a competitive market structure, in equilibrium, economic profits (the excess of accounting profits over implicit costs) would be equal to zero; accounting profits (equal to explicit costs), however would be positive. When a firm makes profits above the normal profits level, it is said to be reaping above-normal profits.
HOW A FIRM ARRIVES AT A PROFIT-MAXIMIZING POINT.
Let us assume throughout the discussion that a firm uses an economist's definition of profits. Assume that profit is the excess of sales revenue over cost (now assumed to be composed of both explicit and implicit costs). It can also be assumed, as discussed above, that the profit maximization is the firm's primary goal. Given this objective, important questions remain: How does the firm decide on the output level that maximizes its profits? Should the firm continue to produce at all if it is not profitable?
A manufacturing firm, motivated by profit maximization, calculates the total cost of producing any given output level. The total cost is made up of total fixed cost (due to the expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of course, the total fixed cost does not vary over the short run—only the total variable cost does. It is important for the firm to also calculate the cost per unit of output, called the average cost. In addition to the average cost, the firm calculates the marginal cost. The marginal cost at any level of output is the increase in the total cost due to an increase in production by one unit—essentially, the marginal cost is the additional cost of producing the last unit of output.
The average cost is made up of two components: the average fixed cost (the total fixed cost divided by the number of units of the output produced) and the average variable cost (the total variable cost divided by the number of units of the output produced). As the fixed costs remain fixed over the short run, the average fixed cost declines as the level of production increases. The average variable cost, on the other hand, first decreases and then increases; economists refer to this as the U-shaped nature of the average variable cost. The U-shape of the average variable cost curve is explained as follows. Given the fixed inputs, output of the relevant product increases more than proportionately as the levels of variable inputs used increase. This is caused by increased efficiency due to specialization and other reasons. As more and more variable inputs are used in conjunction with the given fixed inputs, however, efficiency gains reach a maximum—the decline in the average variable cost eventually comes to a halt. After this point, the average variable cost starts increasing as the level of production continues to increase, given the fixed inputs. First decreasing and then increasing average variable cost lead to the U-shape for the average variable cost. The combination of the declining average fixed cost (true for the entire range of production) and the U-shaped average variable cost results into an U-shaped behavior of the average total cost, often simply called the average cost.
The marginal cost also displays a U-shaped pattern—it first decreases and then increases. The logic for the shape of the marginal cost curve is similar to that for the average variable cost—both relate to variable costs. But while the marginal cost refers to the increase in total variable cost due to an increase in the production by one unit, the average variable cost refers to the average variable cost per unit of output produced. It is important to notice, without going into finer details, that the marginal cost curve intersects the average and the average variable cost curves at their minimum cost points.
In a graphic rendering of this concept there would be a horizontal line, in addition to the three cost curves. It is assumed that the firm can sell as many units as it wants at the given market price indicated by this horizontal line. Essentially, the horizontal line is the demand curve a perfectly competitive firm faces in the market—it can sell as many units of output as it deems profitable at price "p" per unit (p, for example, can be $10 per unit of the product under consideration). In other words, p is the firm's average revenue per unit of output. Since the firm receives p dollars for every successive unit it sells, p is also the marginal revenue for the firm.
A firm maximizes profits, in general, when its marginal revenue equals marginal cost. If the firm produces beyond this point of equality between the marginal revenue and marginal cost, the marginal cost will be higher than the marginal revenue. In other words, the addition to total production beyond the point where marginal revenue equals marginal cost, leads to lower, not higher, profits. While every firm's primary motive is to maximize profits, its output decision (consistent with the profit maximizing objective), depends on the structure of the market it is operating under. Before we discuss important market structures, we briefly examine another key economic concept, the theory of consumer behavior.

TOOLS OF DECISION SCIENCES AND MANAGERIAL ECONOMICS

Managerial decision making uses both economic concepts and tools, and techniques of analysis provided by decision sciences. The major categories of these tools and techniques are: optimization, statistical estimation, forecasting, numerical analysis, and game theory. While most of these methodologies are fairly technical, the first three are briefly explained below to illustrate how tools of decision sciences are used in managerial decision making.
OPTIMIZATION.
Optimization techniques are probably the most crucial to managerial decision making. Given that alternative courses of action are available, the manager attempts to produce the most optimal decision, consistent with stated managerial objectives. Thus, an optimization problem can be stated as maximizing an objective (called the objective function by mathematicians) subject to specified constraints. In determining the output level consistent with the maximum profit, the firm maximizes profits, constrained by cost and capacity considerations. While a manager does not solve the optimization problem, he or she may use the results of mathematical analysis. In the profit maximization example, the profit maximizing condition requires that the firm choose the production level at which marginal revenue equals marginal cost. This condition is obtained from an optimization exercise. Depending on the problem a manager is trying to solve, the conditions for the optimal decision may be different.
STATISTICAL ESTIMATION.
A number of statistical techniques are used to estimate economic variables of interest to a manager. In some cases, statistical estimation techniques employed are simple. In other cases, they are much more advanced. Thus, a manager may want to know the average price received by his competitors in the industry, as well as the standard deviation (a measure of variation across units) of the product price under consideration. In this case, the simple statistical concepts of mean (average) and standard deviation are used.
Estimating a relationship among variables requires a more advanced statistical technique. For example, a firm may want to estimate its cost function, the relationship between a cost concept and the level of output. A firm may also want to know the demand function of its product, that is, the relationship between the demand for its product and different factors that influence it. The estimates of costs and demand are usually based on data supplied by the firm. The statistical estimation technique employed is called regression analysis, and is used to develop a mathematical model showing how a set of variables are related. This mathematical relationship can also be used to generate forecasts.
An automobile industry example can be used for the purpose of illustrating the forecasting method that employs simple regression analysis. Suppose a statistician has data on sales of American-made automobiles in the United States for the last 25 years. He or she has also determined that the sale of automobiles is related to the real disposable income of individuals. The statistician also has available the time series (for the last 25 years) on real disposable income. Assume that the relationship between the time series on sales of American-made automobiles and the real disposable income of consumers is actually linear and it can thus be represented by a straight line. A fairly rigorous mathematical technique is used to find the straight line that most accurately represents the relationship between the time series on auto sales and disposable income.
FORECASTING.
Forecasting is a method or a technique used to predict many future aspects of a business or any other operation. For example, a retailing firm that has been in business for the last 25 years may be interested in forecasting the likely sales volume for the coming year. There are numerous forecasting techniques that can be used to accomplish this goal. A forecasting technique, for example, can provide such a projection based on the experience of the firm during the last 25 years; that is, this forecasting technique bases the future forecast on the past data.
While the term "forecasting" may appear to be rather technical, planning for the future is a critical aspect of managing any organization—business, nonprofit, or otherwise. In fact, the long-term success of any organization is closely tied to how well the management of the organization is able to foresee its future and develop appropriate strategies to deal with the likely future scenarios. Intuition, good judgment, and an awareness of how well the economy is doing may give the manager of a business firm a rough idea (or "feeling") of what is likely to happen in the future. It is not easy, however, to convert a feeling about the future outcome into a precise number that can be used, for instance, as a projection for next year's sales volume. Forecasting methods can help predict many future aspects of a business operation, such as forthcoming years' sales volume projections.
Suppose that a forecast expert has been asked to provide quarterly estimates of the sales volume for a particular product for the next four quarters. How should one go about preparing the quarterly sales volume forecasts? One will certainly want to review the actual sales data for the product in question for past periods. Suppose that the forecaster has access to actual sales data for each quarter during the 25-year period the firm has been in business. Using these historical data, the forecaster can identify the general level of sales. He or she can also determine whether there is a pattern or trend, such as an increase or decrease in sales volume over time. A further review of the data may reveal some type of seasonal pattern, such as, peak sales occurring around the holiday season. Thus by reviewing historical data, the forecaster can often develop a good understanding of the pattern of sales in the past periods. Understanding such a pattern can often lead to better forecasts of future sales of the product. In addition, if the forecaster is able to identify the factors that influence sales, historical data on these factors (variables) can also be used to generate forecasts of future sales.
There are many forecasting techniques available to the person assisting the business in planning its sales. For illustration, consider a forecasting method in which a statistician forecasting future values of a variable of business interest—sales, for example—examines the cause-and-effect relationships of this variable with other relevant variables, such as the level of consumer confidence, changes in consumers' disposable incomes, the interest rate at which consumers can finance their excess spending through borrowing, and the state of the economy represented by the percentage of the labor force unemployed. Thus, this category of forecasting techniques uses past time series on many relevant variables to forecast the volume of sales in the future. Under this forecasting technique, a regression equation is estimated to generate future forecasts (based on the past relationship among variables).

Economics: Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".
Externalities
In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers.
Examples of externalities:
• A smoker annoys others with second hand smoke.
• A gardener delights a neighbour with his beautiful garden.
• A pulp mill pollutes the air and water in town.
• A perfume wearer gives a friend an allergic reaction.
Negative Externalities
When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs.
Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.
Positive Externalities
Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.
Some have argued that governments should subsidize research and development, since it will have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market.
There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value
Solution to Externalities
Externalities lead to an inefficient quantity of production and consumption. This can be remedied by either private arrangements or public policy. Externalities can be dealt with by:
1. Moral codes and social sanctions
2. Voluntary organizations - charitable groups, lobby groups
3. Internalization - when activities with complementary externalities are merged into one firm, thus eliminating the externality
4. Contracts - parties through negotiation can agree as to how to regulate the externality
Coase Theorem
If parties can bargain without cost over the allocation of resources, then the private market can always solve the problem of externalities. It can allocate resources efficiently, irrespective of how the law assigns responsibility for damages. Earlier before Coase, it was argued that the source of the externality should be penalized. It is now recognized that the party that can deal with the externality at least cost should do exactly that.

Economics: Tax and Deadweight Loss

We saw earlier how taxes on goods and services of businesses can change the demand by citizens, supply, and equilibrium price and quantity. Taxes provide revenues to the government and are usually paid by both buyers and sellers. To see the welfare effect of taxes, we need to compare the revenue received by the government, and the dead weight loss (also known as "excess burden" or "distortionary cost") to the consumers and producers.
Deadweight Loss of Taxation
Recall that in a competitive market, a given tax surcharge added to the price of each unit of a particular good (gasoline tax, food tax, federal tax) will:
• lower the price received by the seller and;
• increase the price paid by the buyer.
This allows us to use supply and demand diagram to analyze the effects of a tax on total surplus. We see that the tax places a wedge between the gross price and net prices, and the equilibrium quantity will fall as a result of the tax. What are the gains and losses as a result of a tax? The government receives tax revenue of T x Q, where T is the amount of tax per unit, and Q is the quantity sold. This is a benefit to those on whom the government spends the tax revenue.
To see the welfare losses, consider the total surplus before and after the tax. Deadweight loss, also known as "excess burden", is a pure loss to society. It represents lost value to consumers and producers due to the reduction in the sales of the good, but not captured by government revenue. In other words, the loss to consumers and producers from the tax is larger than the size of the tax revenue.
Determinants of Deadweight Loss
How large will the deadweight loss be from a particular tax? It depends on how much a given tax reduces the amount that:
• consumers are willing to purchase and;
• producers are willing to supply.
What determines how much the market will shrink? Reduction in quantity supplied as a result of a tax depends on the elasticity of supply. Generally, the more inelastic the supply, the smaller the reduction in quantity, and the smaller the deadweight loss. Reduction in quantity demanded depends on the elasticity of demand. Generally, the more elastic the demand, the more quantity demanded decreases and the greater the deadweight loss.
In general, the smaller the decrease in quantity, the smaller the deadweight loss. This occurs since the main cost of a tax is that it shrinks the size of a market below its optimum level. Overall, the more elastic the supply and demand, the larger the dead weight loss of a tax.
Deadweight Loss and Tax Revenue
For the most part, tax revenue will first increase as we raise taxes but as the gross price keeps rising, the quantity decreases more and more. Eventually, the tax revenue will also begin to decrease. the more inelastic the demand, the slower the tax revenue falls. This helps to explain why governments often put taxes on goods in inelastic demand like tobacco and gasoline. Overall, taxes on specific items will:
1. Influence people’s behaviour by inducing them away from the goods that are taxed.
2. Raise revenue for the government to spend, making those who receive the expenditures better off.
3. Create a dead weight loss.

Economics: Monopolistic Competition

Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,
• marginal revenue is always less than demand
• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity
The short-run equilibrium in monopolitic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run.
Long Run Equilibrium
In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each company’s demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each company’s market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity.
If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero.
Monopolistic Competition and Welfare
Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are:
1. Excess Capacity
o companies in perfect competition produce where ATC is at a minimum (efficient scale)
o companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity)
o could increase capacity and lower average costs
2. Make-up Over Marginal Cost
o for a competitive firm, price = marginal cost
o for a monopolistic competition firm, price > marginal cost
o there is a mark-up above MC even though the firm makes zero profits
Efficient Outcomes and Externalities
When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as,
• Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality
• Business-Stealing Externality - this is a negative externality whereby other businesses lose customers
Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market.
Product Differentiation through Advertising
Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits.
One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost.
Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing and availability. Advertising may also be a “signal of quality”, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal.

Economics:Oligopoly Market Structure

Between the definitions of perfect competition and pure monopoly lie oligopolies and monopolistic competition. An oligopoly is where there are a few sellers with similar or identical products, such as hockey skates (Bauer, CCM). Monopolistic competition has many companies with similar but not identical products. Each firm has monopoly power over what it produces, but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of oligopolies include crude oil businesses and auto manufacturers.
The main key to behaviour in an oligopoly, is that companies must take into account what other companies will do. In perfect competition, firms are price-takers and can ignore other firms. In a monopoly, there is only one firm, and it does not take into account what competitors will do. Oligopolists are torn between:
1. cooperating to increase profits by obtaining the monopoly outcome, or;
2. competing to try to gain an advantage over competitors.
Duopolies and Cartels
A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and agree to restrict output to the monopoly quantity, where price is greater than margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies come from collusion where firms agree to share output and set prices such as in a cartel.
A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up with the competitive position with profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and consequently profits.
Size of an Oligopoly and the Market Outcome
Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the number of companies increases, the more the industry resembles a competitive outcome, since each company has a smaller effect on the outcome. The mentality where each company tends to think only of its own profits and strategic behaviour is reduced. Each company will increase production as long as price is greater than marginal cost. As the number of companies increases, we tend to move towards a perfectly competitive outcome.
Game Theory and Prisoners' Dilemma
Game theory is the study of how people behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its profits depend on actions of other firms. This gives rise to the "prisoners’ dilemma".
The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for shortsighted personal gain. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non-dominant) strategy.

Economics:Theory of Consumer Choice

Consumers face trade-offs in their purchase decisions, since their income is limited and choices are numerous. In order to make choices, consumers must combine budget constraints (what they can afford), and preferences (what they would like to consume).
A budget contraint, means what a consumer can purchase is constrained by income. The slope of the budget constraint measures the rate at which one consumer can trade off one good for another, and the relative prices of the two goods. Budget constraints are determined by both the income of the consumers, and the relative prices.
If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. The consumer will get the same level of satisfaction (utility) from either bundles. Graphically speaking, this is known as the indifference curve. This curve shows that all bundles are equally preferred, or have the same utility or same level of satisfaction. The slope of indifference curve is the rate at which a consumer is willing to trade one good for another, which is also known as the marginal rate of substitution (MRS).
Properties of Indifference Curves
1. Higher indifference curves are preferred to lower ones, since more is preferred to less (non-satiation).
2. Indifference curves are downward sloping. If the quantity of one goods is reduced, then you must have more of the other good to compensate for the loss.
3. Indifference curves do not cross (intersect), since this would imply a contradiction.
4. Indifference curves are bowed inward (in most cases). The slope of indifference curves represent the MRS (rate at which consumers are willing to substitute one good for the other). People are usually willing to trade away more of one good when they have a lot of it, and less willingto trade away goods which are in scarce supply. This implies that MRS must increase as we get less of a good.
Nota bene that two extreme examples exist. Perfect substitutes have straight-line indifference curves. As we get more of the good, we trade off with the substitute at a constant rate because we are indifferent between them (i.e. Coke and Pepsi). Perfect complements have right-angled indifference curves. If goods can only be used together, there is no satisfaction in having more of A without additional amounts of B (i.e. left and right shoe). In general, the better substitutes goods are, the straighter the indifference curve.
Consumers' Optimal Choice
We must combine what a consumer can obtain (budget constraint) and the preferences (indifference curve). The optimum is the highest point on the indifference curve that is still within the budget constraint. This will usually occur where the indifference curve is tangent to budget constraint. At the optimum point, MRS = relative prices of goods since MRS = slope of indifference curve, and relative price = slope of budget constraint. The marginal rate of substitution is the rate at which consumers are willing to trade-off, and is equal to rate at which they can trade.
Changes in income will undoubtedly affect the optimal choice. The budget constraint will shift parallel to the original - upwards for an increase in income, and downwards for a decrease in income. The new equilibrium for a higher income will be on a higher indifference curve, and since income is higher, more of both products could be consumed. For normal goods, as income increases, more of the good will be preferred. For inferior goods, as income increases, less of the good will be chosen.
Changes in Prices
A change in price will change the slope of the curve. A fall in price will rotate the budget constraint outwards, and an increase in price will rotate the budget constraint inwards. Thus a change in price will change both the relative prices of the two products and also the amount that can be bought, ceteris paribus (income). Changes in price has two effects:
1. Substitution Effect
o arises from the tendency to buy less of goods which are more expensive
o can be measured by keeping satisfaction constant (stay on same indifference curve and finding where MRS = new relative prices
2. Income Effect
o arises from change in price effect on total amount that can be purchased
o change in consumption when we shift to a new indifference curve as a result of the price change

Elasticity of Supply and Demand

What happens to the quantity demanded when the price of a good changes? If quantity changes a lot, we say that demand is elastic and stretches. If quantity changes only a little, demand is inelastic and the quantity does not stretch much. The "price elasticity (E)" of demand is equal to "% change in quantity demanded" divided by "% change in price".
When the value of E is equal to zero, demand is perfectly inelastic. If E is between 0 and 1, then demand is inelastic. When the value of E is equal to one, demand is unit elastic. If E happens to be greater than one, then demand is elastic. If E is equal to infinity, then demand is perfectly elastic. Note that although price and quantity demanded move in opposite directions, elasticity will always be positive by convention.
Determinants of Elasticity
Many factors influence elasticity, some of which include:
1. Necessities versus Luxuries - It is harder to find substitutes for necessities so quantity demanded will change less.
2. Availability of Close Substitutes - If there are close substitutes, buyers will move away from more expensive items and demand will be elastic.
3. Definition of the Market - The more broadly we define an item, the more possible substitutes and the more elastic the demand.
4. Time Horizon - The longer the time available, the easier to find substitutes and the more elastic the demand.
5. Relative Size of Purchase - Purchases which are a very small portion of total expenditure tend to be more inelastic, because consumers are not worried about the extra expenditure.
Total Revenue and Elasticity
Raising the price will have two effects: more revenue per unit sold and; fewer units sold. In order to increase total revenue, we must decide which of the two effects is greater. When demand is inelastic, total revenue is more influenced by the higher price and increases as price increases. When demand is elastic, total revenue is more influenced by the lower quantity and decreases as price increases.
Income Elasticity of Demand
There are factors other than price that influence the demand for a product. Income elasticity of demand is calculated as the percent change in quantity demanded divided by percent change in income, ceteris paribus. There are two possible relationships. If demand increases when income increases, elasticity is positive and good is normal. If demand decreases when income increases, elasticity is negative and good is inferior.
The main influence on income elasticity of demand is whether a good is a luxury or a necessity. When goods are luxuries, elasticity is usually highly positive (greater than one). When goods are necessities, elasticity is usually lower (less than one). When goods are very basic, they can even be inferior (less than zero), such that demand falls when income rises.
Elasticity of Supply
This is a measure of how much quantity supplied (QS) reacts to a change in prices. Elasticity of Supply is equal to "percent change of QS" divided by "percent change in price". This value can range from zero to infinity. When elasticity is less than one, supply is inelastic. If elasticity is greater than one, then supply is elastic. The main determinant of supply elasticity is length of time. The shorter the time period, the more inelastic the supply, because it is harder to get the additional inputs to increase production. It also depends on whether the firm is near its capacity.

Business Economics

Business economics is defined as the study of how businesses manage scarce resources. Microeconomics is the study of the decisions of individuals, households, and businesses in specific markets, whereas macroeconomics is the study of the overall functioning of an economy such as basic economic growth, unemployment, or inflation. Scarcity in microeconomics is not the same as poverty. It arises from the assumption of very large (or infinite) wants or desires, and the fact that resources to obtain goods and services are limited.
• wants exceed resources necessary to obtain them
• therefore we must make choices
• every choice leads to a cost
Principles of Economics:
1. People face trade-offs.
Every decision involves choices, and more of one good means less of another good. Income and wealth are not limitless, since there is only so much time available. Trade-offs apply to individuals, families, corporations and societies.
2. Cost of something is what you give up to get it.
When we make a decision we implicitly compare the costs and benefits of our choices. Opportunity cost is whatever must be given up to obtain something. Some costs are obvious – out-of-pocket expenses; other costs are less obvious but must be included in total opportunity cost.
3. Rational people think at the margin.
Basic economics assumes that people act rationally and try to act so as to gain the most benefit for themselves compared to the associated costs. Microeconomics focuses on small or marginal) changes, and it is often rational to consider the marginal rather than the average effects of decisions.
4. People respond to incentives.
If rational people compare costs and benefits, then changes in either one may change decisions. An example of an incentive that people respond to, are changes in prices. In general, people are more likely to buy something if it is cheaper. If an action becomes more costly, then there is an incentive to switch to other choices. Note that all actions have substitutes.
Explicit costs vs. Implicit costs
The cost of something, say a business, includes both the explicity cost (usually the price) and the implicit costs. One major implicit cost is the opportunity cost. Opportunity costs includes the next best opportunity given up. Only actions have costs; if there are no choices, then there are no costs. Be aware that cost is subjective. For example, compare the psychological benefit of a new computer. Decide whether you would rather have the a vacation to Europe, or a brand new computer.
Disagreement in Economics
Business economics is both a science and a study of policy – united by a common “way of thinking”. As a science, economists develop models and deliberately simplify accounts of how cause and effect work in some part of the economy. Based on assumptions of what is important, models are created and used to make suggestions about policy and improve basic economic outcomes. Policy involves decisions about scientific theories, personal values and particular circumstances.
Positive statements are claims about what the world is like, although they may be false. For example, "Minimum wage laws cause unemployment". Normative statements are claims about how the world ought to be, and are based on values as well as positive knowledge. For example, "The government should raise minimum wage". Economists may disagree over either positive or normative statements or both, but the great majority tend to agree over basic positive propositions. As such, most disagreements are over normative/policy issues.
Public Goods
Public goods include things such as fireworks displays, and basic research. According to basic economics, a free market is unlikely to provide enough public goods, due to the “free rider” problem. A free-rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity consumed is not directly related to the amount paid. As a result:
• there may not be enough incentive to pay for public goods through individual action;
• you cannot be prevented from consuming the good even if you do not pay for it and;
• it creates an external benefit on those not involved.
Business economics state that we can decide how much of a public good to produce, by considering a cost-benefit analysis of public goods. The total benefit is equal to the total dollar value that an individual places on a given level of production of a public good. Total Cost is what we must give up to get more of the public good. These are often difficult to calculate - especially the benefits. For example, what is the benefit of saving a human life, and what is the benefit of more flowers in the downtown?
Once we decide on the benefits, then we want to provide enough of the public good to maximize net benefits. That is, total benefits - total costs. The private market will usually not produce enough of a public good. However, it is often done by government because it can compel everyone to contribute through taxes.
The problem is not that people are selfish, per se, but the free-rider problem. If some people do not voluntarily contribute, others who do contribute will feel that it is unfair and may stop contributing as well.
Common Property Resources
These resources include clean air, oil pools, congested roads, fish, whales and other wild life. The problem here is that it is hard to exclude people, but one person’s use reduces that of others'. Over-use of these resources is sometimes dramatically referred to as, "Tragedy of the Commons". This tragedy refers to the common grazing rights in medieval England, in which:
• all families could graze sheep on the common land which was collectively owned and;
• as population and number of sheep increased, common land became over-grazed.
People did not reduce their use, because social and private incentives differed. Each individual’s best move is to get as much of the resource as possible before it is gone. The social optimum is to restrict use. The problem is that each individual creates a negative externality by reducing amount available to others. A few possible solutions were:
1. Custom or regulations could put a maximum on how much each family could use the resource;
2. They could have internalized the externality by auctioning off rights to graze and;
3. They could have created private property rights.
Property Rights
Economists realize that property rights are very important for efficient use of resources. When an individual owns and controls the resource, they have an incentive to increase its value. When everyone owns a resource, or rather, no one owns the resource, there is no one to charge for use, or who can attach a price. An example of such, is air that we breath.
For some goods we can establish property rights, like the pollution permit. For other goods, like national defence or clean air, the government can improve the outcome by regulating or providing the product.