Lecture 1: Welcome to Managerial Economics

Abdul Quadir
XLRI

July 5, 2021
Why Economics For Managers?

I Is it better to give cash or ration to a person below poverty line?

I Why should the amusement park charge an entry fee, then there are prices for
each activity?
I When is it good for the airlines to use dynamic prices?
I Why does Uber use surge pricing?
I Why do we see different discounts and sale mechanism in the market?
I Why does a firm produce different varieties of a product?
I Why is the pollution or congestion a big problem in almost all cities?
I How can we price CO2 emission?
Why Economics For Managers?

I Is it better to give cash or ration to a person below poverty line?

I Why should the amusement park charge an entry fee, then there are prices for
each activity?
I When is it good for the airlines to use dynamic prices?
I Why does Uber use surge pricing?
I Why do we see different discounts and sale mechanism in the market?
I Why does a firm produce different varieties of a product?
I Why is the pollution or congestion a big problem in almost all cities?
I How can we price CO2 emission?
Why Economics For Managers?

I Economics provide a framework for thinking

I To understand Society
I To understand domestic and global business affairs
I To understand government complex policy making
I Economics is broadly divided into:
I Microeconomics
I Macroeconomics
I Methods to study economics are broadly divided into:
I Theories and models
I Economic policy (Empirical methods)
Scope and Methods of Economics

Economics is the study of how individuals and societies choose to use the scarce
resources that nature and previous generations have provided.
I Economics is also called the science of constrained choice
I Economics is a behavioral, or social science.
I In broad sense it is the study of how people make choices
I Broadley,
1. What goods and services will be produced, and in what quantities?
2. Who will produce the goods and services, and how?
3. Who will receive the goods and services?
Scope and Methods of Economics

Economics is the study of how individuals and societies choose to use the scarce
resources that nature and previous generations have provided.
I Economics is also called the science of constrained choice
I Economics is a behavioral, or social science.
I In broad sense it is the study of how people make choices
I Broadley,
1. What goods and services will be produced, and in what quantities?
2. Who will produce the goods and services, and how?
3. Who will receive the goods and services?
Tool for Understanding Economic Problems

I Economic models are abstractions from realities to get insight for explaining real
situations
I Model: A formal statement of a theory, usually a mathematical statement of a
presumed relationship between two or more variables.
I In almost all models in Chemistry, physics or economics: there are two types of
variable
I Exogenous variable: A variable whose value is taken as given in the analysis of an
economic system
I Endogenous variable: A variable whose value is determined within the economic
system being studied
Analytical Tools for any Microeconomics Models

Almost all microeconomics models use the following three analytical tools:
1. Constrained optimization
2. Equilibrium analysis
3. Comparative statics
Constrained Optimization

I Constrained optimization is used when a decision maker seeks to make the best
(optimal) choice, taking into account any possible limitations or restrictions on
the choices
I A constrained optimization problems consist on two parts:
1. objective function: It is the relationship that the decision maker seeks to “optimize”
2. a set of constraints
Example

I Suppose a farmer plans to build a rectangular fence as a pen for his sheep.
I He has F feet of fence and cannot afford to purchase more
I However, he can choose the dimensions of the pen, which will have a length of L
feet and a width of W feet
I He wants to choose the dimensions L and W that will maximize the area of the
pen
I He must also make sure that the total amount of fencing he uses (the perimeter
of the pen) does not exceed F feet
I What is the objective function for this problem?
I What is the constraint?
I Which of the variables in this model (L, W , and F ) are exogenous? Which are
endogenous? Explain.
Example

I Suppose a farmer plans to build a rectangular fence as a pen for his sheep.
I He has F feet of fence and cannot afford to purchase more
I However, he can choose the dimensions of the pen, which will have a length of L
feet and a width of W feet
I He wants to choose the dimensions L and W that will maximize the area of the
pen
I He must also make sure that the total amount of fencing he uses (the perimeter
of the pen) does not exceed F feet
I What is the objective function for this problem?
I What is the constraint?
I Which of the variables in this model (L, W , and F ) are exogenous? Which are
endogenous? Explain.
Example

I Suppose a farmer plans to build a rectangular fence as a pen for his sheep.
I He has F feet of fence and cannot afford to purchase more
I However, he can choose the dimensions of the pen, which will have a length of L
feet and a width of W feet
I He wants to choose the dimensions L and W that will maximize the area of the
pen
I He must also make sure that the total amount of fencing he uses (the perimeter
of the pen) does not exceed F feet
I What is the objective function for this problem?
I What is the constraint?
I Which of the variables in this model (L, W , and F ) are exogenous? Which are
endogenous? Explain.
Example

I Suppose a farmer plans to build a rectangular fence as a pen for his sheep.
I He has F feet of fence and cannot afford to purchase more
I However, he can choose the dimensions of the pen, which will have a length of L
feet and a width of W feet
I He wants to choose the dimensions L and W that will maximize the area of the
pen
I He must also make sure that the total amount of fencing he uses (the perimeter
of the pen) does not exceed F feet
I What is the objective function for this problem?
I What is the constraint?
I Which of the variables in this model (L, W , and F ) are exogenous? Which are
endogenous? Explain.
Marginal Analysis and Optimization
Consider that a manager has 1 million rupees at her disposal to spend on
advertisement for a product: either TV advertisement or Radio

Total Spent TV Radio

0 0 0
100,000 4,750 950
200,000 9,000 1,800
300,000 12,750 2,550
400,000 16,000 3,200
500,000 18,750 3,750
600,000 21,000 4,200
700,000 22,750 4,550
800,000 24,000 4,800
900,000 24,750 4,950
1,000,000 25,000 5,000
Marginal Analysis and Optimization

Total Spent TV Marginal Radio marginal

Increment Increment
0 0 0
100,000 4,750 4,750 950 950
200,000 9,000 4,250 1,800 850
300,000 12,750 3,750 2,550 750
400,000 16,000 3,200
500,000 18,750 3,750
600,000 21,000 4,200
700,000 22,750 4,550
800,000 24,000 1250 4,800
900,000 24,750 750 4,950 150
1,000,000 25,000 250 5,000 50
Marginal Analysis and Optimization

Total Spent TV Marginal Radio marginal

Increment per Rs Increment per Rs
0 0 0
100,000 4,750 0.047 950 0.0095
200,000 9,000 0.0425 1,800 0.0085
300,000 12,750 2,550 0.0075
400,000 16,000 3,200
500,000 18,750 3,750
600,000 21,000 4,200
700,000 22,750 4,550
800,000 24,000 0.0125 4,800
900,000 24,750 0.0075 4,950 0.0015
1,000,000 25,000 0.0025 5,000 0.0005
Marginal Analysis and Optimization

I The solution depends on marginal impact of the decision variables on the value of
the objective function
I The marginal impact of money spent on TV advertising is how much new sales go
up for every additional dollar spent on TV advertising
I The marginal impact of money spent on radio advertising is the rate at which new
sales go up for every additional dollar spent on radio advertising
Equilibrium Analysis
I An equilibrium in a system is a state or condition that will continue indefinitely
as long as exogenous factors remain unchanged
p

surplus
S

3 excess demand

200 300 400 q

Comparative Statics
comparative statics is used to examine how a change in an exogenous variable will
affect the level of an endogenous variable
p
S1

S0
30

20

q (metric ton)
720 800
Opportunity Cost

I Opportunity cost: The best alternative that we forgo, or give up, when we make
a choice or a decision
I Example: What is the cost of doing MBA?
I Opportunity cost arises because resources are scare.
I Sunk costs: Costs that cannot be avoided, regardless of what is done in the
future, because they have already been incurred
I Marginalism: The process of analyzing the additional or incremental costs or
benefits arising from a choice or decision
Application: Marginalism and Sunk Cost

Why airlines use dynamic prices?

I Suppose an airline such as indigo incurs 6 lac rupees per flight from Delhi to
Ranchi
I Is it better to charge a fixed price whenever the customer books the ticket?
I Suppose the airlines charges 4000 rupees per seat.
I If the airline succeeds in selling 150 seats, then it can recover the operating cost
of the flight
I After 150, the marginal cost of a passenger is zero.
I Better to increase the prices of the ticket and generate more revenue.
Application: Marginalism and Sunk Cost

Why airlines use dynamic prices?

I Suppose an airline such as indigo incurs 6 lac rupees per flight from Delhi to
Ranchi
I Is it better to charge a fixed price whenever the customer books the ticket?
I Suppose the airlines charges 4000 rupees per seat.
I If the airline succeeds in selling 150 seats, then it can recover the operating cost
of the flight
I After 150, the marginal cost of a passenger is zero.
I Better to increase the prices of the ticket and generate more revenue.
No Free Lunch

I Efficient market: A market in which profit opportunities are eliminated almost

instantaneously
I Example: Shorter queue in supermarket gets equalized immediately
I If you receive a call on your phone from person claiming to be a stock expert and
promising you 20% return, your immediate reaction is skepticism.
Methods of Economics

I Positive economics: An approach to economics that seeks to understand

behavior and the operation of systems without making judgments. It describes
what exists and how it works.
I Normative economics An approach to economics that analyzes outcomes of
economic behavior, evaluates them as good or bad, and may prescribe courses of
action
I This is also called policy economics
Calculus

The derivative of a function is used in defining several basic economic concepts:

I elasticities
I marginal quantities such marginal revenue, marginal cost, marginal utility etc.
I to characterize critical values of a function such as a maximum
The derivative of a function f : X → R, y = f (x) is given by

dy f (x + δ) − f (x)
= lim
dx δ→0 δ
dy
Sometime we denote dx by f 0 (x).
Derivative Rules
dy
1. Derivative of a constant function y = f (x) = a: dx =0
2. Derivative of a function y = x n : dy
dx = nx n−1
dy
3. Derivative of a function y = af (x): dx = af 0 (x)
4. Derivative of the sum or difference of two functions, y = f (x) + g (x):
dy 0 0
dx = f (x) + g (x)
5. Derivative of the product of two functions, y = f (x)g (x):
dy 0 0
dx = f (x)g (x) + f (x)g (x)
f (x)
6. Derivative of the quotient of two functions, y = g (x) :

dy g (x)f 0 (x) − f (x)g 0 (x) x 2 − 3x

= Example: y =
dx (f (x))2 x2
dy du
7. Derivative of a composite function, y = g (u), u = f (x) or y = g (f (x)): du dx
Derivative Rules

I Example of derivative of a composite function: y = u 2 and u = 2x + 5 or

y = (2x + 5)2
I dy du dy du
du = 2u and dx = 2, thus du dx = 4u = 4(2x + 5)
I The derivative of the natural logarithm, y = ln x: dy 1
dx = x
I The derivative of the exponential function, y = e x : dy
dx = e
x

I Second-order derivative of a function y = f (x):

d 2y
 
d dy
= = f 00 (x)
dx dx dx 2
Slope

I The slope of the line indicates whether the relationship between the variables is
positive or negative
I The slope of a line between two points is the change in the quantity measured on
the Y -axis divided by the change in the quantity measured on the X -axis
I That is, ∆Y Y2 −Y1
∆X = X −X 2 1
I For smooth curve, we can use calculus for increasing and decreasing curves
I dy
dx > 0 implies increasing slope
I dy
dx < 0 implies decreasing slope
I the second order derivative depicts the curvature of the function
I Increasing at a (increasing) decreasing rate or decreasing at a (increasing)
decreasing rate
Slope
Convex and Concave Curve

I the second order derivative depicts the curvature of the function

I Increasing at a (increasing) decreasing rate or Decreasing at a (increasing)
decreasing rate
I d 2y
dx 2
≥ 0, convex
I d 2y
dx 2
≤ 0 concave
Non-Linear Graphs