Basic Economic Relations Outline

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Basic Economic RelationsOutline

• Economic Optimization
• Basic Economic Relations
• Review of Basic Microeconomics

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Economic Optimization

• Optimal decision- the choice alternative that
  produces a result most consistent with managerial
  objectives, which we presume is profit
  maximization.

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Maximizing the Value of the Firm

• The value of the firm is impacted by
• Total Revenue.... which is a function of
  marketing strategies, pricing and distribution
  policies, nature of competition....
• Total Cost .... which is a function of the price
  and availability of inputs, alternative
  production methods...

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Steps in the Decision Process

• Economic relations must be expressed in a form
  suitable for analysis the managerial decision
  problem must be expressed in analytical terms.
• Optimization techniques must be applied to
  determine the best, or optimal, solution in light
  of managerial objectives.

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Basic Economic RelationsOutline

• Functional Relations Equations
• Total, Average, and Marginal Relations
• Graphing Total, Average, and Marginal Relations

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Functional Relations EquationsDefinitions

• Equations Analytical representation of
  functional relationships.
• Dependent Variable The variable on the left
  side of the equation...the y-variable...the
  variable whose value is dependent upon changes in
  the x-variables...the endogenous variable.
• Independent Variable The variables on the right
  side of the equation...the x-variables...the
  variables who determine the value of the
  y-variable...the exogenous variable.

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Functional Relations EquationsMore Definitions

• Endogenous variable A factor that is determined
  by the independent variables in the model.
• Exogenous variables A factor determined outside
  the model, yet impacts the dependent variable in
  the model.

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Functional Relations Equations

• TR f(Q)
• In words....
• Total Revenue is a function of output.
• What is endogenous?
• What is exogenous?
• Are there other variables that will impact total
  revenue?

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Total, Average, and Marginal RelationsDefinitions

• Marginal change in a dependent variable caused
  by a one unit change in an independent variable.
• A Marginal Change is represented as
• ?Y / ?X
• Alternative definitions
• Rate of change
• Slope

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Examples of Marginal Relationships

• Marginal Revenue change in total revenue
  associated with a one-unit change in output.
• Marginal Cost Change in total cost associated
  with a one-unit change in output.
• Marginal Profit Change in profit associated
  with a one-unit change in output.

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Examples of Average Relationships

• Average Revenue Total Revenue/Output
• What is another name for average revenue?
• Average Cost Total Cost/Output
• Average Fixed Cost TFC / Q
• Average Variable Cost TVC/Q
• Average Profit Total Profit/ Output

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Graphing Total, Marginal, and Average Relations

• Slope a measure of the steepness of a line.
• OR The rate of change
• The marginal relation
• Tangent a line that touches but does not
  intersect a given curve.
• This is used to find the slope of a nonlinear
  curve.
• Inflection Point a point of maximum slope.

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Review of Basic Microeconomics

• Law of Demand As the price of a good rises,
  quantity demand will fall, ceteris paribus.
• In equation form P a bQ
• Total Revenue Price Quantity
• In equation form TR PQ
• OR TR aQ bQ2

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Review of Basic Microeconomics

• Own-price elasticity
• ?Q / ?P
• How does elasticity vary along a linear demand
  curve?
• The upper half of a linear demand curve is
  elastic.
• The lower half of a linear demand curve is
  inelastic.
• BE ABLE TO EXPLAIN WHY!!!
• The search for substitutes as price increases
• Big number, small number explanation
• Calculating elasticity at the midpoint.

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Review of Basic Microeconomics

• Connecting Elasticity to Total Revenue
• If change in Q gt change in P
• decreasing the price will increase TR
• and marginal revenue must be positive.
• If change in Q lt change in P
• increasing the price will increase TR
• and marginal revenue must be negative.
• BE ABLE TO ILLUSTRATE THE RELATIONSHIP

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Review of Basic Microeconomics

• Revenue Maximization Activity level that
  generates the highest revenue.
• If P 100 2Q, how much should I produce to
  maximize total revenue?
• Marginal Revenue 100 4Q
• Total Revenue is maximized when marginal revenue
  is zero. WHY???
• When Marginal Revenue is positive, Total Revenue
  is rising.
• When Marginal Revenue is negative, Total Revenue
  is falling.
• When Marginal Revenue is zero, Total Revenue is
  neither rising or falling, therefore it is
  maximized.
• Therefore, total revenue is maximized at 25 units.

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Review of Basic Microeconomics

• What is the objective of the firm?
• PROFIT MAXIMIZATION
• Profit Total Revenue Total Cost
• To understand profit, you need to understand both
  revenue and cost. Understanding total revenue
  begins with the Law of Demand. Understanding
  total cost begins with the Law of Diminishing
  Returns.

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Review of Basic Microeconomics

• The Law of Diminishing Returns As a variable
  input increases, holding all else constant, the
  rate of increase in output will eventually
  diminish.
• DO NOT PARAPHRASE!!!
• The Law of Diminishing Returns is the foundation
  from which we build the relationship between
  output and total cost, marginal cost, and average
  cost.

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Review of Basic Microeconomics

• Average Cost Minimization
• Why not Total Cost Minimization?
• If Marginal Cost is less than Average Cost,
  Average Cost will be declining.
• If Marginal Cost is greater than Average Cost,
  Average Cost will be increasing.
• When MC AC, Average Cost is Minimized.

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Review of Basic Microeconomics

• Profit Total Revenue Total Cost
• Marginal Profit MR MC
• Profit is maximized when marginal profit equals
  zero. WHY?
• When marginal profit is positive (MRgtMC), profit
  is rising.
• When marginal profit is negative (MRltMC), profit
  is falling.
• When marginal profit is zero (MRMC), profit is
  not rising or falling, it is maximized.

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The Law of Demand
Law of Diminishing Returns

• Total Cost and Output
• Marginal Cost and Average Cost
• AVERAGE COST
• MINIMIZING LEVEL OF
• OUTPUT

• Price and Output
• via Own-Price Elasticity
• Total Revenue and Output
• Marginal Revenue and Output
• REVENU E MAXIMIZING LEVEL
• OF OUTPUT

Profit Total Revenue Total Cost Marginal
Profit Marginal Revenue Marginal Cost PROFIT
MAXIMIZING LEVEL OF OUTPUT