Finance 30210: Managerial Economics

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Finance 30210 Managerial Economics

• Supply, Demand, and Equilibrium

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When we talk about the market process, we are
talking about the interaction between two groups
of people
Consumers make decisions about what to buy, where
to shop, etc. in order to maximize their
enjoyment we can summarize these decisions with
a demand curve
Businesses make decisions about what to produce
and how to produce to maximize profit we can
(sometimes) summarize their decisions with a
supply 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
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Lets start with a very simple questionif you
were to buy an ice cream cone right now, how much
would you be willing to pay? What factors
influence your choice?
Lets suppose that you would pay up to, but not
over 5
Price
Now, suppose that the market price for ice cream
is 3
5
2
3
We refer to the 2 difference between what you
are willing to pay and what you actually pay your
consumer surplus
Quantity
1
4
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 diminishing marginal utility
Now, at the same market price, you would be
willing to buy two ice cream cones
Price
5
4
2
1
3
With 2 ice cream cones, you would earn 3 of
consumer surplus
Quantity
1
2
5
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
is a function of
Quantity demanded for some commodity x
5
Price of X
D
Income
Prices of other goods
Quantity
1
Note that a particular demand curve shows the
quantity demanded for any given price HOLDING
EVERYTHING ELSE CONSTANT!!!
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Demand curves slope down due to diminishing
marginal utility. The elasticity of demand
measures the strength of this effect
Price
-
5
- 20
4
D
Quantity
1
2
100
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If we know the form of the demand function, there
is an easy way to calculate elasticity.
Price
Change in demand with respect to price
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One particular point on the demand curve
D
Quantity
100
8
Look what happens as we change the point on the
demand curve
20
15
5
50
150
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For linear demand curves, elasticity is not
constant!
How is knowing the elasticity of demand useful?
A/B
High elasticity
Low elasticity
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Expenditures are maximized at the point on the
demand curve where elasticity equals -1
Expenditures 1550750
20
Expenditures 101001000
15
10
5
Expenditures 5150750
50
150
100
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Elasticity and Expenditures
10
5
150
100
If the elasticity is less than one, the revenues
increase if elasticity is greater than negative
one, revenues decrease
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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
Suppose that a 40 increase in your income (say,
from 100 per week to 140) induces you to buy an
additional ice cream at the initial 5 price
Price

5
D
Quantity
1
2
100
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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
Suppose that a 50 increase in the price of soda
induces you to buy an additional ice cream at the
initial 5 price
Price
or -
5
D
Quantity
1
2
0
100
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While each consumer is making purchasing
decisions (intensive margin), the market demand
adds up these decisions across all consumers
(extensive margin).
Individual
Aggregate
3
3
2
5
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Now, suppose that you are an ice cream salesman.
At what price would you be willing to sell ice
cream? What factors influence your decision?
Lets suppose that you would require at least 2
to cover your costs of producing that ice cream.
We call this cost your marginal cost
Price
Now, suppose that the market price for ice cream
is 5
5
3
We refer to the 3 difference between the market
price and your marginal production cost your
producer surplus
2
Quantity
1
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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
Note that marginal costs are increasing with
production
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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 cream cones
Price
5
2
3
3
2
With 2 ice cream cones, you would earn 5 of
producer surplus
Quantity
1
2
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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
is a function of
Quantity supplied for some commodity x
Price of X
2
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!!!
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Supply curves slope up due to diminishing
marginal utility. The elasticity of supply
measures the strength of this effect
Price

3
50
2
D
Quantity
1
2
100
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An increase in costs at the margin will lower
quantity supplied. The cost elasticity of supply
measures the strength of this effect
Suppose that a 50 rise in marginal costs lowers
supply from 2 to one at the 3 price
Price
-
3
2
D
Quantity
1
2
-50
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While each producer is making supply decisions
(intensive margin), the market demand adds up
these decisions across all producers (extensive
margin).
Individual
Aggregate
5
10
4
2
6
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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.
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
100
200
25
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Also, note that every item that is sold is
profitable for everyone involved
Price
S
6
Consumer Surplus
4
Producer Surplus
2
D
Marginal Cost
Quantity
100
25
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In fact, the market equilibrium maximizes both
consumer surplus and producer surplus.
Therefore, everyone involved has accomplished
their objectives.
Price
Total Consumer Surplus
S
Total Producer Surplus
4
D
Quantity
Total Production Costs (Less Fixed Costs)
100
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The market process represents an aggregation of
preferences. Freely adjusting prices give
everyone the proper incentives.
P
Supply curves aggregate the costs of producers
S
4
Demand curves aggregate the preferences of
consumers
D
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
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Suppose that the value of this product to
consumers increases
P
S
4
At the initial price, a temporary shortage
exists. Consumers battle to obtain the good
prices get bid up
D
Q
100
A rising price creates the incentive for firms to
raise production.
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Suppose that the production costs drop
P
S
At the initial price, a temporary surplus exists.
Firms cut prices to increase sales
4
D
Q
100
A falling price creates the incentive for
consumers to increase their purchases.
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An Application of Supply and Demand
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What Factors are driving crude oil prices?
OPEC is limiting production to maintain high
prices
IRAQ
Iraqi Oil Production hasnt picked up as quickly
as expected following the gulf war.
Nigeria
Nigerian rebels are threatening oil production
Venezuela
Venezuela has yet to fully recover from the
strike of 2003
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What Factors are driving crude oil prices?
Economic Growth Rates (Inflation Adjusted) 2004
As world incomes rise, so does demand!!
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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).
Both factors are acting to increase price!!
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30
40
60
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Market prices should be a reflection of valueto
everybody!
Suppose that your 10th hour of work produces 80
worth of output
Productivity per hour
80
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Your 60th hour produces much less than the 10th
hour
20
D
Hours
10
30
60
Generally speaking, the more one works, the less
productive they become.
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Market prices should be a reflection of valueto
everybody!
Time Value
S
100
Your 100th hour of work (your 100th hour of
foregone leisure) is worth a lot more
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5
Hours
4
20
100
Your 4th hour of work (your 4th hour of foregone
leisure) is only worth 5 to you.
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A market equilibrium represents trades that are
beneficial to everyone involved!
Every hour worked is profitable for the firm
Wage
S
The worker is compensated by at least as much as
is required for every working hour
50
D
Hours
38
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So, why do we see wages rising over time?
Wage
Explanation 1 Individuals are requiring more
compensation over time
S
50
Explanation 2 Individuals are becoming more
productive over time
D
Hours
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So, which is it?
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• Labor productivity growth has averaged 1-2.5 per
  year since WWII.
• Wages have grown (in real terms) by 2 per year

Wage
S
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Suppose that new technology makes us 10 more
productive across the board
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D
Hours
38
40
This is generally consistent with what we see in
the short term as well.
Percentage Change
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However, an anomaly appears at the micro level
Salary
Salary
220,000
Productivity
4/yr
46,000
Age
21
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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)
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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 cant 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)

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The preservation paradox

• By recycling one ton (2,000 lbs.) of paper, we
  save 17 trees 6,953 gallons of water 463
  gallons of oil 587 pounds of air pollution 3.06
  cubic yards of landfill space and 4,077 Kilowatt
  hours of energy.
• The average American uses 650 pounds of paper per
  year.

Lets do a back of the envelope calculation here
300 million Americans translates into roughly 100
million tons of paper used per year if this
paper was recycled, we could save roughly 1.7
BILLION Trees per year!!!
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Is it possible for recycling to actually LOWER
the number of trees in the US?
Lets think about this from the point of view of
a logging companysuppose our logging company
owns 100 acres of forest. Each acre of land
produces 50 trees per year, but different
terrains have different logging costs.
20 Acres 160 per acre
25 Acres 150 per acre
25 Acres 190 per acre
30 Acres 180 per acre
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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 per year
1250
2250
3750
5000
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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 recycling programs lower the
need for trees. What happens?
Revenue per acre
S
D
200
190
180
D
170
160
150
Number of Trees supplied per year
5000
2250
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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!!
20 Acres 160 per acre
25 Acres 150 per acre
Treeless Land!!
Im not sure this is what conservationists had in
mind!!!
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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
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The indifference principle states that the
marginal consumer should be indifferent between
any two choices!
Economic Incentive (Expected) Benefit
Opportunity Cost
Determined in college tuition market
Determined in job markets
For the marginal consumer, Expected Benefits
Costs!!
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The indifference principle states that the
marginal consumer should be indifferent between
any two choices!
30k/yr
20k/yr
32k/yr
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30k/yr
20k/yr
32k/yr
Expenses
Benefits
30k/yr Tuition
12k/yr Higher Salary
20k/yr Lost Wages
The Present Value of 12K per year for 40 years
(I 5) is 200K
50k/yr x 4 200K
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30k/yr
20k/yr
50k/yr
Suppose that high education jobs were overvalued.
How would markets adjust?
As more people chose to leave unskilled jobs and
return to school, the supply of unskilled labor
would fall (raising unskilled wages) while demand
for college rises (tuition increases)
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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 doesnt the government pay hotels to leave
some of their rooms unoccupied (shouldnt the
reduction in rooms raise the price)?
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Arbitrage
Generally speaking, properly functioning,
competitive markets should eliminate any risk
free profit opportunities. Therefore, we
shouldnt see the same product selling for a
different price in two locations
Sell in DC
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Washington DC
20
New York
40
30
Buy in NY
Arbitrage (Buy Low, Sell High) should eliminate
any price discrepancies
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Speculation
Speculation is the same concept as arbitrage.
Simply replace locations in space with locations
in time!!
40
20
Now
Next Year
The key difference is that we cant always
predict the future!!