MICROECONOMICS

Decision-making in a Market Economy

26-6-2015

The three over-arching issues in Economics

1. Individuals make choices to improve economic well-being
People make economic choices all the time (about human capital
acquisition, occupation, financial portfolios)
- Businesses make economic choices all the time ((about what to sell,,
how much to sell, who to sell to)
- Governments make economic choices all the time (about taxes,
money supply, interest rates)
2. Individual choices interact to generate aggregate outcomes
- what kinds of goods and services are produced (production)
- how they are traded (allocation)
- and who consumes what (consumption)
3. Given scarcity of resources, individual choices and aggregate
outcomes reflect fundamental trade-offs
- economic policy aims to influence/control these trade-offs

The ambit of Economics

[1] Studying the principles of economic decision-making
[2] Understanding economic outcomes generated by the aggregation
of individual decision-making
[Individual decisions are affected by the economic environment, while
the environment is itself shaped by aggregation of individual decisions]
- Robinson Crusoe had to worry about [1] given scarcity of resources
but not about [2]
- Our advantage over Crusoe is that we can reap the benefits of
specialization / division of labour
- But how much benefit we can reap depends on the functioning of our
economic
economic institutions / the market mechanism
mechanism
- The functioning of these institutions are affected by issues of
competition / coordination / and incentives
Economics studies these issues with a major focus on the questions:
When does the market mechanism work well, and when does it not?
When it does not, what policy interventions can improve matters?

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

The Progression of Economic Analysis

Consumers
& Firms

The Market
The National Economy

The Global Economy

Microeconomics: Studies decision-making of buyers and sellers,
andd hhow these
h
ddecisions
ii
gell to generate market
k outcomes
Macroeconomics: Studies levels and fluctuations of aggregate
economic variables: GNP, employment, inflation, interest rates
International Economics: Studies trading relations between nations
and the interactions among national macro-economies

Substantive assumptions about motivation and behaviour

Neo-classical Economics makes the following assumptions:
(1) All decision-makers are rational, and
(2) every individual and collective entity abides by the rule of law.
Rational decision-making is the process of making decisions by
solving constrained optimization problems in which each
decision-maker maximizes a well-specified objective function subject
to a comprehensively specified set of constraints that she faces
(constraints arising from a combination of limited resources, limited
options, limited time, and limited computing ability).

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Cost-Benefit Analysis An Example

At 9 am on 1/1, I have Rs. 1000,000 to invest for TWO years, and
have THREE indivisible & mutually exclusive ventures available:
Venture 1: Invest entire amount in bank Fixed Deposits (FDs)
Venture 2: Invest Rs. 480,000 in 2-yr Project A & remainder in FDs
Vent re 3: Invest
Venture
I e t Rs.
R 500,000
500 000 in
i 2-yr
2 Project
P je t B & remainder
e i de in
i FDs
FD
Interest rate on bank FD: 10% per year (compounded)
this is the market risk-free interest rate [there is no inflation]
Return structure of the 2-yr projects (I can predict the future perfectly):
End of year returns
End-of-year

Project A
200,000
200 000 & 800,000
800 000

Project B
500 000 & 500,000
500,000
500 000

Net earnings at the end of two years from each of the ventures:
Venture 1: 1.21 1000,000 = 1210,000
Venture 2: {1.21520,000} + {(1.1200,000) + (800,000)} = 1649,200
Venture 3: {1.21500,000} + {(1.1500,000) + (500,000)} = 1655,000

Net Present Value (NPV) Analysis

NPV of project A: 480,000 + [200,000/1.10] + [800,000/(1.10)2]
= 480,000 + {842,980} = 362,980
NPV of project B: 500,000 + [500,000/1.10] + [500,000/(1.10)2]
= 500,000 + {867,770} = 367,770
NPV of Venture 1: zero [as FD rate is risk-free rate, any inv in FD is a 0-NPV inv]
NPV of Venture 2: 362,980
NPV of Venture 3: 367,770
Net Present Value Rule of Investment: Among a set of indivisible
and mutually exclusive ventures, invest in that specific venture V that
has the highest
g
non-negative
g
NPV.
Relating the NPV rule to the concept of maximizing economic profits:
The opportunity cost of engaging in Venture 3
is the foregone NPV in the next best alternative: 362,980 in Venture 2
Long-term economic profits from engaging in Venture 3
= NPV of Venture 3 opportunity cost of Venture 3 = 4,790

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Continuation NPV
After starting Venture 3 at 9 am on 1/1, at 12 noon I realize that Bs
annual returns will be 400,000. Should I continue with B at 12 noon or
pull out and get into A (if I can costlessly break pre-invested FDs)?
- Determine how much of Bs up-front investment cost is recoverable
(i.e., how much of the cost can be recovered when pulling out of B)
- If recoverable amt is X, continuation NPV of Venture 3 (at 12 n) is:
X + {[400,000/1.10] + [400,000/(1.10)2]} = 694,220 X
- So, I should pull out of B and get into A at 12 noon if and only if:
NPV of V2 (362,980) > continuation NPV of V3 (694,220 X)
Decision: If X > 331,240, then switch to A, otherwise continue with B
Sunk costs are start-up costs that are not recoverable once made
- In our example: upfront investment X [if X = 350K then sunk costs= 150K]
- sunk costs are to be ignored in making current/future decisions
At any point in time, an already-initiated project should be continued
if and only if the amount of past investments that is recoverable (i.e.,
non-sunk) is smaller than a critical value

Opportunity Costs and Sunk Costs

The opportunity cost of using up a resource is the return that the
resource would generate in its next best alternative use
Sunk costs are those irrecoverable past investment costs that are to
be ignored in deciding whether to continue with a project
Often,
Often we wrongly ignore opportunity costs
costs,
and get wrongly influenced by the magnitude of sunk costs
Ignored opportunity costs: The Generally Accepted Accounting
Practices (GAAP) allows the deduction of cost of debt from
accounting profits to determine taxable profits
but does not allow deduction of the cost of equity
[concept of economic
economic value added
added by a firm addresses the problem]
Sunk Costs Fallacy: We often decide to continue in a previously
started project only because we have already sunk a lot of resources
in the project

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Optimal Decisions and Marginal Analysis

Some decisions can be changed in increments (volume, price, portfolio)
I have 5 mill. of which I can invest Z mill. in a divisible 2-yr project

which would generate end-of-yr returns: [1.1Z] & [1.21Z], and

put the remaining money in bank FDs giving 10% risk-free intt.
Marginal
M
i l Analysis:
A l i An
A att the
th margin
i thought
th
ht experiment
i
t to
t determine
d t
i
if a proposed {Z} is optimal, and if not, then to find the optimal Z*
(I) If I increase project investment by from {Z} to {Z+ }
more project earnings generating marginal benefit of 2[(Z+ ) Z]
and less FD earnings generating marginal cost of
(II) If I decrease project investment by from {Z} to {Z}
more FD earnings
g ggenerating
g marginal
g
benefit of
and less project earnings generating marginal cost of 2[Z (Z)]
Decision to invest {Z*} in the divisible project will be optimal only if:
marginal benefit marginal cost at {Z*} in (I) as well as (II)
If the maximand is globally concave then the unique optimal
decision is attained where marginal benefit = marginal cost
- this condition characterizes the peak of the profit hill

Markets / Industries
Customers
range from price-takers
to price-makers

a retail consumer market has

...many small price-takers

Active Firms [Industry]

commodity suppliers are
Input Suppliers
..........small price-takers

Market : triadic relation between firms, customers & input suppliers

Market boundary depends mainly on (a) range of products related
in consumption / production, (b) geography, and (c) time.
F two
For
t products
d t to
t be
b in
i the
th same market,
k t relative
l ti price
i changes
h
should lead to substantial change in relative demand and/or supply
Market Structure is composed of (i) demand structure (many small
or few large buyers), (ii) input supply structure, and
(iii) industry structure size distribution of firms (i.e., the number of
active firms in the market and their sizes)

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Industry Structure and Market Power

Two extreme firm size distributions:
Perfectly competitive industry numerous small firms with negligible
power to affect input or output prices [fully fragmented industry with
firms having miniscule market shares]
(vegetable
(vege
ab e mkts,
s, co
commodities
od es mkts,
s, secondary
seco da y stock
s oc markets
a e s ??)
Bilateral monopoly a single seller of a unique product with
substantial power to affect both input and output prices [fully
concentrated industry with a single firm having 100% market share]
(a pharma multinational selling a patented drug, a public utility ??)
The reality is in the middle:
g p
with a finite number firms ((sellingg
Most industries are oligopolies
close substitutes) that can affect/set both input and output prices
- airlines, auto-makers, telecom, soft drinks, .
Question: Why are some oligopolies tight (closer to monopoly) while
others are loose (closer to perfect competition)?
Answer related to market fundamentals nature of market demand
and of production technologies (entry barriers and economies of scale)

The Structure, Conduct, Performance Theory

Our central aim is to uncover the systematic relationship between three
sets of variables: (1) market fundamentals, (2) industry structure, and
(3) market power of different market participants.
In the 1960s, Harvard economist Joseph Bain (and others) developed
the following paradigm to relate industry structure
structure, firm conduct,
conduct and
market performance:
Market fundamentals like higher entry barriers and scale economies
lead to greater industry concentration (i.e., fewer and larger firms)
Greater industry concentration leads to monopolistic firm behavior
(i.e., firms exercising market power and enjoying greater margins)
Monopolistic firm behavior leads to larger firm profits and lower
social efficiency
Critique: firm conduct & performance influence future industry structure
Missing markets and the role of entrepreneurship
Some markets do not operate in spite of positive consumer valuations
for products, because sellers havent discovered profitable ways to serve
consumers - entrepreneurship is about finding such profitable ways

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Prices:
Prices determine allocation of goods and services, determine incomes/
profits, and convey information about profitable future investments
Two problems with nominal prices:
(1) Nominal
N i l price
i off a goodd in
i a particular
ti l geographical
hi l area might
i ht nott
precisely indicate the true value/expensiveness of the good
- We need to focus on the relative price: by deflating the nominal
price of the good by the appropriate price index of other goods in
that same geographical area
[comparing affordability of a good across space]
(2) Nominal price of a good at a specific point in time might not precisely
indicate the true value/expensiveness of the good
- We need to focus on the real price: by deflating the nominal price
of the good by the appropriate inflation index
[comparing affordability of a good over time]

Price Indices
Constructing the Consumer Price Index for Food (CPI-F) in India in
2015 with respect to the base year 1984
Let food basket = {rice, wheat, chicken}
Let PR(Y), PW(Y), and PC(Y) denote the Rupee prices of rice, wheat,
andd chicken
hi k in
i year Y
Let R(X), W(X), and C(X) denote the total volume of rice, wheat, and
chicken bought in year X
Then the CPI-F in 2015 with base year 1984 [Laspeyres Index] =
PR(15)R(84) + PW(15)W(84) + PC(15)C(84)
100
PR(84)R(84) + PW(84)W(84) + PC(84)C(84)
[Paasches Index will, in contrast, use the current year quantities]
A general Consumer Price Index (CPI) is constructed using a
representative consumption basket of all major consumption goods
- Weights assigned to different components should be consistent
with actual consumption patterns

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Using CPI to determine real prices & inflation rates

Real price of good A in 2015 in 1984 rupees (given base yr 2000) =

{Nominal price of A in 15}{CPI in 84 w.r.t.00 / CPI in 15 w.r.t.00}

Evolution of real price of going to College in the US:

Year

Nominal
Price

CPI
(base 1985)

Real Price in 1970 $

1970

$2,530

38.8

1990

$12,018

130.7

38.8
* $2,530 $2,530
38.8
38.8

* $12,018 $3,569
130.7

2002

$18,273

181.0

38.8
* $18,273 $3,917
181 0
181.0

Note that the 20 year consumer inflation rate in the US between

1970 and 1990: f(70-90) = (130.7 38.8)/38.8 = 236.85%

- and so, the real price of going to College in 1990 (in 1970 $) is:
12,018/(1+ f(70-90)) = 3,569

The Real Interest Rate

An interest rate is also a price: it is the relative price of current
..consumption vis--vis future consumption
- when there is inflation, one has to distinguish between the real and
the nominal interest rate

Nominal interest rate p.a.

Annual inflation rate
Real interest rate p.a.

1990
10%
7%
2.8%

2004
5%
3%
1.94%

2006
6%
4%
1.92%

2008
9%
9%
0%

Let i = nominal interest rate p.a. and f = annual inflation rate

The real interest rate p.a. (r) is given by:
(1 + r) = (1 + i)
(1 + f)
When i and f are quite small, r approximately equals (i f)

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Firms: Internal Structures and Objectives

The internal structure of a firm is either a proprietorship, or a
partnership, or a privately held limited liability company, or a
publicly held limited liability company
The objectives of a firm will depend on its internal structure
When there is separation of ownership and control (as in large
corporations), management might be more interested in its own
objectives (of short-term returns / empire building) rather than
maximizing long-term shareholder value
The main aim of corporate governance is to align managerial
objectives with shareholder objectives (through ESOPs etc.)
In most of Microeconomics, we will study firm behaviour under the
profit maximization hypothesis owners / managers take purposive
decisions to maximize long-term economic profits of a firm
We will have to define what we mean by long-term economic profits

Understanding Economic Profits

Annual Economic profits = Annual Revenues Annual Economic Costs
- Latter should include all explicit and implicit costs yet to be incurred
and should not include any irrecoverable expenditure already spent.
Example: Monica will graduate on 31/12 and leave the country one year
l t
later.
She
Sh has
h to
t decide
d id what
h t to
t do
d in
i the
th coming
i year: she
h can gett a
call-centre job OR she can run a boutique in her garage.
She will have Rs. 2,00,000 on 1/1.
Call-centre job will pay Rs.60,000 for the year.
She can also get Rs. 18,000 by renting out her garage.
Boutique will need capital investment of Rs.1,00,000 on 1/1, of
which Rs.90,000 will be recouped at year-end.
year end.
Annual expenditures in running the boutique will be Rs.40,000 on raw
materials, Rs.25,000 on wages, and Rs.15,000 on advertising.
Annual sales revenues from the boutique will be Rs.1,75,000.
All receipts and expenditures will happen at the end of the year.
Annual market interest rate is 10%, all incomes are taxed at 10% per
year, and there is no inflation.

ARIJIT SEN
IIM Calcutta | Term I, 2015

MICROECONOMICS
Decision-making in a Market Economy

26-6-2015

Economic Profits from Boutique at year end:

Sales revenues =
Explicit Costs

Depreciation =
Raw materials =
Wages =
Advertising =

Accounting Profits =
Taxes =
After-tax Accounting Profits =

1,75,000
10,000
40,000
25,000
15,000
85 000
85,000
8,500
76,500

After-tax implicit costs Foregone call-centre salary = 54,000

Foregone interest income = 9,000
Foregone garage rental =
16,200
79,200
Monicas Economic Profits from boutique =
2,700
Annual economic profits = Annual after-tax accounting profits
net opportunity (implicit) costs of all resources used over the year
Monicas Economic Profits from call centre =
2,700
Conclusion: Monica should take the call centre option as that will
generate super-normal economic profits for her

Long-term Economic Profits

Annual economic profits = annual sales revenue annual economic
costs [i.e., accounting (explicit) costs + opportunity (implicit) costs of
all resources used over the year]
Normal and super-normal profits: Normal profits earned over the year
when revenues equal
q economic costs;; supernormal
p
profits
p
are earned
when revenues are greater than economic costs [in both cases,
accounting profits (revenues accounting costs) are positive]
Let t(xt) be annual economic profits accruing to a firm at the end of
year t, where xt is a set of managerial decision variables; and let rt be
the annual (compounded) interest rate or t-year deposits
Then the long-term economic profits of a firm on 1-1-t is the
present discounted value of future profit stream as valued at 1-1-t :
t (xt)/(1+rt) + t+1 (xt+1)/(1+rt)(1+rt+1) + t+2 (xt+2)/(1+rt) (1+rt+1)(1+rt+2) +
.

Where does this stream end?

Should we use real or nominal values?
How should we account for the fact that the future is uncertain?

ARIJIT SEN
IIM Calcutta | Term I, 2015

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