Managerial Economics

CyryxCollege, Maldvies
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Managerial Economics
Syllabus
Lecture 1 Notes
Lecture 2 Notes Problem Set 1 Problem Set 1Key
Lecture 3 Notes Problem Set 2 Problem Set 2 Key
Lecture 4 Notes
Lecture 5 Notes
Lecture 6 Notes
Lecture 8 Notes
Lecture 9 Notes
Lecture 11 Notes
Lecture 12 Notes
Lecture 14 Notes
Lecture 16 Notes
Test 1 Review Outline
Lecture 17 Notes Problem Set 7 Problem 7 Key
Lecture 18 Notes
2
Lecture 20 Notes
Lecture 24 Notes
Lecture 25 Notes
Lecture 26 Notes
Lecture 27 Notes Problem 12
Lecture 28 Notes
Lecture 29 Notes
Lecture 30 Notes Problem 13 NEW Problem 13 Key
Test 2 Review Outline
Lecture 31 Notes
Lecture 32 Notes
Lecture 33 Notes Problem 14 Problem 14 Key
Lecture 34 Notes
Lecture 35 Notes
Lecture 36 Problem 15 Problem 15 Key (CORRECTED)
Lecture 37
Lecture 38
Review Outline for Final Examination
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Review Outline for Final Examination
I. Chapter 1. The Fundamentals of Managerial Economics

A. Definition of Topic.
1. Economics
2. Managerial Decisions
B. Components of Effective Decision Making

1. Identify Goals and Constraints:
2. Recognize the Nature and Importance of Profits: Economic profits differ from
Accounting profits. . Good decision-making involves the maximization of economic
profits.
3. Understanding Incentives. .Compensation and the structure of organizations
affects importantly organizations.
a. Organizational Incentives
b. Incentives for Motivating Individuals
4. Understand Markets. Market forces represent a series of rivalries. In any
problem, you must appreciate your position relative to other agents.
5. Recognize the Time Value of Money
6. Appreciate Marginal Analysis. Marginal decisions are an easy way to optimize
totals. Calculus is just a formal expression of marginal analysis.
a. Discrete Decisions.
b. Continuous Decisions and the calculus
c. Incremental Analysis
1. Pay attention to incremental costs and incremental benefits.
2. Ignore sunk costs. .
II. Chapter Market Forces: Demand and Supply

A. Introduction and Overview.
1. Overview
2. The structure of the supply and demand model.
B. The Demand Side.

1. Motivation: Diminishing marginal utility:
2. Definition of Demand Curve
3. Determinants of Demand.
4. Changes in demand vs. changes in qty demanded.
5. The Notion of Consumer Surplus
6. An Analytical Example
C. The Supply Side.

1. Driving Force. The Law of Diminishing Returns
2. Definition of Supply Curve
3. Determinants of supply:
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4. Changes in supply vs. changes in quantity supplied.
5. Producer Surplus.
6. An Analytical Example.
D. Equilibrium. Putting Supply and Demand Together

1. Definition.
2. Binding the market.
Price floors
Price Ceilings
E. Comparative Statics.
1. Supply or Demand Shifts
2. Supply and Demand Shifts
III. Quantitative Demand Analysis
A. Price Elasticity of Demand

1. Motivation
2. Calculations
a. Arc price elasticity of demand
b. Point price elasticity of demand
c. Percentage Changes
3. A Graphical Interpretation of Price Elasticity.
4. Some Observations about Price Elasticity of Demand
a. Most Demand curves have elastic and inelastic segments
b. Exceptions
c. Elasticity and the Slope of Demand Curves
5. Price Elasticity, MR and TR.
6. Determinants of price elasticity of demand
B. Other Demand Elasticities

1. Cross Price Elasticities
2. Income Elasticities
3.Other Elasticites.
C. Elasticities and demand functions

1. Linear Demand functions.
2. Logrithmic Demand.
D. Estimating Demand: Regression Analysis.

1. Interpreting the significance of individual parameter estimates
2. Forecasting
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IV. Chapter 5. The Production Process and Costs
A. Introduction
B. The Production Function

1. Short Run Production.
a. Diminishing Marginal Productivity and Marginal Product
b. Relationships between Productivity Measures.
c. Optimal Use of a single input.
2. Long Run Production (Optimal use of multiple inputs)
3. Returns to scale: Given a production function of the form
F(K,L) = KL
The function exhibits increasing returns to scale if >.5
constant returns to scale if =.5
decreasing returns to scale if <.5
C. Costs.
1. The relationship of production functions to cost functions.
2. Short run costs.
a. Cost curves
b. Sunk vs. Variable Costs
c. Algebraic forms of cost curves
3. Long-Run Costs
a. Long Run Average Costs
b. Economics of Scale
4. Multiple Output Cost functions
a. Economies of Scope
b. Cost complementarities
V. Chapter 6. The Organization of the Firm.
A. Overview and Motivation.
B. Optimal Methods of Obtaining Inputs

1. Options
a. Spot
b. Contract
c. Internal Production
2. Factors affecting choice of the optimal method
a. Costly Bargaining
b. Underinvestment
c. The Hold-up Problem.
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C. Managerial Compensation and the Principal-Agent Problem.
1. The Principal-Agent Problem.
2. Structuring Contracts for Managers (review).
3. The Manager/Worker Problem.
a. Profit Sharing.
b. Revenue Sharing.
c. Piece Rates.
d. Time clocks and time checks
VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically

Competitive Markets.
A. Introductory Comments on Chapter 7.

B. Competition.
1. Assumptions
2. Optimal short run decisions
a. Graphically
b. Analytically (set P = MR = MC)
3. Long run decisions.
C. Monopoly
1. Assumptions, Sources of monopoly power.
2. Characterization:
a. Graphically
b. Analytically
Q* is where MR = MC
P* is the demand curve at Q*
Profits are TR - TC
3. Observations: Social Costs of Monopoly
D. Monopolistic Competition
. 1. Assumptions
3. Optimizing decisions.
4. Observations.
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VII. Chapter 11. Pricing Strategies.
A. Basic Pricing Strategies for Firms with Market Power
1. Optimal Pricing for a monopolist or monopolistic competitor
a. Basic Case
b. Imperfect Demand Information
P = MC/[1+1/].
B. Strategies that yield higher profits

1. Price Discrimination
a. Perfect (1st degree) price discrimination
i. Calculating gains
ii. Necessary conditions
b. Price List (2nd degree) price discrimination
c. Group Division (3rd degree) price discrimination.
2. Two part pricing.
3. Commodity Bundling
4. Peak Load Pricing

1. Economics

profits.
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1. Overview
B. The Demand Side.

C. The Supply Side.


1. Definition.
Price floors
Price Ceilings

1. Motivation
2. Calculations
b. Exceptions
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3.Other Elasticites.

1. Linear Demand functions.
2. Logrithmic Demand.

2. Forecasting
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A. Introduction

3. Returns to scale: Given a production function of the form
F(K,L) = KL
The function exhibits increasing returns to scale if >.5
constant returns to scale if =.5
decreasing returns to scale if <.5
C. Costs.
2. Short run costs.
a. Cost curves
3. Long-Run Costs
V. Chapter 6. The Organization of the Firm.
A. Overview and Motivation.

1. Options
a. Spot
b. Contract
b. Underinvestment
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C. Managerial Compensation and the Principal-Agent Problem.
a. Profit Sharing.
b. Revenue Sharing.
c. Piece Rates.
VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically

A. Introductory Comments on Chapter 7.

B. Competition.
1. Assumptions
2. Optimal short run decisions
a. Graphically
b. Analytically (set P = MR = MC)
C. Monopoly
a. Graphically
b. Analytically
Q* is where MR = MC
P* is the demand curve at Q*
Profits are TR - TC
D. Monopolistic Competition
. 1. Assumptions
4. Observations.
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VII. Chapter 11. Pricing Strategies.
a. Basic Case
P = MC/[1+1/].

c. Group Division (3rd degree) price discrimination.
Lecture 1
Preview:
1. Economics

profits.
Lecture_______________________________________________
A first topic involves defining the scope of the course:
1. Economics: The study of how societies and individuals allocate scarce resources
among competing ends.
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Observation: This is a study of allocation decisions. It applies widely to an immense
variety of topics. It is not, for example, particularly focused on the decisions of
businesses. It applies to profit as well as to non profit institutions.
2. The Manager. A person who directs resources to achieve a stated goal.

Observation: Again, this is a very broad definition. Clearly, you manage your own lives.
In business or organizational contexts, managers control resources other than their own
time and energy such as
a. The efforts of others
b. Input acquisition and use
c. Output/Pricing decisions
3. Managerial Economics: The study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal.
Observation: The difference between this course and, say microeconomics is that it is
policy oriented. That is, we focus on giving you tools to make decisions, rather than
describing how a market or an economy as a whole works.
B. Effective Management from an Economic Perspective. Economic “tools” are

guides to good allocative decision-making. Elements of good decision-making can be
divided into six categories
1. Identify Goals and Constraints: This is critical for defining the dimension of the
problem.
Objectives are simply what you would like to accomplish. Constraints are the
natural (and perhaps unfortunate) consequence of scarcity.
a. Having a well-defined objective in mind when making an allocative decision is

critical. (Very concretely, imagine how one might decide to allocate time to this course if
it were uncertain whether your intention was to get a good grade or to merely pass)
b. Also, it is necessary to evaluate the constraints available in the decision

process. (For example, time is typically the constraint in making personal allocative
decisions. Most of our applications will focus on the decisions of a profit-maximizing
firm. Here the objective is typically profits. Constraints arise in the form of pricing
limitations, and production considerations.)
2. Recognize the Nature and Importance of Profits: When discussing the firm, profits
take on a special role. However, when making allocative decisions you must have the
correct definition of profits in mind.
a. Accounting Profits
A = TR - TCA
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b. Economic Profits
E = TR - (TCA +TCI)
The difference in the definitions is implicit costs. Implicit costs are measured in terms of
foregone alternatives. Economic costs are the sum of implicit and implicit costs.
Economic costs can be measured in terms of choices foregone, or opportunity costs.
Observations
a) The function of economic profits. Accounting profits are not an incorrect

definition of profits, just inappropriate for the purpose of making allocative decisions.
Example: Suppose you consider opening a T.J. Cinnamon Franchise in a storefront you
own in the VA Center Commons, North of Richmond. Suppose the franchise fee is
$20,000 per year, and you must pay $80,000 per year for materials and help. How much
must you earn to realize an accounting profit?
Suppose that you must work in the store (and quit your job paying $25,000 per
year). Also you could rent the store slot for $1000 per month. If you expected revenues
of $120,000 per year, would this be a good allocation of resources?
b) The difficulty of collecting implicit cost information. In fact, it is relatively

difficult get good information pertaining to opportunity costs. A legitimate (and
important) function of the manager is to do as good a job as possible in collecting this
information.
Lecture 2
1. Economics

2. Recognize the Nature and Social Role of Profits:
a. Defining Economic Profits Economic profits differ from Accounting
profits. . Good decision-making involves the maximization of economic profits.
Preview__________________________________________________________
b. Understanding the Social Role of Profits.
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6. Appreciate Marginal Analysis Marginal decisions are an easy way to optimize
Lecture_____________________________________________________________
b) The social role of profits. The 1980’s are popularly called “the decade of
greed.” A popular depiction of attitudes in the 80’s was the film “Wall Street” where
Michael Douglas gives a lecture to shareholders extolling the virtues of selfishness. This
is passe, of course, but, even at its height, it was a caricature of the role of profits in
society.
Profits serve a valuable social function if certain assumptions regarding competitive

performance are satisfied. These assumptions include:
-many buyers and sellers. This is referred to as the structural assumption. Violations
cause problems of monopoly or oligopoly.
-perfect information about both product quality and price. This an informational
assumption: Violations are of the form of “lemon’s markets” problems, as well as
“Diamond Paradox”
-pure privacy in consumption and production. The privacy assumption. Violations cause
“free-riding” and “externalities.
If these assumptions are met, then the signals sent by profits channel resources into their
most efficient use. To quote Smith (1776)
“It is not out of the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own interest.”
Profits send signals about entry, exit, expansion and innovation.
Example: The computer industry in the 1980s was very dynamic. The number of firms
increased substantially. As a consequence, prices fell, and also the quality of computers
increased. More recently, computers have become a more commodity-like product. The
number of firms has decreased, and production runs have increased.
If competitive assumptions are satisfied, economic profits are a temporary phenomenon,

attributable to a new idea, product develop or change in consumer tastes. Entry will
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dissipate these profits. On the other hand, if competitive assumptions are not satisfied
(because, a firm has a patent, or unique license) then they are permanent, and not socially
beneficial.
3. Understanding Incentives. If profits restrict the behavior of firms via incentives, in the
market, it is also important to understand the effects of incentives within the firm.
a. Institutional organization affects performance. The way an institution is
organized often puts incredible limitations on the power of personalities to exert
influence. Sometimes this is healthy (e.g., in the U.S. government, laws severely restrict
the power of the presidency.) In other environments institutional restrictions are an
important handicap. For example, the recent scandals at Enron and WorldCom are not a
consequence of “bad guys”. Rather the institutional structure of these firms, and the
oversight process for these firms, not only allowed, but encouraged illegal behavior.
Reorganizing the structure of an institution, as well as the laws regulating the oversight
process, can make firms more reliable and more efficient.
b. The way people are rewarded can influence their incentive to work
Example: Suppose you pay someone $75,000 to manage your restaurant. Would this
person do better than someone paid $50,000? There is no particular reason to suppose
that the answer should be in the affirmative. A compensation package that more nearly
aligns the interests of the owner and the manager would be one that provided incentives
to the manager that paralleled the interests of the owner. (e.g., a profit-sharing
arrangement.)
This type of problem is called a principle-agent problem. It is a common problem in

many firms. Particularly in publicly-held firms, where the stockholders have only limited
control over the decisions of the CEO.
4. Understand Markets. Markets are the regulating force for firms, and the source
of incentives for their activities. These incentives arise via transactions, and are the
consequence of competing interests. For every transaction, there are two parties.
a. Consumer-Producer Rivalry: Consumers and producers are simultaneously trying to

take advantage of each other. They are limited by reputation and bargaining skills. As a
consequence of bargaining, each gets less than they want, but not more than it is worth,
or less than it costs.
b. Consumer-Consumer Rivalry: Consumers compete with each other for products. In
the process, the purchasing consumer pays more than (s)he wants, but not more than it is
worth to him or her. (Example: This is most clearly seen in auctions for specialized
consumer goods, such as antiques. Bidding by rival potential purchasers drives up the
price.)
c. Producer-Producer Rivalry: Producers compete with each other, and as a consequence,
offer better quality, and higher quantities at a lower price than they would like. (Again,
this is most directly seen in a procurement auction)
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d. The Role of Government: Provided that the conditions that I mentioned above are
satisfied, there is no need for the government to intervene. However, when one or more
of these assumptions fails, the Government frequently intervenes to restore the balance.
5. Recognize the Time Value of Money. It is important to realize that money earned in the
future is not valued the same as money earned today. Allocative decisions should be
adjusted accordingly.
a. Present Value Analysis.
Suppose that the interest rate is 10%. Then it would take $1.10 next year to equal $1
today. In general
PV(1+i) = FV
Similarly, for two years hence
PV(1+i)2 = FV
and in general
PV = FV
(1+i)n
Often times we are interested in a stream of earnings.
PV =  FVt
(1+i)t
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In valuing a stream of earnings relative to a cost. (As is typical for any investment
decision) It is important to consider the net present value
NPV =  FVt - Co
(1+i)t
Example: Suppose you are given the opportunity to purchase a new high-speed lathe
that will reduce the costs of producing cedar wooden eggs by $2 per egg. At current
prices, you sell 10,000 per year for each of the next 4 years. If the interest rate is 10%,
and the machine costs $65,000 is it a good purchase?
20,000/(1.1) + 20,000/(1.1)2 + 20,000/(1.1)3 + 2 0,000/(1.1)4
= 18,182 + 16258 + 15026+ 13660 = 63,397
No. The NPV is -$1,603.
Lecture 3
Problems: Collect Problem Set 1
REVIEW___________________________________________________:

b. Incentives for Motivating Individuals.
Example: What is the best way to motivate Meg Whitman, CEO of Ebay?
5. Recognize the Time Value of Money.

a. Discounting the Future.
b. Calculating Net Present Value of a Project
Example: Suppose that a firm expects to net an extra $10,000 in yearly
earnings from the production of a machine for each of the next 3 years. Suppose
that the interest rate is 8%. If the machine costs $20,000 is it a good purchase?
Preview__________________________________________________________
c. The present value of a firm/ Discounting over an infinite horizon
6. Appreciate Marginal Analysis Marginal decisions are an easy way to optimize
LECTURE______________________________________________
c. The present value of a firm. The discounting equation used last lecture can be
generalized to value the profitability of a firm, simply by substituting  for FV
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PV =  t
(1+i)t
Accounting for indefinite life. There is, however, one important complication. Unlike a
piece of equipment, firms are not expected to be finitely lived. In this case, the
summation in the present value formula becomes infinite, e.g.,
PV = 0 + 1 + 2 + 3 + …
1 2
(1+i) (1+i) (1+i)3
We can still come up with a finite present value if we assume that the stream of revenues
each period is fixed. That is, consider a “perpetuity” e.g,. a constant cash flow (“CF”)
that, starting one year from today, will be paid to you the first day of each year, forever.
The present value of that flow is
PV = CF + CF + CF + …
(1+i)1 (1+i)2 (1+i)3
Notice, that as long as i > 0, terms get smaller as we get further into the future. It is well
known that the present value of such a perpetuity can be expressed simply as
PV = CF/i
Similarly, for a firm generating a constant profit
PV = /i
Notice that the above PV formula excludes a payment received now (e.g., at time 0).The
PV of a stream of returns starting today is
PV = /i +  = [(1+i) ]/i
You must always be careful to stipulate the timing of the first payment when doing PV
calculations.
Note: Your text discusses extensions of this model. In this class you will be responsible
only for the material covered above.
6. Using Marginal Analysis. A final principle in intelligent decision-making pertains to

the unit of analysis used. One can often cut through a very difficult optimization process
by confining attention to incremental changes.
a. Discrete Decisions. Example. Suppose you were faced with the problem of trying to
allocate study time between two courses for a test on the same day. If you had a total of
6 hours to study, you might have the following possibilities.
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Econ Math
Hours score Hours score
0 0 0 0
1 30 1 40
2 55 2 65
3 75 3 77
4 93 4 86
5 98 5 94
6 100 6 100
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One way to approach this problem would be to consider all combinations of all totals that
were available:
Scores Total
Math Math
Econ Econ
0 6 0 100 100
1 5 30 94 124
2 4 55 86 141
3 3 75 77 152
4 2 93 65 158
5 1 98 40 138
6 0 100 0 100
An equivalent solution, however, is obtained by considering just the marginal changes

A marginal change is the change in the total associated with studying an extra hour.
Econ Math
Hour score marginal hour score marginal
increase increase
0 0 0 0
1 30 30 1 40 40
2 55 25 2 65 25
3 75 20 3 77 12
4 93 18 4 86 9
5 98 5 5 94 8
6 100 2 6 100 6
Note: This process has the advantage that it requires less information.
Lecture 4 Problems: Return Problem Set 1,

Problem Set 2 – due Monday.
REVIEW

5. Recognize the Time Value of Money.
a. Discounting the Future.
b. Calculating Net Present Value of a Project
Comment: Recall problem 1. A student asked if in deciding whether to
undertake a project, it made a difference if the net present value if a project was less than
the cost the project. I ERRED IN MY RESPONSE. The correct answer is: ANY
PROJECT WITH A POSITIVE NPV SHOULD BE UNDERTAKEN.
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To see this, suppose you are given the chance to invest $100,000 in a project that will
yield $60,000 for each of the next two years. If i=.10, then the PV of the returns is
60,000/1.1 + 60,000/1.12
=54,540 + 49,587
=104,132.
The Net Present value is 104,132-100,000 = 4,132. (That is, you end up with 4,132
MORE than 100,000 in present value terms.)
Suppose, alternatively, that you took the 100,000 and put it in the bank for two years. If i
= .10, you would have 110,000 after one year, and $121, 000 after two years. The
present value of that money is (by definition) $121,000/(1.1)2 = 100,000
c. The present value of a firm/ Discounting over an infinite horizon.

With the first payment coming in one year,
PV = /i
If the first payment is tomorrow,
PV = /i +  = [(1+i) ]/i
Example: Suppose you can purchase a share of a firm that will pay a
dividend of $10 each year, starting one year from today. If the discount rate is
.05, what is the present value of this stock?
10/.05 = $200.
How would your answer change if the first payment came tomorrow?
10/.05 + 10 = $210.
5. Appreciate Marginal Analysis. Marginal decisions are an easy way to

optimize totals that require less information in the decision-making process.
a. Discrete Decisions
- Allocating time for a test
Preview__________________________________________________________
5. Marginal Analysis Continued
- Comparing TR to TC
b. Continuous Decisions
LECTURE______________________________________________
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5. Using Marginal Analysis. A final principle in intelligent decision-making pertains to
the unit of analysis used. One can often cut through a very difficult optimization process
by confining attention to incremental changes.
a. Discrete Decisions. Example. Suppose you were faced with the problem of trying to
allocate study time between two courses for a test on the same day. If you had a total of
6 hours to study, you might have the following possibilities.
Econ Math
Hours score Hours score
0 0 0 0
1 30 1 40
2 55 2 65
3 75 3 77
4 93 4 86
5 98 5 94
6 100 6 100
24
One way to approach this problem would be to consider all combinations of all totals that
were available:
Scores Total
Math Math
Econ Econ
0 6 0 100 100
1 5 30 94 124
2 4 55 86 141
3 3 75 77 152
4 2 93 65 158
5 1 98 40 138
6 0 100 0 100
An equivalent solution, however, is obtained by considering just the marginal changes

A marginal change is the change in the total associated with studying an extra hour.
Econ Math
Hour score marginal hour score marginal
increase increase
0 0 0 0
1 30 30 1 40 40
2 55 25 2 65 25
3 75 20 3 77 12
4 93 18 4 86 9
5 98 5 5 94 8
6 100 2 6 100 6
Note: This process has the advantage that it requires less information.
More generally, we might consider a situation in which there were both costs and benefit
(for example the case of profit maximization, where
 = TR - TC
Control
Variable TB TC NB MB MC MNB
0 0 0 0
1 90 10 80 90 10 80
2 170 30 140 80 20 60
3 240 60 180 70 30 40
4 300 100 200 60 40 20
5 350 150 200 50 50 0
6 390 210 180 40 60 -20
7 420 280 140 30 70 -40
8 440 360 80 20 80 -60
9 450 450 0 10 90 -80
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10 450 550 -100 0 100 -100
Definition: The Marginal Principle: To maximize net benefits, the manager should
increase the managerial control variable to the point where marginal benefit equals
marginal costs.
Graphically, this can be illustrated both by graphs of totals and of marginal changes:
Total changes
600
500
400
TC TB
300
200
100
0
0 1 2 3 4 5 6 7 8 9 10
Output
100
90
80
70
MB, MC
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7 8 9 10
Output
Observe the role of marginals and totals.
(Notice that the totals and marginal lines should not line up exactly. There are two points
of total maximization. This is due to the discreteness of decisions here. )
Lecture 5 Problems: Problem Set 2 – due Monday.
REVIEW___________________________________________________:
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5. Appreciate Marginal Analysis.

- Allocating time for a test. (Recall the point, making the
best incremental decisions at each step in a sequence will
drive you to the maximum total.
- Comparing TR and TC
On a graph, the point where  is maximized is where the
difference between TR and TC is maximized. This is also the point
where MR =MC. The DISTANCE between TR and TC equals the
AREA above MC and below MR (We will use this to show that
equilibrium is efficient in Chapter 2.)
Note, however, in your homework that your marginals

never quite line up. This is a problem with discrete analysis. Your
rule in such a case is to take (produce) the last unit such that
MR>MC.
Example:
Q TR TC TNB MR MC MNB
0 0 1 -1
1 19 3 16 19 2 17
2 36 9 27 17 6 11
3 51 19 32 15 10 5
4 64 33 31 13 14 -1
5 75 51 24 11 18 -7
6 84 73 11 9 22 -13
If you plot this you will see that MR and MC never equal, given we are restricted
to discrete changes. In a continuous world, we could find an exact answer..
Preview__________________________________________________________
5. Marginal Analysis Continued
c. Incremental Decisions
LECTURE______________________________________________
b. Continuous Decisions. Notice that in some circumstances, it is possible to make

adjustments more continuously
Notice in my graphical analysis that my graphs are always a bit off. This is a problem of
discreteness.
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More generally, we might consider a situation in which there were both costs and benefit
(for example the case of profit maximization, where
 = TR - TC
Now, suppose that I tell you that in the problem in the introduction that TR = 20Q – Q2
and that TC = 1 + 2Q2 I could come closer to finding the optimum if I used a finer grid.
For example, suppose I reduce Q steps to .5
Q TR TC TNB MR MC MNB
0 0 1 -1
0.5 9.75 1.5 8.25 9.75 0.5 9.25
1 19 3 16 9.25 1.5 7.75
1.5 27.75 5.5 22.25 8.75 2.5 6.25
2 36 9 27 8.25 3.5 4.75
2.5 43.75 13.5 30.25 7.75 4.5 3.25
3 51 19 32 7.25 5.5 1.75
3.5 57.75 25.5 32.25 6.75 6.5 0.25
4 64 33 31 6.25 7.5 -1.25
What if I wanted to find the exact maximum? I could do this by taking a infinitesimal
changes. Let’s do this in parts. Start with the Total Revenue relationship.
TR = 20Q -Q2
Consider the slope of the line tangent to the curve at Q=4.
Q TR
0 0
1 19
2 36
3 51
4 64
Graphically,
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120
100
80
60
40
20
0
0 2 4 6 8
Consider the slope of the line tangent to the curve at Q =4. We could estimate this by
calculating the average slope over progressively narrower ranges, e.g.,
(64 - 0 )/(4 - 0) = 64/4 = 16

(64 - 19 )/(4 - 1) = 45/3 = 15
(64 -36 )/(4 - 2) = 28/2 = 14
(64 -51)/(4 - 3) = 13/1 = 13
If we really wanted the slope of the line tangent to the curve, we must take an
infinitesimally small change -h. Then
64 - [20(4-h) - (4-h)2]
4 -(4-h)
= 64 - 80 + 20h +16 – 8h + h2
h
= _Q2 +12h
h
and as h  0 this becomes 12.
This is the idea of a derivative. The only difference between taking limits, and the rules
of derivation that you learned is that the rules are just a shorthand, for example,
TR = 20Q -Q2
TR' = MR =20 - 2Q
At Q = 4, TR'= 12.
29
You could do the same thing for costs
TC = 1+2Q2
TC = MC = 4Q
This is the slope of the line tangent to the TC curve
To maximize profits, set MR = MC
TR = 20 – 2Q = 4Q = TC
Q = 20/6 = 3.33
Comments
a) I assume that you all have been exposed to simple differential calculus. The above
development was done only to complete a little intuition pertaining to calculus. In the event
that your calculus is a bit rusty, I can assure you that with only a few exceptions, our
derivatives will be restricted to the following functional forms.
Derivative of a constant
f(x) = a; f’(x) = 0
Derivative of a linear equation

f(x)= ax; f’’(x) = a
Derivative of an exponential function

f(x) = xn; f’(x) nxn-1
You may also find it useful to recall the following:
f(x) = g(x) + h(x); f’(x) = g’(x) + h’(x)
f(x) = g(x)h(x); f’(x) = g’(x)h(x) + h’(x) g(x)
f(x) = g(h(x)) = g’(h(x))h’(x)
b) Finally, in your homework, I would like for you to report your marginal revenue and
marginal costs as derivates, rather than as incremental changes.
Lecture 6 Problems: Collect Problem Set 2.

(Other review problem, 2, 3, 5, 8, 10)
REVIEW___________________________________________________:

30
5. Appreciate Marginal Analysis.
TR = 10Q – Q and that TC = .25Q2 (In problem 2). I can see the relationship of
2
marginals to the totals on the marginals graph, as well as on a totals graph. But we also
learned the idea of a derivative, which is just a slope over an infinitesimally small range.
Derivative of a constant
f(x) = a; f’(x) = 0
Derivative of a linear equation

f(x)= ax; f’’(x) = a
Derivative of an exponential function

f(x) = xn; f’(x) nxn-1
You may also find it useful to recall the following:
f(x) = g(x) + h(x); f’(x) = g’(x) + h’(x)
f(x) = g(x)h(x); f’(x) = g’(x)h(x) + h’(x) g(x)
f(x) = g(h(x)) = g’(h(x))h’(x)
Preview__________________________________________________________
Some review problems.
LECTURE______________________________________________
Incremental analysis: For many (if not most) decisions, the manager must make a binary
(yes or no) choice. In that case, the tools described above are appropriate. However,
rather than considering the entire set of possibilities, consider only the changes from the
status quo, and determine whether the incremental change is desirable. The trick to this
incremental analysis is to attend only to the things that actually change with the decision,
and ignore the rest.
One practical way express this is the following:

a) In making a decision pay attention to marginal costs and marginal benefits
b) In making a decision, pay attention only to marginal costs and marginal benefits
(That is, ignore sunk costs)
Example, suppose you wait in a line in a grocery store. Another line opens up. What
value should you place on the time you’ve spent waiting in your present line (none)
31
Example; Suppose you have a 12 month lease on an apartment. You must pay $700 per
month. If you get a new job in May that forces you to leave town in May and if your
lease runs through August, how much, at a minimum must you get to sublease the
apartment? (Answer, you must cover any variable costs, and nothing more!)
Example: A more involved example. Suppose you manufacture umbrellas, and you are
deciding whether or not to purchase a new “game day” golf umbrella, which is big
enough to keep the entire family dry in a halftime downpour.
The new machine costs $40,000. For simplicity, we assume that the machine lasts
one year, and is then useless. You can put the machine in a slot where a now defunct
standard machine sits. Old machine removal and recycling costs are $5,000, and must be
borne independent of whether or not you buy the new machine.
Installation costs for the new machine are $4,000. Variable costs for the new
umbrellas are $8 per umbrella for materials and energy and $4 per umbrella for labor.
Suppose that you can reasonably expect to sell 2000 of these umbrellas next year, at $35
each. Is the machine a good investment?
Incremental revenues are ($35)(2000) = $70,000
Incremental Costs are

$40,000 new machine
$4,000 installation
$24,000 variable expenses ($12)(2000)
$68,000
Result: Yes, purchase the machine. Notice, however, that the $5,000 removal expenses
should not be considered in this analysis.
Lecture 7
REVIEW___________________________________________________:
In attempting to optimize, two rules:
- Attend to marginal benefits, attend to marginal benefits and marginal costs.

-Attend only to marginal benefits and marginal costs. (Ignore sunk costs)
Preview__________________________________________________________

1. Overview
B. The Demand Side.
32
LECTURE______________________________________________
1. Overview. The purpose of this chapter. Economics proceeds via models. A model is
an abstraction from reality, done for the purpose of explanation, or prediction. It is
important to emphasize that these models are necessarily unrealistic. A “model” that
captured all the complexity of reality wouldn’t be useful at all. Rather the
oversimplification of a model is useful if it serves effectively an explanatory or predictive
function.
For example, the first model presented in this class was the present value characterization
of the firm, introduced in chapter 1. This model, of course misses many elements,
including the uncertainty of returns over time, as well as the possibility that interest rates
may change. Nevertheless, it is useful in that it provides some insight into the issues
relevant to considering the inter-temporal value of a firm.
This chapter presents a second model, the theory of price and quantity
determination. This model should be a review for most of you. Nevertheless, it is of
prominent importance. The purpose of this model is both explanatory and predictive. It
is the primary tool that you can use to infer the effects of market impacts on prices and
outputs. You are expected to master the mechanics of this model.
A second function of this review is to present this model in simple algebraic
terms. This presentation should help “acclimatize” you to the type of analysis we will do
in this course.

a. Overview. In this model, we divide people into two groups
i. Households: Who attempt to maximize utility, they face diminishing marginal

utility, and are subject to a budget constraint.
ii Firms: Attempt to maximize profits. Firms fact cost constraints, and are subject
to a law of diminishing returns in production.
We will look at Demand (household behavior) Supply (firm behavior) and equilibrium,
the interaction of these parts that generates price and output predictions
B. The Demand Side.
1. Motivation: Consider an example of consuming a good. Suppose that it’s 100 degrees
F outside, and you play 3 sets of tennis and then run 10 miles. Then you put on a coat,
jump in the car, turn the heater up to full blast, and drive 3 hours in the sun. At the end of
33
all this, you 1/2 dozen chili peppers. Now stop at a gas station and purchase cans of
Sprite, one by one. Consider how much you would pay, for the first can, for the second,
the third, and etc. The fact that you are gradually getting full is the notion of diminishing
marginal utility.
Diminishing marginal utility: In a given time frame, consumption of additional

units of a good yields decreasing increments to total well being due to relative
satiation (fullness).
2. Definition (for output market):
The Demand Curve: A curve indicating varying quantities of a good or service that
consumers are ready, willing and able to purchase at varying prices, per unit of time,
other things constant. Demand is down-sloping due to the diminishing marginal utility of
consumption.
There are a number of important components in this decision
a. Price/Quantity relationship: Price is the most important determinant of

Quantity
b. Ready, willing and able: Defines the market.
Ready - in the market.
Willing - desires the good.
Able - has the wherewithal.
c. Per unit of time: Time must be specified, as it affects diminishing marginal
utility.
d. Other things constant. A number of things aside from the price affect qty
purchased (including substitutes, complements, and advertising, and etc.)
e. Down-sloping due to diminishing marginal utility (Fullness). This is the reason
that there is an inverse relationship between price and quantity.
3. Determinants of Demand. Things that affect the Marginal Utility of purchasers in

the market. In addition to price, determinants include:
Ps -Price of substitutes
Pc Price of complements
I Income (Normal goods or Inferior goods)
E Expectations (regarding relative future prices
B Number of buyers (population)
4. Changes in demand vs. changes in qty demanded. When one of the non-price
determinants of demand changes, it is necessary to draw a new demand schedule. This is
known as a change in demand (schedule). When there is a change in price, other things
held constant, this is called a change in quantity demand (a movement along a schedule)
Example, consider
34
Qd = f(P, Ps, Pc, I)
This is a demand function. It is a relationship between quantity demanded, and the entire
collection of elements that determine sales quantity. The demand curve is a relationship
between price and quantity alone, holding all other elements constant.
Suppose income increases. Then it would be necessary to shift the demand schedule.
Note: The one thing that CANNOT change demand (curve) is a change in the price of
the good!
Lecture 8
REVIEW___________________________________________________:

1. Overview
B. The Demand Side.
Preview__________________________________________________________
LECTURE______________________________________________
4. Changes in demand vs. changes in qty demanded. When one of the non-price
determinants of demand changes, it is necessary to draw a new demand schedule. This is
known as a change in demand (schedule). When there is a change in price, other things
held constant, this is called a change in quantity demand (a movement along a schedule)
Example, consider
Qd = f(P, Ps, Pc, I)
35
This is a demand function. It is a relationship between quantity demanded, and the entire
collection of elements that determine sales quantity. The demand curve is a relationship
between price and quantity alone, holding all other elements constant.
Suppose income increases. Then it would be necessary to shift the demand schedule.
Note: The one thing that CANNOT change demand (curve) is a change in the price of
the good!
5. The Notion of Consumer Surplus In markets where all consumers pay a uniform price
for a good, most of the consumers who purchase the good place a higher value on the
product than the purchase price. This difference between purchase price and value is
termed consumer surplus.
P
$8
Consumer Surplus for unit Q1
$5
D
Q1 10 QD
For example, a consumer who values unit Q1 at $8 and pays $5 for the unit enjoys a
consumer surplus of $3. Notice that the entire consumer surplus for the market is the
area between the demand curve and the price.
Notice that in some contexts, it is possible for a seller to collect some of the consumer
surplus realized in a single-price market. In particular, the seller may sell “packages” of
units at a higher price than single quantities of the same unit, to achieve a given sales
total. (We will discuss this later in the semester.
6. An analytical example
Consider the following, simple demand function.
Qd = 10 - 2P + .33I.
Suppose I=30, then the demand curve can be written as
Qd = 20 - 2P
Or inverse demand:
P = 10 - Q/2
This is shown as D on the figure below
36
16
14
12
10
6
D'
4
2
D
0
0 5 10 15 20 25
If I increases to 60 then
Qd = 10 - 2P+ .333(60)
Qd = 30-2P
So inverse demand is
P= 15-Q/2, illustrated as D’ in the above figure.
Suppose that the price is $5. How much consumer surplus to consumers receive at that
price?
When 15-Q/2 = 5, Q = 20. So the area of the C.S. triangle is
(.5)(15-5)(20) = 100
This is the triangle illustrated below
37
16
14
12
15-5 D'
10
D
4
2
20
0
0 5 10 15 20 25
Lecture 9
REVIEW___________________________________________________:
B. The Demand Side.

Preview__________________________________________________________
C. The Supply Side.

LECTURE______________________________________________
C. The Supply Side. In output market, this defines the behavior of sellers,
1. Initial assumption. Firms are motivated by the profit incentive, but constrained by
increasing marginal costs (or, better yet, the law of diminishing returns (crowding).
38
Example, consider conditions under which you would produce for sale quartz lamps from
your uncle's shack in Southern Montana. As the amount of variable inputs (quartz, and
workers) increases, the room should become “crowded,” and unit costs should increase as
more variable inputs (labor) becomes “imbed” in each unit of output. This, we would
expect, there would be a direct relationship
2. Definition
The supply curve: A schedule of intentions indicating varying quantities of a good

or service that sellers are ready, willing and able to place on the market at varying
prices, per unit of time, other things constant. The supply curve is upsloping due
to the law of diminishing returns (“crowding”)
Important elements
a. Schedule of intentions: An estimate

b. Price/Quantity relationship: Price is the most important determinant of
quantity.
c. Ready, willing and able: Defines the market of relevant suppliers.
Ready: Has access to market.
Willing: Is a reasonable use of resources,
Able: Has productive means
d. Per unit of time: Time must be specified, as it affects LDR.
e. other things constant.
f. Upsloping due to the law of diminishing returns (crowdedness)
3. Determinants of supply: Things other than the price that affect how r.w. and a. sellers
are to offer goods to the market. As a class, these are things that affect production costs
Technology
Factor prices.
NUMBER OF SELLERS.
Price expectations (e.g. hold grain in silo if price is expected to increase next
year).
Taxes (excise or ad valorem)
Definition. (As with demand): A change in quantity supplied occurs in response to a

change in the price of a good, all other things held constant.
A change in supply occurs in response to a change in something other than price.
Again, price is, by definition, the one thing that cannot change supply.
39
a. Definition Symmetric to the notion of consumer surplus, in a market where a
single price is charged for all transactions, producers typically receive more from a sale
than is necessary to induce them to offer a unit to the market.
P
S
$5
Producer Surplus for unit Q1
$3
D
Q1 10 QD
The producer surplus for unit Q1 is $5 - $3 = $2. The producer surplus for the market is
the triangle bounded by the vertical axis, the production cost, and the price.
b. Observations
-Producer surplus is not the same as profit. We will talk about this more later, when
we discuss the theory of the firm.
-There are ways for a savvy purchaser to extract producer surplus in making
purchasing decisions. Similar to demand, this is typically accomplished via bulk
purchases.
Lecture 10
REVIEW___________________________________________________:
C. The Supply Side.

Preview__________________________________________________________
1. Definition.
40
Price floors
Price ceilings
LECTURE______________________________________________
C. The Supply Side.
6. An analytical example. Consider the market supply schedule for small laser-light
paper erasers. The supply function is given by
Qs = -44 + 20P - 4W - 2M, where
P = the price of the erasers

W = the average hourly wage for labor
M = an index measuring materials costs.
If W = 10 and M = 8, what is the market supply curve?
Qs = -44 + 20P - 4(10) -2(8)

= -100 + 20P, thus
Inverse supply becomes
P = 5 + .05Q
Plotting in a table
Q P
5 5.25
10 5.5
15 5.75
20 6
25 6.25
Now, suppose that M increases to 18, then what happens to supply, or to quantity
supplied?
Qs = -44 + 20P - 4(10) -2(18)

= -120 + 20P, thus
There is a change in supply

P = 6 + .05Q
Q P
5 6.25
10 6.5
15 6.75
20 7
41
25 7.25
Alternatively, suppose that P increases from 6.5 to 17what happens to Q?

There is a change of quantity supplied from 10 to 20.
8.5
S2
8
7.5
7 S1
6.5
5.5
5
0 10 20 30 40 50
Graphically
Q P1 P2
0 10 15
2 9 14
4 8 13
6 7 12
8 6 11
1. Definition. Equilibrium: A price quantity combination where Qs = Qd, and where Ps =

Pd.
Analytically. Suppose
Qd = 100 - 4P +10I, and

Qs = 10 + 6P -3W
If W = 30, I =10, what are equilibrium values?
Qd = 100 - 4P +10(10), and

Qs = 10 + 6P -3(30)
Qd = 200-4P
Qs = 80+6P
42
Setting Qd = Qs implies that
P Qd Qs
15 140 170
14 144 164
13 148 158
12 152 152
11 156 146
10 160 140
9 164 134
Observe at a price of 15 dollars, there is a surplus, Qs = 170 > Qd = 140. Conversely, at a

price of $9, there is a shortage, Qd = 164 > Qs = 134.
2. The stability and desirability of equilibrium. Absent a tendency for markets to

equilibrate (or given regulations which prevent such convergence), the surplus or
shortages just discussed would be permanent. However, markets do equilibrate. Given
excess supply the sellers have an incentive to reduce prices. This price reduction
prompts changes in quantity supplied and quantity demanded. Similarly, given an excess
demand, buyers have an incentive to bid prices up, again causing a change in quantity
supplied and quantity demanded.
Importantly, if the assumption of ‘pure privacy’ is satisfied, the equilibrium
outcome is also socially desirable. Given an absence of externalities, the TC curve equals
TSC and the TB curve equals TSB. Thus, D=MSB and S=MSC. At the equilibrium,
where S=D, the net difference between TSB and TSC are maximized.
3. Binding the market. Permanent shortages and surpluses can be caused by regulation.
A price floor: A regulated minimum price, below which the market price cannot
fall. If the floor is below the equilibrium, the regulation exerts no effect. If the
floor is above the equilibrium, there is a permanent shortage that the market
cannot eliminate.
a. Example. A price floor: Suppose the government refuses to let cheese be sold for less
than $3.00 per pound. Result: A permanent surplus, and one that cannot be resolved by
the market
A price ceiling: A regulated maximum price, above which the market price
cannot rise. If the floor is above the equilibrium, the regulation exerts not effect.
If the floor is below the equilibrium, there is a permanent shortage that the market
cannot eliminate.
b. Example: A Rent control. Result: A shortage of housing, and one that cannot be
resolved by the market.
43
Complications: One solution by sellers is to force multiple purchases (e.g., Impose a price
ceiling on rents, but then make people agree to unusual lease terms, or to purchase other
high cost items along with the lease). In fact, it is possible that given rent controls, the
non-monetary components associated with increasing the price of a good may generate a
full price for each consumer that equals the total market consumer surplus.
Notice that when a ceiling binds the market, the full economic price is the sum of the
pecuniary plus the non-pecuniary price (e.g., the price of waiting, purchasing undesired
packages of goods, etc.) In general, with a price ceiling, buyers who purchase a good
will pay the demand price, at the restricted quantity. For example
P
S
Pf
Pc D
Qc Q
Given a Price ceiling Pc, Qc units will be sold. The full economic price paid by buyers
will equal Pf.
There are parallel examples in input markets (where the government acts more
aggressively).
Usury laws (a market for loanable funds)

Minimum wage legislation.
The point: Equilibrium is a socially desirable outcome. We interfere with the

workings of a competitive market at our peril!
Lecture 11
REVIEW___________________________________________________:
1. Definition.
2. The Stability and desirability of equilibrium
44
Price floors
Price ceilings
Point: Binding the market imposes high social costs
Preview__________________________________________________________
1. Single market changes.
2. Multiple Market Changes

1. Motivation
LECTURE______________________________________________
E. Comparative Statics. Given the tendency of markets to converge to competitive
predictions in an unfettered and competitive market, we can use this model to predict the
effects of changes in the world.
Strategy: To find the new equilibrium, consider the old equilibrium price, and the new
equilibrium supply and demand curves. Then shortages or surpluses will motivate an
adjustment.
a. Change in demand, supply stable.
Example, suppose the price of coffee falls by half. What should this do to the
market for pastries?
Example: What should the current economic recession do to the price and
quantity of automobiles sold?
b. Change in supply, demand stable
Example: Suppose a new process for manufacturing computers is developed that

cuts production costs by 50%. What is the predicted effect on the number of
computers sold, and the price of computers?
c. Change in supply and demand… (and ambiguous effects).
Example: Suppose software costs fall, and that at the same time a new Pentium X
chip is developed that can be installed to do twice as much at 1/2 the price. What
is the net effect of these changes on the price and quantity of personal computers
sold?
45
Example: Consider the market for cheese produced by U.S. farmers. Suppose that
due to the flooding in Northern Europe, Farmers in the Netherlands lose half of
their dairy herd. Suppose also that new environmental deregulation cuts
production costs in half. What are the net effects of these changes on the market
for cheese produced by U.S. Farmers?
A more complicated story variant: Consider the above problem, but suppose that
at the outset the U.S. government imposed a price floor for cheese that at the
initial equilibrium. How does the price ceiling affect results?
Lecture 12
REVIEW___________________________________________________:
Equilibrium is
1. Stable
2. Socially desirable
2. Multiple Market Changes
Preview__________________________________________________________

1. Motivation
2. Calculation
a. Arc price elasticity of demand:
Lecture ______________________________________________________
III. Chapter 3. Quantitative Demand Analysis
Introduction: In the preceding chapter we reviewed the basic supply and demand model
used to predict price and quantity outcomes. This model is an extremely useful device
for making qualitative predictions. An important limitation of the model as it has been
presented, however, is that it does not allow quantitative predictions. For quantitative
predictions, it is necessary to more fully characterize the arguments in the demand and
supply functions.
46
We start with demand in this chapter. The presentation is divided into two parts.
The first will deal with the quantitative conclusions that may be fairly limited elasticity
information. In the second part, we turn more comprehensive analysis of demand
estimation via the use of regression.
1. Motivation: Elasticity this is a tool for estimating responsiveness of some dependent

variable to a change in a dependent variable, based on very little information.
Definition: Elasticity: The percentage change in an independent variable brought

about by a 1% change in an independent variable.
Intuitively, elasticity may be regarded as a measure of sensitivity. If people are

sensitive, we will say that they are elastic. If they are insensitive, we will regard them as
inelastic.
For concreteness, we will focus initially on price elasticity of demand (change

definition accordingly)
Price Elasticity of Demand: The percentage change in Quantity Demanded brought about
by a 1% change in the price of a good, or
 = %Qd/%P = Q/Q = QP

P/P PQ
2. Calculating Elasticity of Demand. There are three ways to calculate price elasticity of
demand: arc price elasticity, point price elasticity, and direct percentage changes. The
method that is appropriate in any particular context depends on the information provided.
a. Arc Price Elasticity. Applies to a discrete change. For example, consider the
demand curve implied by the following table:
P Q
4 40
5 10
47
D
10 40 Q
Notice Q may be calculated as Q1-Q0, and

P = P1-P0. Then  = (Q1-Q0)P/(P1-P0)Q
But it makes a big difference if you use (P0,Q0) as your divisor, or (P1,Q1).
For example:
(40-10) (4) = 30(4) = -3.00

(4-5) (40) -1(40)
(40-10) (5) = 30(5) = -15.00

(4-5) (10) -1(10)
Neither of these points is inherently more correct. As a convention, we calculate the arc
price elasticity of demand using the average of the distance between the 2 points:
 = (Q1-Q0)(P1+P0)/2
(P1-P0)(Q1+Q0)/2.
In this case
= (40-10) (4+5)/2 = 30(4.5) = -5.4

(4-5) (40+10)/2 -1(25)
Arc Price elasticity is interpreted as follows: Over the range of prices between $4 and $5
on average, a 1% reduction in price increases quantity demanded by 5.4 %.
b. Point price elasticity: When you are given a slope, and a point.
Insight  = (dQ/dP)(P/Q)
Example: Suppose a demand curve is
Q = 30 - 10P
Then, if P = 2, then Q=10 and elasticity is
-10 ( 2/10) = -2.
Uses: Mostly when given a demand function.
48
Point Price elasticity is interpreted as follows: At a price of $2 a 1% reduction in price
increases quantity demanded by 2 %.
c. Percentage changes. For rough policy purposes.

Insight  = (%Q)/(%P)
Example. Suppose that beer sales at Joe's Inn increased 20% in response to a “half
price” (50% off night). What is the implied elasticity of demand?
-20/ 50 = -.4
Example: Suppose that Joe sells 400 beers per day. What would be the effect of a 10%
increase in beer prices on his sales?
-.4 = %Q/10 implies 4 % decrease, or a decrease of .04(400) = 16 beers per day.
Lecture 13
REVIEW___________________________________________________:
1. Motivation
2. Calculation
a. Arc price elasticity of demand:
Example: If Rick Redfern reduces the price of potato chips from $2 per bag to $1
per bag, and if daily sales increase from 10 to 15, what is the arc price elasticity of
demand?
 = (10-15)(2+1) = -5(3) = -3/5

(2-1) (10+15) 1(25)
Example: If demand is given by

Q = 100 – 10P and P = 6, what is price elasticity of demand?
 -10 (6)/40 = -1.5

(Notice: If P = 4, elasticity becomes
 -10 (4)/60 = -.67
A preview: Price elasticity changes with position on the demand curve.
49
Example: If Ford Taurus sales increase by 20% in response to a 10% off sale,
what is the implied price elasticity of demand?
 = -20/10 = -2
Preview__________________________________________________________

b. Exceptions
5. Elasticity TR and MR
Lecture ______________________________________________________
a. Intuition: One way to consider the problem of sensitivity is to ask the

following question: What happens to total revenue (TR) when price is changed?
Consider a price increase. If TR increases, then we will say that people are "insensitive"
to the change (meaning that more revenues were gained from people staying in the
market and paying the higher price, than were lost from people who left the market. On
the other hand, if TR falls, then people are "sensitive" in the sense that more revenues are
lost from people leaving the market in response to a price decrease, than were gained
from the higher prices.
b. Illustration. This can be graphically illustrated as follows. Consider the problem

of calculating price elasticity for a standard linear demand curve.
Po
Price box
P1
Quantity Box D
Q0 Q1 Q
50
Associated with a price change are competing effects,
PQ a "price" box.
QP a "quantity" box.
Elasticity is the ratio of the qty box to the price box.
Let’s explain this in words. Suppose we talk about a price reduction.
The ‘price box’ is the loss in revenues on units that would have sold at the higher price
The ‘quantity box’ is the increase in revenues due to new units that are sold as a result of
the price reduction.
Elasticity is the ratio of the qty box to the price box.
When inelastic, the coefficient is small (close to zero)

When elastic, the coefficient is large (far from zero).
4. Some observations about price elasticity of demand (:
a. In general
 is between 0 and infinity
 <0 by definition (though it is often treated as a positive number).
- Most curves have elastic, inelastic and unitary components.
Inelastic Unitary Elastic

(Price box is larger than (Price box equals (Price box is smaller
Quantity box) Quantity box) than Quantity box)
b. Exceptions:
51
Perfectly Inelastic CES Perfectly Elastic
(Only Price box) (Only Qty. Box)
c. Tendencies
E
U
I E
U
I
Relatively Relatively
Inelastic Elastic
d. Summary. Coefficient values are related to the above graph as follows.
Inelastic TR moves with P Price box > Qty box. <1

Unitary TR is Unchanged Price box = Qty. box =1
Elastic TR moves with Q Price box < Qty. box >1
Lecture 14
REVIEW___________________________________________________:
b. Exceptions
Preview__________________________________________________________
5. Elasticity TR and MR
6. Determinants of Price elasticity
52
53
Lecture ______________________________________________________
5. Price Elasticity, MR and TR
a. Motivation: What can we say about the optimality of prices, given limited
information. (Say, only information about the demand schedule, and perhaps MC
information). Some important inferences can be drawn only from information about
elasticity.
Definition of Marginal Revenue (MR). Recall that on most demand curves, there
are elastic, unitary and inelastic segments. (Motivate from comparison of quantity box to
price box). Price elasticity is the ratio of the quantity box to the price box.
Marginal revenue is the difference between the quantity box and the price box.
P
MR D
TR Q
MR (at max)
TR
E I
b. Relation between MR, TR and 
>1, MR >0
 <1, MR <0
 =1, MR =0
Thus: TR is maximized when MR = 0.
- A monopolist with no marginal costs would price where MR = 0.
54
-A price-setter could never increase revenues by cutting price when |<1. (ex. Never cut
prices to sold out concerts, generally don't raise price for bus service).
d. Some examples:
Example Suppose you are a monopolist, who owns a bridge. Access doesn't
deteriorate the bridge. What price should you set? (Suppose you have no marginal costs)
Answer: The price where ||=1
Example: The elasticity of demand at Jones Co. is -.5. They are considering a
sale. What can you say about the rationality of a price cut?
Answer: No firm can maximize profit on the inelastic portion of their demand
curve. They should raise price.
Example: Suppose (inverse) demand is
P = 10 - 2Q.
If P =2, what can you say about the optimality of pricing policy?
Answer: MR = 10 - 4Q. When P = 2, Q = 4. Thus, they are on inelastic part of

demand curve (and the firm could increase profits by raising price.
6. Determinants of price elasticity of demand. Your text (p.81) lists elasticities of

demand for selected products in the U.S. ranging from Motorcycles and Bicycles (-2.30)
to Transportation (-.6). It is important for you to be able to interpret these numbers.
Some assistance may be developed by considering factors that tend to make demand
curves have more or fewer elastic points.
a. Determinants of price elasticity of demand
i.) Availability of close substitutes: Demand is more elastic, the more substitutes
that are available.
ii) Price relative to income: Demand is more inelastic, the smaller price is relative
to income.
iii) Time: Demand is more elastic, the longer the time frame (because there are
more available substitutes).
b. Applications. You should be able to make comparative statements about the

elasticity of demand for various products:
55
i) What is more elastic: the demand for automobiles in general, or the demand for
VW Polos?
ii) What is more elastic: Demand for salt, or the demand for an automobile?
iii) What is more elastic: Your demand for pain pills at 3 a.m. at the 7-11, or your
demand for pain pills in general for your medicine cabinet.
You should also be able to combine elasticity calculations with determinants information.
iv) Suppose that auto-seller Jim Ford at Ford city lowers the price of the popular
Focus by $2000 in honor of Spring. Suppose that in response, weekly sales at
increase from 4 per week to 8. If the normal price of a new Focus is $10,000
what is the arc price elasticity of demand?
  = (8-4)(18,000)/[-2,000(12)]
= -3.
- Over the current price range, is Marginal Revenue positive or negative?
- Could Jim Ford expect to increase revenues by further lowering price? Would
such a move be profitable?
- What would you expect to be the response of customers to a similar percentage

mark-down on all cars in the Ford city lot?.
v) Suppose all U.S. domestic auto sales increase over last year by 5% in response
to a 10% price decrease. What is the implied price elasticity?
  = -5/10 = -.5
vi) You can say a lot about the optimality of pricing from elasticity. Consider a
firm selling plastic 3-sided rulers (inches, centimeters, and thumbs). Suppose that
price elasticity was -.2. What can you say about the optimality of the firms'
pricing decision?
B. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of interest

with respect to any independent variable. Some other important elasticities can be readily
calculated from a demand function.
Here at the end of the lecture, we introduce one: Cross price elasticity
1. Cross Price Elasticity. The purpose of a cross price elasticity estimate is to capture
some sense of the responsiveness of sales for one good to a change in the price of some
related good.
56
a. Definition. The cross price elasticity of good x with respect to a change in the
price of a related good y is:
XY %Qx/%Py
or, decomposing,
XY = (Qx/Py)(Py/Qx)
Using our point price elasticity formula, this could be calculated as:
XY = Qx Py
Py Qx
For example, with a demand function
Qx = 98 – 10Px + 4Py
Let Px = 5
And Py = 3
Thus, Q = 98 – 10(5) + 4(3)

= 60
The cross price elasticity of Qx w.r.t. a change in the price of Py would be
4(3)/62 = .2
Notice that cross price elasticity information can be used to distinguish substitutes from
complements. In this case, the coefficient is postitive, indicating that the products are
substitutes.
Lecture 15
REVIEW___________________________________________________:
5. Elasticity TR and MR. A firm maximizes profits on the elastic portion of the
demand curve
6. Determinants of Price elasticity
Availability of close substitutes
Price as a Percentage of Income
Time
57
B. Other Demand Elasticities (introduction)
Review HW#5
Preview__________________________________________________________
1. Cross Price Elasticity (continued)
2. Income Elasticity
Lecture ______________________________________________________

1. Cross Price Elasticity. The purpose of a cross price elasticity estimate is to capture
some sense of the responsiveness of sales for one good to a change in the price of some
related good.
a. Definition. The cross price elasticity of good x with respect to a change in the
price of a related good y is:
XY %Qx/%Py
or, decomposing,
XY = (Qx/Py)(Py/Qx)
Using our arc price elasticity formula, this could be calculated as:
XY = [(Qx1-Qx0)/(Py1- Py0)][(Py1 + Py0)/(Qx1+ Qx0)
Percentage and point price changes are similarly calculated in a way that parallels the
calculation of own price elasticity..
b. Interpretation: The percentage change in sales of good x brought about by a

1% change in the price of good y.
c. Uses:
i. To assess responses of competitor's actions.

XY > 0 good are substitutes.
XY < 0 goods are compliments.
XY = 0 goods are unrelated
58
Lecture 16
REVIEW___________________________________________________:
II. Quantitative Demand Analysis
1. Cross Price Elasticity
Preview__________________________________________________________
1. Cross Price Elasticity (continued)
2. Income Elasticity
3. Advertising Elasticity
C. Point price elasticities and demand functions

1. Linear Demand functions
2. Logarithmic Demand
Lecture ______________________________________________________

1 Cross Price Elasticity of Demand (continued)

c. Uses:
i. To assess responses of competitor's actions.

XY > 0 good are substitutes.
XY < 0 goods are compliments.
XY = 0 goods are unrelated
ii. Forecasting. Suppose you sell fish dinners. A close rival also sells the same,
and lowers his price 20%. If the cross price elasticity of demand is 2, how much will you
lose in terms of sales?
2 = (%Qx)/-20. thus, - 40% is the answer.
59
iii. More complicated interactions. Continuing with the above example,
Suppose your own price elasticity is -3. How much of a price increase would restore
your sales?
-3 = 40/%P. Implies 13.33% price decrease.
2. Income elasticity:
a. Definition: The percentage change in demand brought about by a 1% change in

income on aggregate demand.
I = (Q/I)(I/Q)
via the arc price estimate, this is calculated as:
= [(Q1-Q0)/(I1-I0)][(I1 +I0)/(Q1+Q0)]
Point and percentage change calculations are also parallel to those for price elasticity.
b. Use: To assess effects of changes in underlying economic conditions
- If 0 < I < 1, the good is noncyclical. Ex: Foods, shoes, gasoline.

- If I > 1 We will say the good is cyclical. Ex: Autos, housing, luxury goods.
- If -1< I < 0 the good is inferior
- If I < -1 the good is countercyclical (Note: We don’t talk much about
countercyclical goods. There are few)
c. Applications:
i) Assessing susceptibility to economic conditions. With normal goods, firms
with a big income elasticity of demand will grow quickly. Example, Income elasticity of
demand for autos is 3. Such goods are also sensitive to decreases in aggregate income.
ii) Forecasting: Suppose income elasticity for cigarettes is .6. A 5% increase in

personal income could be expected to increase demand by :
.6 x .05 = .03 or 3%.
3. Other Demand Elasticities. Elasticity is a sensitivity measure that may be of

interest with respect to any independent variable. Some other important elasticities can
be readily calculated from a demand function. To illustrate, we introduce one final
elasticity measure, Advertising Elasticity
a. Definition. The percentage change in Quantity induced by a one percent

change in advertising expenditures.
60
A = (Q/A)(A/Q)
- Using the arc elasticity formula
= [(Q1-Q0)/(A1-A0)][(A1 +A0)/(Q1+Q0)
A point advertising elasticity parallels the statement of the other elasticities.
b. Uses: It is one of the variables the firm can control, and can use to respond to
changes in the things it cannot control (such as the price of related goods, income etc.)
Notice that advertising elasticity should be positive. If not, it is an advertising campaign
that is detracting from sales.
c. Examples.
-Suppose that the income elasticity of demand is .5, and the advertising elasticity
of demand is .2. If income falls by 2%, how much would a firm have to increase
advertising to make up for the difference?
(%Q)/(%I) = .5
If %I = -2, then %Q = -1. If A= .2, then
1/(%A) = .2, or
%A = 5.
-Suppose a competitor lowers the price of a good by 20% and that A = 1, XY = 2
and  = -3. How much must you lower price in order to keep sales constant? How much
must the firm increase advertising in order to keep sales constant?
C. Point Price Elasticities and Demand Functions. Given the underlying demand
function, we are able to make more precise elasticity calculations. We will consider first
how to draw inferences from linear demand specifications. This will be followed by
inferences from a second popular demand specification, a logarithmic specification.
1. Elasticity and Linear Demand Estimates. Consider the following demand function
(say Q = mugs of beer in local restaurants), Pf = the price of meals, A = Advertising
expenditures)
Q = -50P + 20I -5Pf + .1A
Where I is measured in 000's of dollars. and where
I = $10,000, Pf = $10, A = $500, and, say, P = $2. Then
Q = 200 - 50(2) = 100
61
- Point price elasticity is
dQ/dP = -50
 = -50(2)/100 = -1.
- Point income elasticity is
dQ/dI = 20
I = 20(10)/100 = 2
- Cross price elasticity is
dQ/dPf = -5
bf = -5(10)/100 = -.5
- Advertising elasticity is
dQ/dA = 0.1
A = 0.1(500)/100 = .5
And you can do exactly the same exercises as before.
i) Suppose that GNP increases by 5%. How much could restaurants raise price
and keep sales constant?
2 = x/5 implies a 10% increase in sales.

To offset the sales increase, a 10% increase in price would suffice.
ii) Suppose that food prices increase by 10%. What change in advertising
expenditures would keep sales constant?
Answer: Food price increases by 10% imply that beer sales decrease by 5% (due to the
cross price elasticity of -.5) A 10% increase in advertising expenditures would offset the
change.
2. Logarithmic demand. A problem with trying to do exercises with interrelated

elasticities in this context is that the elasticity coefficients change with alterations in the
value of the independent variables. It is for this reason that an alternative specification is
used frequently. This alternative specification, called a constant elasticity demand curve,
has the property that elasticities remain constant.
Q = aPb1Ib2
If a = 200, b1 = -.3 and b2 =2, then
62
Q = 200P-.3I2
Although this looks obtuse, it is in fact pretty useful. Most importantly, it is readily
estimated, by taking logarithms:
log Q = log 200 + -.3 log P + 2 log I.
More importantly, the parameters in this case are directly the elasticities. It is for this
reason that this is called a constant elasticity demand function. It is a useful
approximation when you wish to assume that elasticity of demand is constant.
(Q/P)(P/Q) = ab1Pb1-1 Ib2(P/Q)

= b1
With this information we can examine firm responses to own and other effects.
3.. Some Practice Exercises with Demand Functions.
i. Example: Joe Doe, CEO of Doppler Inc. observes the sales of his weather radar
printers fall 10% in response to a 5% increase in the price of weather tracking software.
a. What is the implied cross price elasticity of demand? How are radar printers
and weather tracking software related? What would be another example of such goods?
b. Suppose that own price elasticity is -.5. Approximately, how much, and in
what direction could John adjust the price in order to restore sales quantity to its original
level? Would such a response be a profitable?
ii. Example Suppose that the income elasticity for Calaphon aluminum cookware
is 1.5, and that the advertising elasticity is 2. Approximately how much, and in
what direction could Calaphon adjust its advertising revenues to counteract the
effects of a projected 5% decrease in GNP in the coming year?
iii. Example Suppose that the demand function for Sorby Floppy disks is of the
form
Qx = 600 - 40Px + .2Py + 2I
Where Qx = Hundreds of packages of Sorby Floppy disks sold in the U.S. per week,
Px = the price of a package of the disks.
Py = the price of upgrade Hard Disk Drives for Personal Computers.
I = per capita income (in thousands of dollars).
Suppose that at present

Px = 10
63
Py = 300
I = 10,000.
a. Calculate the point price elasticity of demand, the point cross price elasticity of
demand for computer disks with respect to hard disk drives, and the point income
elasticity of demand.
Qx = 600 - 40(10) + .2(300) + 2(10)

= 600 - 400 + 60 + 20
= 280
Thus  = -40(10)/280 = -1.43
b. Given the above demand relationship, what can you say about the relationship
between hard-disk drives and floppy disks? Why?
Answer: The sign on the intercept for hard disk and floppy disks is positive,
indicating that an increase in hard-disks will increase floppy disk sales. The
products are substitutes.
c. Given the above demand relationships, are computer disks a normal or inferior
good? Why?
Answer: The positive sign on the income coefficient indicates that the floppy
disks are normal goods. Incidentally, the income elasticity is
 = 2(10)/280 = -0.07.
Thus, the goods are noncyclical normal goods.
d. Could the makers of computer disks increase profits by raising prices?

Why or why not?
Answer: You can’t tell. The firm is on the elastic portion of the demand curve.
An increase in prices will decrease both revenues and costs. A definitive answer
could be given in this case only with information about the cost function.
iv. Example You can do problems with non-linear equations. Suppose, for
example, that the demand function is given by
logQx = 5 - 1.7log Px + .3log S - 3 log Ay
Then what is price elasticity of demand?
Answer  = -1.7
64
Lecture 17
REVIEW___________________________________________________:
C. Point price elasticities and demand functions
1. Linear Demand functions
2. Logarithmic Demand
Preview__________________________________________________________
1. The Bivariate Case
2. The Multivariate Case
LECTURE_________________________________________________________
D. Estimating Demand: Regression Analysis. Our intention in this section is to
learn from where the parameters of a demand function might come. That is, given the
relationship
Y = A + B1X + B2P + B3I + B4Pr
Where
Y = qty. demanded
X = advertising and promotional expenses
P = price of a good
Pr = price of a related (competing) good.
We would like to know how to get values for the parameters A, B1, B2, B3, and B4.
Regression analysis is simply a statistical tool that allows us to estimate the magnitude of
these parameters. Estimates may be made from the price and quantity data generated in
the sales process.
a. Advantages
i. Inexpensive
ii. Non-invasive
c. Disadvantages
Estimates may be unreliable or imprecise. (But we can learn to
qualify appropriately results)
1. The Bivariate Case. Suppose in some simple world, sales are only affected by
advertising expenditures. Assume also that the factors are linearly related. Then we have
Y = A + B1X.
65
Suppose further, however, that this specification is a model - by assumption a
simplification from the natural world. Suppose that there is some random error e in our
estimate. That is, for each observation i,
Yi = A + B1Xi + ei
ei has a mean of 0.
Graphically
Q
}A
A
This is called a population regression line. (or the true underlying relationship). Of
course, we don't see the underlying population regression line. Rather, we must try to
estimate it from available data. The general expression for this sample estimate is
^
Yi = a + bXi.
That is, given Xi, we pick a and b to estimate Yi . For example, an estimate might be:
^
Yi = 2.533 + 1.504Xi
Sales
^
* Y
*
* *
1.504
*
* *
*
*
} 2.533
X = Advertising
The method of least squares is simply a way to pick the intercept and slope
of a line that gives a “best” fit of the points. The idea is simply to minimize the
sum of squared differences
^
between Yi andY i. We will call this sum S, or
66
^
S =  (Yi -Y i )2
S =  (Yi -a - bXi )2
To optimize this equation, simply take the derivatives and solve: (but we will skip this
derivation!)
2. Multivariate Regression. The intuition that we have motivated with a single variable
readily extends to multiple variables. Although the calculations quickly become very
messy, they are easy to do with a computer.
a. The Problem. Consider our original problem, but now include P;
Yi = A + B1Xi + B2Pi + ei
(assume that X and P are independent, and that the average ei is 0) via a regression, we
can compute and estimate:
^
Yi = a + b1Xi + b2Pi
Via such an analysis you would generate a demand function estimate of the type
Yi = 100 + 4X - 2.5Pi
We could, with this linear relationship, do precisely the sorts of elasticity calculations and
estimates that we discussed just prior to the first exam.
Lecture 18
REVIEW___________________________________________________:
. Estimating Demand: Regression Analysis.
1. The Bivariate Case
2. The Multivariate Case
(Recall, regression analysis is just an analytical way of picking the intercept and the slope
of a line to ‘best fit’ the data, where by the term ‘best fit’ we mean a line that minimizes
the sum of squared deviations between observations and the estimated line.
Squaring deviations has the advantages of (a) keeping positive and negative
deviations from canceling each other out, and (b) paying particular attention to outliers.
Preview__________________________________________________________
3. Doing regressions. Examples and an analysis of regression output.
67
4. Interpreting the Significance of Individual Parameter Estimates.
5. Forecasting.
LECTURE_________________________________________________________

Regressions are quite easy to do with a spreadsheet.
a. Let’s start with a bivariate case. Suppose we are interested in estimating the
relationship between sales of a good (Yi) and advertising expenditures (Xi). We
have the following data.
Sales Yi Adv Xi
4 1
6 2
8 4
14 8
12 6
10 5
16 8
16 9
12 7
We can use a spreadsheet to do many the appropriate calculations. In class, we

will replicate these columns on EXCEL, and use the regression package to yield
the following result (I interpret regression output more fully below, but here are
your parameters)
^
Yi = 2.533 + 1.504 Xi
b. A Multi case. Adding independent variables is straightforward.

Consider our original problem, but now include price. P;
That is, we estimate
Yi = A + B1Xi + B2Pi + ei
as
^
Yi = a + b1Xi + b2Pi
Using a spreadsheet, suppose we extend our original as follows:
Sales Adv Price

(mill U) Exp
4 1 1
6 2 0.5
8 4 5
14 8 8
68
12 6 4
10 5 3
16 8 2
16 9 7
12 7 6
Regressing the first column on the second and third generates
a = 2.61, b1=1.75 and b2=-0.36
(Observe that the b1 coefficient changes from before (now it is 1.76 vs 1.5 before. The
reason is that the new equation holds constant the effect of price changes.
Notice that we can do the same exercises that we did with other elasticity estimates.
Suppose, for example, that p = 20 and Sales Exp. = 6. Then what is the price elasticity of
demand?
Q = 2.61+ 1.765(6) - 0.36(20) = 6
Thus,  = -0.36(20)/ 6 = -1.2.
c. Regression Output. A more detailed overview.. In this section, we review

regression results. In this course, we will focus on just three aspects of regression results.
(a) The “goodness of fit” or R2, (b) the standard error of the regression estimate, and (c)
the standard errors of the coefficient estimates.
Suppose that you conduct a linear regression of the equation:
Q = o + 1P + 2 Py + 3A
where P is the price of the good, Py is the price of a substitute good, and X are advertising
expenditures. Your data look like the following
Q P Py A
50 5.8 10 10
40 6.2 9 20
60 5.1 15 10
50 5.5 11 13
35 4.8 9 7
40 5 10 11
61 3.8 17 22
46 4.5 8 13
52 4.3 11 15
26 7 7 6
33 5.6 9 8
47 4 11 12
69
51 4.5 15 15
29 7 8 12
42 4.8 12 22
19 12 6 10
72 5 18 18
30 6.8 6 10
41 5.2 9 20
32 6 12 11
47 5 10 21
65 3.7 17 10
Notice that you have a total of 22 observations. Now, if you input this data into EXCEL
and run a regression, you will get output in three blocks of rows. At the top, you get
70
Regression Statistics
Multiple R 0.904081
R Square 0.817362
Adjusted R 0.7869
Square
Standard 6.158553
Error
Obs 22
Here, you should pay attention to two things. First note R2 . R2 is a descriptive measure
indicating how well the estimate fits the regression line. A number closer to 1 indicates a
better fit.
Second look at the Standard Error (here 6.15) we will use this later when we talk about
forecasting
A second block of information is the following:

Coefficient Standard t Stat P-value Lower 95% Upper 95% Lower Upper
s Error 95.0% 95.0%
Intercept 24.2067 10.08245 2.400875 0.027378 3.024246 45.38916 3.024246 45.38916

X Variable 2 -2.06908 0.971137 -2.13058 0.04717 -4.10937 -0.0288 -4.10937 -0.0288
X Variable 3 2.620155 0.488371 5.365095 4.24E-05 1.594126 3.646185 1.594126 3.646185
X Variable 4 0.196674 0.291057 0.675724 0.507805 -0.41481 0.808163 -0.41481 0.808163
This information summarizes the descriptive power of individual coefficients. Observe

first that the variables are simply summarized as “X Variable 1”, “X Variable 2” and etc.
You should replace these with your variable titles, for example:
(1) (2) (3) (4) (5) (6) (7) Lower Upper

Coefficients Standard t Stat P-value Lower 95% Upper 95% 95.0% 95.0%
Error
Intercept 24.2067 10.08245 2.400875 0.027378 3.024246 45.38916 3.024246 45.38916

Price -2.06908 0.971137 -2.13058 0.04717 -4.10937 -0.0288 -4.10937 -0.0288
Price of X 2.620155 0.488371 5.365095 4.24E-05 1.594126 3.646185 1.594126 3.646185
Advertising 0.196674 0.291057 0.675724 0.507805 -0.41481 0.808163 -0.41481 0.808163
Now, the second column provides an estimate of the parameter values, for example, our
estimated equation is
Q = 24.207 – 2.069 P + 2.62 Px + 0.197 Adv.
Column 3 provides some particularly interesting information, in that this is a measure of

the precision of the estimate. It is called the standard error of the parameter estimate i ,
or . For those of you who remember some statistics, you may recall from the central
limit theorem, that about 95% of standard errors fall within the range i 2
Columns (6) and (7) provide a more precise statement of the bounds of 95%
confidence bands about particular parameter estimates. If these bounds exclude 0, then
71
you may conclude at a 95% level of confidence that the parameter explains some of the
movement in the dependent variable.
4. Interpreting Significance of Parameter Estimates

Column (4) lists the t test statistic for each parameter estimate. This test statistic
is simply the parameter estimate divided by its standard error. The test statistic is just an
alternative way to assess whether or not estimates fall within the i 2 bound.
Suppose, for example, that the lower bound of the 95% confidence range for an estimate
is i -2 =0 implies that
(i)/  = 2
or that the bounds of the confidence band just equals zero. If the lower bound was
greater than zero, for example,
i -2 =1, then
i / = 1/ +2, a number larger than 2.
Oftentimes, you will see the information from your regression output summarized in a
write up as follows

Q = 24.207 – 2.069 P + 2.62 Px + 0.197 Adv. R2 = .82 , n=22
(10.1) (0.97) (0.49) (0.29)
Where the standard errors are written in parentheses below the coefficient estimates.
I would like you to be able to interpret the following from this information:
a) The variability of individual parameter estimates. There is (roughly) a 95%

chance that the true value of any coefficient estimate is within  2 of the estimate.
For example, the price coefficient is in the interval –2.069 –2(0.97) and –2.069
+2(0.97), or -4.09 to -.129. Thus the price coefficient is, significantly less than 1 with a
95% probability (alternatively, you might observe that -2.069/.97 = -2.13
Lecture 19
REVIEW___________________________________________________:

Preview__________________________________________________________
5. Forecasting.
72
A. Introduction:
B. The Production Function.
LECTURE_________________________________________________________
4. Interpreting the significance of individual parameter estimates.
Example #1. If I give you the estimated equation


Q = 24.207 – 2.069 P + 2.62 Px + 0.197 Adv. R2 = .82 , n=22
(10.1) (0.97) (0.49) (0.29) SER = 2.2
I might ask whether or not price was a significant explainer of sales. You could evaluate
this by adding and subtracting 2 times the std. error of the regression to the parameter
estimate. If the interval doesn’t include zero then at a 95% level of confidence, an inverse
relationship exists between price and quantity.
-2.069 + 2(.97) = -.129

- 2.069 – 2(.97) = -4.009
Result: Yes, price is inversely related to quantity. On the other hand, consider
advertising
.197+ 2(.29) = .1125
.197 – 2(.29) =-.383
This interval includes zero, so we cannot conclude that there is a direct relationship
between advertising and quantity at a 95% level of confidence.
Comments on Multivariate Regression. Obviously, when constructing a demand

relationship, you have some choice as to which variables to include. Increasing
the number of independent variables always improves your estimate in the sense
that you get a better "fit." (Intuitively, by adding terms you gain extra latitude in
trying to minimize the squared differences between observed and predicted data.)
Nevertheless, it is generally not a good idea to add variables to "maximize the fit,"
for you can easily add in too many things, disguising possible significant
relationships.
Question: In the above, if Advertising does not significantly affect sales, should
we delete it from the analysis? No, because advertising may still be important,
and deleting imwe might introduce bias.
In general, the appropriate approach is to include all variables for which you have
a straightforward reason for including.
73
5. Forecasting. One can also get a feel for the precision of a forecast by using the SER
Given independent variable values one can construct an approximate 95% forecast
interval by adding and subtracting 2* the MSE of the regression to the point estimate.
For example, example 1 above, suppose P = 2, Px = 1 and Adv =10.

Then
Q = 24.207 – 2.069(2) + 2.62 (1) + 0.197 (10)

= 24.659
An approximate 95% confidence interval about the estimate would be
24.659 + 2(2.2) = 29.059
24.659 - 2(2.2) = 20.259
Your estimates get worse the further away you get from the mean of the sample. Thus,
observations out of the range of the sample are very speculative. (Example: Can you
forecast future sales, given price and advertising expenses? It depends on the relationship
between your proposed price and advertising expenditures, and those you've observed in
the past.)
Also, your forecasts will be worse, to the extent that there is any expectation that the
future may be different from the past (For example, a forecast of cigarette sales would be
very considerably more variable than a 95% confidence interval would suggest were
there some substantial possibility that cigarette sales would be outlawed next year.
74
Some additional examples:
Example #2: Suppose you conduct a regression with n=9 data points, and generate the
following results:
Qi= 10 - .5Pi + .1 Ai
(5) (.03) (.2)
n = 9, R2 = .83 SER = .5
- Interpret R2,
- Does price explain movement in sales?
- IF p=4 and A=10, make a 95% confidence interval for sales
Example #2. Consider a regression with the log of data.
lnQi= 50 - .2 ln Pi + .12ln Ai
(20) (.3) (.08)
n = 12, R2 = .68,
- Interpret R2
-. Does price alone explain movement in sales, Qi?
Notice finally, that we can make one further interesting insight with a log linear
regression. Observe that =-.2 Notice that two standard deviations about -.2 are not
necessarily greater than zero. However, this interval does not include -1. Thus, we can
conclude that we are on the inelastic portion of the demand curve.
Lecture 20
REVIEW___________________________________________________:

5. Forecasting.
Preview__________________________________________________________
75
A. Introduction:
1. Overview.
2. The Role of the Manager in the Production Process.
Lecture _______________________________________________________________
A. Introduction:
1. Overview. The purpose of this chapter is to provide tools allowing a manager to
make better decisions about choosing which inputs to use in a production process, and
what level of output to produce. To a large extent, this chapter is a much more detailed
development of the material motivating the supply decisions of the firm that we used to
develop the supply and demand model of chapter 2. The discussion falls into 2 parts. A
first part deals with ‘production theory’ or the right combinations of inputs to employ.
The second part ‘costs’ addresses the appropriate level of output. We start with
production
76
2. The Role of the Manager in the Production Process. In turn production (input
acquisition and use) has two dimensions: (i) Planning (or deciding what types of fixed
productive assets to acquire), and (ii) Operating.
In the operating horizon, the manager must attend to two issues. These are much
easier to articulate than to do
a. Produce on the Production Function. A production function illustrates the

maximum amount of output feasible given a particular set of inputs. If the
workers do not work to maximum capacity, less will be produced. One very
important managerial function is to motivate workers to work efficiently.
Observation: The same sorts of principle-agent problems that we mentioned in

chapter 1 could be a problem for managers here as they try to develop
compensation schemes for their employees.. Clothes sales-people are paid sales
commissions and waiters tips as a means of improving service. We will talk more
about these problems in chapter 6.
b. Use the Right Level of Inputs. The manager must decide the optimal amount of
variable inputs to use. (The right number of sales people, or waiters, etc.) To
analyze this question, we must characterize the productivity of inputs. That is our
next project.
B. The Production Function. We start by characterizing the way that inputs are converted
in to units of output. The process is represented by a production function, which
illustrates the maximum amount of output available for a given combination of inputs.
Although the production function that is appropriate for a particular circumstance is
particular to that firm, the general issues underlying production analysis are illustrated by
considering a generic production function
Q = F (K, L)
Where Q = units of output

K = units of capital input (typically machines of some sort)
L = units of labor input.
Notice that although this function is generic, it is not a poor general description of the
production process. Most typically, production requires some combination of machines
and labor.
Time Horizon: Economists often find it convenient to divide input allocation decisions
into two parts. The parts are distinguished by time frame. In a short run
some factors of production (usually capital) are fixed. In the long run, all factors are
variable. Thus, the short run is an operating horizon, where the optimal amount of
variable inputs are chosen. In distinction, the long run is a planning horizon, where all
inputs are variable.
77
Observation: The amount of time necessary to define the short run varies across industry.
The short run in steel production, for example, is a much longer period of time than the
short run for a pizza maker. Nevertheless, in either environment, within the short run the
same sort of issues are relevant.
1. Short run decisions. As just mentioned, in the short run some factors are fixed.
Let us assume that K, capital is fixed at level K*, or
Q = F(K*,L)
Then, the relevant problem is to determine the optimal amount of variable input
L. To answer this question, consider the following production relationship
K* L  Q = TP  Q/L =

 APL
2 0 - 0 - -
2 1 1 4 4 
2 2 1 10 6 5
2 3 1 18 8 6
2 4 1 24 6 6
2 5 1 28 4 5.6
2 6 1 30 2 5
2 7 1 30 0 4.2857
1
2 8 1 28 -2 3.5
Notice in the above relationship that K is fixed at 2 units. If PK= $100 per day,
then fixed costs = $100*2 = $200.
a. Measures of Productivity. Now let’s consider the variable input. First, we

must define some terms.
Total Product: (TP) is simply the maximum total output available from a given
combination of inputs.
Average Product (AP) is the average output for all units of a given input. In the above
table the average product of the variable input labor
APL = Q/L
Marginal Product (MP) is the change in output associated with the use of an additional
input unit. The above table the marginal product of labor, is
MPL = Q/L
78
Observation: Diminishing Marginal Productivity : As is the case in much of economic
analysis, marginal decisions play a pivotal role in production analysis. In the table,
notice that MP first increases, then decreases. This is a very typical pattern, and reflects
basic economic assumptions. As a few resources are hired, there are gains from
specializing the use of these inputs (for example, by dividing tasks and creating an
assembly line). After a while, however, factors begin to experience some crowding (e.g.,
workers on the line start getting in each others way.) Thus, declining marginal
productivity is a consequence of the law of diminishing returns. Eventually, crowding
becomes so severe that marginal productivity is negative. In this case, total output
actually falls as extra units of input are hired. No rational manager would use resources
to the point of negative marginal productivity.
But notice also, that diminishing marginal productivity is not a consequence of “worse”
or “lazy” workers. Rather it is a consequence of crowding.
b. Relationships between Productivity Measures. The productivity measures are

related systematically. These interrelationships can be seen by plotting the curves
suggested in the above table. These charts appear below.
35
30
25 TP
MP
20
15
10
0
0 1 2 3 4 5 6 7 8 9
10
4 AP
2
MP
0
0 1 2 3 4 5 6 7 8 9
-2
-4
Increasing Decreasing Negative

Marginal Marginal Marginal
Returns Returns Returns
AP
79
MP
i. TP, MP and AP. In the upper table: The marginal productivity is illustrated as
the slope of the line tangent to the total product curve. Notice that the curve first
increases at an increasing rate (reflecting gains from specialization), then
increases at a decreasing rate (the law of diminishing returns) finally peaks out
and decreases (indicating negative marginal productivity).
In the lower table the marginal schedule also reflects the combination of first
increasing marginal returns, then decreasing marginal returns, and finally negative
marginal returns.
Observation: The above curves do not line up exactly. (I’ve stretched out the lower cuve
a bit) This is because we use discrete rather continuous changes. If I had used an actual
function and taken derivatives for the marginals this sort of adjustment would not have
been necessary.
Observation: An optimizing firm will always produce in the range of decreasing marginal
returns to labor. Reason: A firm would never stop where there are increasing marginal
returns, because if it is profitable to hire a worker who makes 6 units per hour, it should
be profitable to hire a worker who makes more than 6. Similarly, a firm would never
stop when there are negative marginal returns, because output could be increased by
laying off workers and cutting production expenses.
ii. The relationship between marginal and average. Note the relationship
between the MP and the AP curves. The marginal curve drives the average curve. This
is a general relationship and we will see it often.
Motivation: Consider the grades of a representative student.
Semester MGP Overall GPA

0
1 3 3/1
2 3 6/2
3 2 (3+3+2)/3 = 2.67
4 1 (3+3+2+1)/4 = 2.25
5 2 (3+3+2+1+2)/5 =2
6 4 (3+3+2+1+2+4)/6= 2.5
Intuition: The average conveys the same information as the marginal, but it is a less
volatile measure. The average carries the weight of all previous semester’s grades.
Rule: When the marginal is below the average, it pulls the average down, when the
marginal is above the average, it brings the average up.
Lecture 21
80
REVIEW___________________________________________________:

A. Introduction:
1. Overview.
2. The Role of the Manager in the Production Process.
a. Relationships between Productivity Measures.
b. The relationships between Marginals and averages.
c. Optimal Use of a Single Input.
i. Rule
ii. Comparative Statics
3. Long Run Production
a. Optimal Use of Multiple inputs
Preview__________________________________________________________
c. Optimal Use of a Single Input

.
i. VMP. To decide the appropriate level of a variable input to use, simply convert
productivity into value. Do this by multiplying marginal productivity in units, by the
value of the units.
For labor.
VMPL = PQ(MPL).
(Similarly, for capital VMPK = PQ(MPK).
The optimal hiring decision for labor can be seen by modifying the production function
above. Suppose that output sells for $3 per unit, and that labor costs $400 per week.
Then the following relationship applies.
81
L L Q = TP QL PQ VMPL PL
 MPL
0 - 0 -
1 1 4 4 100 400 300
2 1 10 6 100 600 300
3 1 18 8 100 800 300
4 1 24 6 100 600 300
5 1 28 4 100 400 300
6 1 30 2 100 200 300
7 1 30 0 100 0 300
8 1 28 -2 100 -200 300
Graphically
1000
800
600
400
PL
200
0
0 1 2 3 4 5 6 7 8 9
-200
VMPL
-400
Rule: Profit Maximizing Input Usage: To maximize profits a manager should use an
input L up to the point where VMPL is as close to w as possible without w exceeding
VMPL.
ii. Comparative Statics. Notice that you can use the above graph to anticipate the
response of a firm to changes in underlying conditions. For example, what would be the
effects of a change in the PL? What would be the effects of a change in the price of
inputs?
Examples. Starting from an initial equilibrium, consider the effects of an increase in the
price of labor on the amount of labor employed
82
$
w’
w
VMP = MP*PQ
L
L* L
As seen in the above chart, the optimal amount of labor will fall.
Suppose now that the product becomes more popular, and consequently, PQ
increases.
VMP*
VMP = MP*PQ
L
L* L
This outward shift of the VMP schedule will increase the amount of labor employed. A
labor enhancing improvement in the production function will have a similar effect.
2. Long Run Production. Now, let us suppose that a firm can vary all its factors of
production. Starting from the relationship
VMPL = MPLPQ = PL
83
Observe that we might rewrite
MPL/ PL = 1/PQ
If the firm had multiple inputs, this relationship should hold for all inputs. That
is, for inputs i, j
MPi /Pi = MPj Pj
This is called the least cost combination of inputs. It is an important and general
principle of hiring multiple inputs: A firm should hire resources until the marginal
value per dollar spent is equal for all inputs.
Example: Jones & Printing Co. is presently paying $10 per hour for labor, and $5 per
hour for Printing Machines.
- If the Marginal Productivity of labor is 100 pages per day, and the marginal
productivity of machines is 150 per day is it using a least cost combination of
inputs?
- If not which machines should be used relatively more?
Example: Suppose that Randolph Tire Co. Currently uses Labor and Rubber Banding
Machines to finish tires. Suppose that labor is negotiating its contract, and asks for a
33% increase in salary. Management argues that the consequence of such a wage
increase will be a sharp reduction in the number of employees. Employees don’t believe
management. They firmly believe that management will continue to employ the same
number of workers even after a substantial wage increase.
Lecture 22
REVIEW___________________________________________________:

Optimal Allocation of a single resource: Hire until VMPL = PL
2. Long Run Production
Optimal Allocation of multiple inputs: Hire until
MPL/PL = MPK/PK
Preview__________________________________________________________
C. Costs.
84
2. Short run costs.
a. Cost curves
Lecture____________________________________________________________
C. Costs and the Theory of the Firm
1. The Relationship of Production Functions to Cost Functions. To provide some context

for this discussion, consider the problem of producing blueberry tarts in my house. We
may have the following relationship.
(a) (b) (c) (d)

Inputs: Output Marginal Marginal Costs Per pie (Assume
(Number of Workers) (Number of Pies that labor costs $20 per unit, and
Blueberry Pies) that ingredients are free)
0 0
1 5 5 $20/5 =$4
2 15 10 $20/10=$2
3 23 8 $20/8 = $2.5
4 29 6 $20/6 = 3.33
5 33 4 $20/5 =$5
6 35 2 $20/2 = $10
In the lecture on short run production, we focused on the relationship between the
number of workers (column a) and the marginal productivity of those workers (column
c). A closely related question pertains to the relationship between the number of pies
made (column b) and the marginal costs of making pies (column d).
Observations
- After exhausting gains from specialization the relationship between units of
labor and marginal productivity is inverse. This motivates the labor demand
curve we developed last time in class.
12
Marginal Number of Pies
10
(Column c)
8
6
4
2
0
0 2 4 6 8
Units of Labor (Column a)
85
- Conversely, the marginal cost curve first falls, and then, upon exhausting gains
from specialization, increases.
Marginal Costs Extra Pies $12

$10
(Column d)
$8
$6
$4
$2
$0
0 10 20 30 40
Units of Output (pies column b)
- Intuitively, marginal costs increase as Marginal productive decreases, because

the marginal productivity increases imply that more labor is “imbedded in each
unit of output.
In this section we focus on this latter view of the relationship between inputs and
outputs. We start with the single output case, first in the short run, and then in the
long run. Then we consider some aspects of costs in a multi-product
environment.
2. Short Run Costs. Recall that the short run is defined as a timeframe where there are
unavoidable input commitments, as well as variable inputs. The short run cost function
may be used to describe this relation.
a. Cost function components.

Fixed costs: Costs associated with fixed input commitments. These costs
do not change with the level of output
Variable costs: Costs associated with the variable components. These

costs vary with the level of output.
b. Total cost relationships. One way to represent these costs is in terms of

total expenditures. Let’s shift to a new problem expressed exclusively in
terms of Q. Consider, for example, the first three columns of the following
table.
Q TFC TVC TC MC AFC AVC ATC

0 10 0 10
1 10 6 16 6 10 6 16
86
2 10 10 20 4 5 5 10
3 10 12 22 2 3.333333 4 7.333333
4 10 16 26 4 2.5 4 6.5
5 10 23 33 7 2 4.6 6.6
6 10 35 45 12 1.666667 5.833333 7.5
7 10 53 63 18 1.428571 7.571429 9
8 10 78 88 25 1.25 9.75 11
Graphically, these relationships appear as follows:
100
TC TC
80
TVC
60 MC
MC TVC
40
20
TFC
0
0 2 4 6 8 10
FC
Observations
-Notice that the TVC and the TC curves both take on the shape of a “recliner”:
that is, first increasing at a decreasing rate, and then increasing at an increasing
rate. The difference between the two curves is TFC, which is a fixed amount.
-Notice also that the slope of the line tangent to either TVC or TC is the marginal
cost. Marginal costs first decrease and then increase due to the law of
diminishing returns. (This is the same logic as diminishing marginal productivity:
At the outset, gains from division of labor increase. Thus marginal productivity
increases, and marginal costs increase, reflecting gains from specialization. Later,
as the law of diminishing returns sets in, marginal productivity falls, as marginal
costs increase. Intuitively, more labor is “imbedded” in each unit of output.)
c. Average Cost Relationships. The same relationships can be generated

by dividing costs by quantity, to get per unit costs. In this case:
AFC = TFC/Q (Average Fixed Costs)

AVC = TVC/Q (Average Variable Costs)
ATC = TC/Q (Average Total Costs
MC = TC/Q
These are illustrated in the rightmost columns of the above table. Graphically, these
curves are represented as
87
30
25 MC
20
15
ATC
10
AVC
5
0
0 2 4 6 8 10
Observations
- ATC and AVC approach each other as quantity expands. This is because
the difference between the two curves is AFC. AFC is a fixed quantity
allocated over an increasing number of units.
- MC intersects ATC and AVC at their minimum points. This follows for
the same reason that MP intersects AP at its peak: The marginal drives the
average. The averages reflect the same information as the marginal. The
marginal is more volatile, however, because it is not weighed down by the
effects of any output other than the current increment.
Lecture 23
REVIEW___________________________________________________:

C. Costs.
2. Short run costs.
a. Cost curves
1. TC, TVC and TFC
2. MC, AVC and ATC
a. Relationship between MC and AVC/ATC
b. Relationship between AVC and ATC
Preview__________________________________________________________
c. The supply curve for the firm
d. Algebraic Forms of the Cost Function.
e. Sunk costs vs. Variable Costs
3. Long Run Costs
a. Long run average costs
b. Economies of Scale
88
c.
Lecture____________________________________________________________
2. Short Run Costs: Observations (continued)

c. The Supply Curve for the Firm: The price a firm might receive for
producing units is often dictated by factors beyond the firm’s control.
However, suppose that price is fixed. Observe that a firm will
shutdown if unit revenues do not exceed AVC. The firm will
breakeven when P = ATC.
o Why would a firm produce at a loss in the short run? A firm
can minimize losses by producing at a loss. For example,
suppose you were a plumber and you had fixed cost obligations
of $500 per month for licenses and tool payments. Suppose you
there was a job that would cost you $1000 in variable cost to
complete. How much must you earn to break even? How much
must you earn to take the job?
o What does breakeven mean? The breakeven point implies that
all factors of production (including the entrepreneur) are
earning enough to be indifferent between staying in the
industry and doing something else. Firms earn “normal” profits
at the breakeven point.
d. Algebraic Forms of the Cost Function. The appropriate specification of

the cost function depends on the underlying cost relationships. However,
a cubic cost function is often used, because it is sufficiently general to
allow any relationship.
If C(Q) f + aQ + bQ2 + cQ3
Notice that fixed costs are f.

Marginal costs are the derivative of C(Q), or
C’(Q) = a + 2bQ + 3cQ2
Notice that other cost relations are easily derived. For instance, average
variable costs are
AVC = a + bQ + cQ2
Example: Suppose C(Q) = 200 + 2Q2
What are marginal costs, average fixed costs, average variable costs and
average total costs when Q=10? When are average total costs minimized?
(To be worked in class).
89
C(10) = 200 +2(10)2 this is total cost
ATC = 400/10 = 40
ATC = 200/Q + 4Q
ATC min =100 -2Q2
100/3 = Q2
The firm earns 0 profits at the ATC min, or when MC=ATC

At what price would the firm earn 0 profits? At what price would the firm
shut down?
e. Sunk vs. Variable Costs. A final distinction (and one we’ve made
before). Fixed costs may be divided into two components: Sunk costs and
recoverable costs. Sunk costs are costs forever lost after they are paid.
This is an important distinction, for the opportunity costs of recoverable
assets and sunk cost assets is remarkably different.
Example: Suppose you are choosing between the purchase of a Toyota Corolla (for
$12,500) and a GEO Probe (for $11,000). After a year the book value on the cars will be
$11,000 and $7,000. What are the sunk cost components associated with the purchase of
each car? How does this difference affect your decision to undertake a 5 year loan to pay
for the cars?
3. Long-Run Costs. In the Long run, all costs are variable. As I indicated at the outset of
this chapter, the long run may be viewed as the planning horizon, since the project for the
firm is to pick the optimal plant size. Information about the Long-Run Average Cost
curve is very useful for determining the structure of an industry.
a. Long Run Average Costs. The long run average cost curve (LRAC) is the
envelope of all short run costs curves. That is, the LRAC is the tangency of all
efficient production points on for each plant size.
ATC0
ATC1 ATC3
ATC2
Economics of Diseconomies of Scale

Scale
Efficient Plant Size Q
90
In the above chart, the bold line is the LRAC. Note that the efficient scale of operation is
not at the point of minimum marginal costs unless the firm is at an optimal plant size.
Economies of scale arise when LRAC falls as the plant expands.
Diseconomies of scale arise when LRAC increases as the plant expands.
Minimum Efficient Scale (MES): The first point where LRAC is at a

minimum
If a range exists where costs neither increase nor decrease, there exist
constant returns to scale.
Application: The shape of the LRAC can determine how many firms can survive in an
industry.
- Suppose that MES is 10,000 units, and that market demand, at a competitive
price is 40,000 units. How many efficient firms can survive in the industry?
- Suppose that MES is 10,000 units, but that diseconomies of scale set in very
soon after achieving the optimal plant size. Can a single firm efficiently service
the industry?
- Suppose an industry is characterized by continuous diminishing returns to scale.
What is the optimal industry structure?
Lecturer 24
REVIEW___________________________________________________:

C. Costs.
2. Short run costs.
a. Cost curves
1. TC, TVC and TFC
2. MC, AVC and ATC
a. Relationship between MC and AVC/ATC
b. Relationship between AVC and ATC
Preview__________________________________________________________
b. The supply curve for the firm
c. Algebraic Forms of the Cost Function.
Lecture____________________________________________________________
Lecture: Discussion of the supply curve for the firm
91
In the short run, a firm will produce the quantity Q* where MR = MC (or, in a world of
discrete changes , the last level of output here MR exceeds MC). To determine profits
and losses, compare AR to ATC.
If it is the case that at Q* AR=ATC, the firm earns zero economic profits. This is
known as the breakeven point. The breakeven point occurs where MC=ATC
If it is the case that at Q* AR<AVC, the firm will shutdown. The point where
AR=AVC at Q* is the shutdown point, that is, the lowest price such that the firm will
produce at a loss in the short run. The shutdown point occurs where MC=AVC
The supply curve for the firm is the MC curve above the shutdown point (e.g.,
where MC=AVC)
d. Algebraic Forms of the Cost Function. The appropriate specification of

the cost function depends on the underlying cost relationships. However,
a cubic cost function is often used, because it is sufficiently general to
allow any relationship.
If C(Q) f + aQ + bQ2 + cQ3
Notice that fixed costs are f.

Marginal costs are the derivative of C(Q), or
C’(Q) = a + 2bQ + 3cQ2
Notice that other cost relations are easily derived. For instance, average
variable costs are
AVC = a + bQ + cQ2
Lecture 25
REVIEW___________________________________________________:

C. Costs
1. Short Run Costs.
b. The supply curve for the firm
Preview__________________________________________________________
c. Algebraic Forms of the cost function (continued)
d. Sunk costs vs. Variable Costs
92
Lecture____________________________________________________________
2. Short Run Costs: Observations (continued)
Example: Suppose C(Q) = 200 + 2Q2
What are marginal costs, average fixed costs, average variable costs and
average total costs when Q=10? When are average total costs minimized?
(To be worked in class).
C(10) = 200 +2(10)2 this is total cost
ATC = 400/10 = 40
ATC = 200/Q + 4Q
ATC min =100 -2Q2
100/3 = Q2
The firm earns 0 profits at the ATC min, or when MC=ATC

At what price would the firm earn 0 profits? At what price would the firm
shut down?
e. Sunk vs. Variable Costs. A final distinction (and one we’ve made
before). Fixed costs may be divided into two components: Sunk costs and
recoverable costs. Sunk costs are costs forever lost after they are paid.
This is an important distinction, for the opportunity costs of recoverable
assets and sunk cost assets is remarkably different.
Example: Suppose you are choosing between the purchase of a Toyota Corolla (for
$12,500) and a GEO Probe (for $11,000). After a year the book value on the cars will be
$11,000 and $7,000. What are the sunk cost components associated with the purchase of
each car? How does this difference affect your decision to undertake a 5 year loan to pay
for the cars?
Example: Suppose you are the Ford Motor Company, and you purchase vast quantities of
titanium dioxide for use in catalytic converters. You purchase so much that the price of
the metal skyrockets to $50 per ounce. Then a new catalytic converter technology is
developed that no longer uses titanium dioxide. The market price of the compound falls
to $2 per ounce. You have 100,000 tons of titanium dioxide. What should you do with
it?
Notice a firm whose fixed costs are sunk will behave differently that one whose fixed
costs are resalable. Consider, for example the decision to stay in the airline industry
when you can resell your fleet of planes, and when you cannot. You would stay in
business longer when you cannot resell your fleet, because those costs are sunk.
93
Lecture 26
REVIEW___________________________________________________:

C. Costs
2. Short Run Costs.
d. Sunk costs vs. Variable Costs
Preview__________________________________________________________
3. Long Run Costs
b. Economies of Scale, Diseconomies of Scale and Long Run
Survivability
4. Multi-Output Cost Functions
Lecture____________________________________________________________
3. Long-Run Costs. In the Long run, all costs are variable. As I indicated at the outset of
this chapter, the long run may be viewed as the planning horizon, since the project for the
firm is to pick the optimal plant size. Information about the Long-Run Average Cost
curve is very useful for determining the structure of an industry.
a. Long Run Average Costs. The long run average cost curve (LRAC) is the
envelope of all short run costs curves. That is, the LRAC is the tangency of all
efficient production points on for each plant size.
ATC0
ATC1 ATC3
ATC2
Economics of Diseconomies of Scale

Scale
Efficient Plant Size Q
In the above chart, the bold line is the LRAC. Note that the efficient scale of operation is
not at the point of minimum marginal costs unless the firm is at an optimal plant size.
94
b. Economies of Scale
Economies of Scale arise when LRAC falls as the plant expands.
Reasons for Economies of Scale:
- Physical Relationships (double a pipe diameter, and flow through
expands quadratically)
- Gains from specialization and division of labor
Diseconomies of scale arise when LRAC increases as the plant expands.

Reasons for Diseconomies of Scale
Transportation Costs
“Crowding” with respect to managerial efficiency
Minimum Efficient Scale (MES): The first point where LRAC is at a minimum
If a range exists where costs neither increase nor decrease, there exist
constant returns to scale.
Application: The shape of the LRAC can determine how many firms can survive in an
industry.
- Suppose that MES is 10,000 units, and that market demand, at a competitive
price is 40,000 units. How many efficient firms can survive in the industry?
- Suppose that MES is 10,000 units, but that diseconomies of scale set in very
soon after achieving the optimal plant size. Can a single firm efficiently service
the industry?
- Suppose an industry is characterized by continuous diminishing returns to scale.
What is the optimal industry structure?
c. Measuring Returns to Scale. The notion of scale economies and diseconomies

is related to production, and can be measured with a production function.
A firm is said to enjoy increasing returns to scale if a constant increase in all

inputs causes a more than proportionate increase in output. A firm that enjoys
economies of scale does because it realizes increasing returns to scale
The firm enjoys constant returns to scale if a constant increase in all inputs causes
a constant increase in outputs. A firm with a range of plant choices at MES will
enjoy constant returns to scale over this entire range.
The firm has decreasing returns to scale if a constant increase in outputs causes a
decreasing increment to outputs. Firms with diseconomies of scale may suffer
decreasing returns to scale.
Increasing, constant or decreasing returns to scale can be determined analytically.

Here we introduce this by focusing on a specific form of production function
95
Q = F(K,L) = (KL)a
Consider a production function consisting of both Capital and Labor, Q = F(K,L)

= K x L. When one unit of each input is used Q = 1. Doubling both inputs
increases outputs to 2x2 = 4. This firm has increasing returns to scale.
A firm with the production function Q = F(K,L) = (KL).5 has constant returns to
scale. To see this, observe that when K = 1, and L = 1, Q =1. When K=2, L = 2,
Q =2, etc.
A firm with the production function Q = (K,L).25 has decreasing returns to scale
When K=1 and L=1, Q =1. When K=2, L=4, Q = 4.25 =1.41
RULE: For any production function of the form
Q = F(K,L) = (KL)a
The firm exhibits increasing returns to scale if a>.5

The firm exhibits decreasing returns to scale if a<.5
The firm exhibits constant returns to scale if a=.5
Example: Suppose that the production function for Grecko’s Smoothies is

F(K, L) = (KL).25
Grecko currently produces with K=4 and L=4.

- What is output?
- Would Grecko enjoy increasing, decreasing or constant returns to scale if it doubled
output to K = 8, L = 8?
- How would your answer change if Greko’s production function wast
F(K, L) = (KL)1
4. Multiple Output Cost Functions. All of the insights pertaining to single product output
apply to a multi-product firm. There are, however some interesting additional cost issues
that arise. In finishing this chapter, consider two points: The notion of economies of
scope, and economies of scale.
To illustrate, we will consider cost conditions for a firm that produces just two
products: Q1 and Q2. Denote the cost function for this firm as C(Q1, Q2).
a. Economies of Scope: Exist when the joint production of two goods is less
expensive that the production of both goods separately. Mathematically, if
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
96
Economies of scope are an important reason why firms produce multiple
products. For example, it may be more efficient to produce both cars and light
trucks in a single plant than to produce both good separately, the two products
may share many parts of the same assembly (such as the chassis) and producing
the products separately would require considerable duplicative construction.
b. Cost complementarities: These exist in the marginal cost of producing one

good increases when the output of another product is increased. Mathematically,
when:
MC1(Q1, Q2)< 0
Q2
This often arises when one product is a by-product of another. For example there
are cost complementarities in the production of in the production of Flouride and
Aluminum Ingot from Alumina.
Cost complementarities are an important reason for economies of scope.
These notions are conveniently expressed algebraically with at quadratic cost

function:
C(Q1, Q2) = f + aQ1Q2 + Q12 + Q22
Then MC1 = aQ2 + 2Q1
Cost complementarities exist whenever a < 0.
Economies of scope exist whenever
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
C(Q1, 0) = f + Q12
C(0, Q 2) = f + Q22
Thus, economics of scope exist if
2f+ + Q12+ Q22 > f+ aQ1Q2 +Q12+Q22
Or if f - aQ1Q2 > 0.
Comparing the two conditions, it is seen that cost complementarities are a

stronger condition than economies of scope. Given a<0, cost complementarities
always exist. However, economics of scope may also even without cost
97
complementarities, if the costs of paying fixed set-up costs twice are sufficiently
high.
Example: Suppose
C = 100 - .5Q1Q2 + Q12 + Q22
Do cost complementarities exist?
Do economies of scope exist? What about the case where
C = 100 + .5Q1Q2 + Q12 + Q22 ?
Notice the existence of economies of scope and cost complementarities have a lot
to do with the effectiveness of mergers and the sales of subsidiaries. Sales of an
unprofitable subsidiary may not reduce losses much, due to cost
complementarities. Similarly, due to economies of scope, it may be the case that
multi-product mergers are efficient.
Lecture 27
REVIEW___________________________________________________:

C. Costs
3. Long Run Costs
b. Economies of Scale, Diseconomies of Scale and Long Run
Survivability
c. Measuring returns to scale
Preview__________________________________________________________
V. Chapter 6. The Organization of the Firm. Ch. (6.)
A. Overview and Motivation
B. Optimal methods of obtaining inputs
Lecture____________________________________________________________
4. Multiple Output Cost Functions. We end this chapter by considering briefly cost
conditions for firms that produce multiple outputs. In general, all of the insights
pertaining to single product output apply to a multi-product firm. There are, however
98
some interesting additional cost issues that arise. In finishing this chapter, consider two
points: The notion of economies of scope, and economies of scale.
To illustrate, we will consider cost conditions for a firm that produces just two
products: Q1 and Q2. Denote the cost function for this firm as C(Q1, Q2).
a. Economies of Scope: Exist when the joint production of two goods is less
expensive that the production of both goods separately. Mathematically, if
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
Economies of scope are an important reason why firms produce multiple

products. For example, it may be more efficient to produce both cars and light
trucks in a single plant than to produce both good separately, the two products
may share many parts of the same assembly (such as the chassis) and producing
the products separately would require considerable duplicative construction.
b. Cost complementarities: These exist in the marginal cost of producing one

good increases when the output of another product is increased. Mathematically,
when:
MC1(Q1, Q2)< 0
Q2
This often arises when one product is a by-product of another. For example there
are cost complementarities in the production of in the production of Flouride and
Aluminum Ingot from Alumina.
Cost complementarities are an important reason for economies of scope.
These notions are conveniently expressed algebraically with at quadratic cost

function:
C(Q1, Q2) = f + aQ1Q2 + Q12 + Q22
Then MC1 = aQ2 + 2Q1
Cost complementarities exist whenever a < 0.
Economies of scope exist whenever
C(Q1, 0) + C(0, Q2) > C(Q1, Q2)
C(Q1, 0) = f + Q12
C(0, Q 2) = f + Q22
99
Thus, economics of scope exist if
2f+ + Q12+ Q22 > f+ aQ1Q2 +Q12+Q22
Or if f - aQ1Q2 > 0.
Comparing the two conditions, it is seen that cost complementarities are a

stronger condition than economies of scope. Given a<0, cost complementarities
always exist. However, economics of scope may also even without cost
complementarities, if the costs of paying fixed set-up costs twice are sufficiently
high.
Example: Suppose
C = 100 - .5Q1Q2 + Q12 + Q22
Do cost complementarities exist?
Do economies of scope exist? What about the case where
C = 100 + .5Q1Q2 + Q12 + Q22 ?
Notice the existence of economies of scope and cost complementarities have a lot
to do with the effectiveness of mergers and the sales of subsidiaries. Sales of an
unprofitable subsidiary may not reduce losses much, due to cost
complementarities. Similarly, due to economies of scope, it may be the case that
multi-product mergers are efficient.
Lecture 28
REVIEW___________________________________________________:

C. Costs
Economies of Scope and Cost Complementarities.
Preview__________________________________________________________
B. Overview and Motivation
B. Optimal methods of obtaining inputs
Lecture____________________________________________________________
V. The Organization of the Firm: Optimal Contracting, and Motivating Resources

to Work Efficiently (Chapter 6)
100
A. Overview and Motivation. In the preceding chapter we discussed the decision
rule for the optimal combination of inputs. That is, firms should hire resources until
MPL = MPK
w r
assuming that the inputs are working on their production function. This rule suggests two
important issues that are the subject of this chapter: (a) Is the firm obtaining resources at
the minimum necessary price? Clearly, the firm will suffer inordinately high costs if this
condition is not met. (b) Are inputs working efficiently? As mentioned in Chapter 1, in
many instances the incentives of individuals and firms do not naturally overlap.
Compensation schemes may in many instances be altered to make incentives more
compatible.
Consider these questions in turn.
A. Methods of Procuring Inputs:
1. There are three generic ways to acquire inputs:
a. Spot purchases. This is purchasing on an as needed basis at the then prevailing

market price. Spot exchanges allow firms to avoid vertical integration, and to
concentrate on their primary specialty. Homogenous inputs that are available at a
competitive price are often purchased on a spot basis.
b. Contract purchases. This is an agreement to purchase inputs under some

continuing arrangement that specifies the terms of exchange. In many instances,
particularly when the arrangement is fairly complicated, terms of the exchange are not
entirely spelled out. These areas are a problem of incomplete contracts and are a basis
for negotiation.
c. Internal production. Occurs when firms decide to go into the production of the
needed input. Internal production can come at the cost of administrative overhead, and
requires development of a specialization in production of the input.
Example. Suppose I sell ice cream cakes. I need ice cream as an input.
- If I go to a food wholesaler and make purchases as needed, I make a spot

purchase.
-If I strike a one-year deal with Breyer’s, to use only their products, I have made a
contractual arrangement.
-If I decide to make ice cream myself, I have gone into internal production.
2. Specialized Investments and Transactions Costs. If spot purchases are the easiest,
allow the most efficient specialization, why aren’t all inputs acquired on a spot basis?
The reason is that not all inputs are available on an essentially competitive basis. Rather,
101
firms frequently must make specialized investments either to use or to produce particular
inputs. Contracting could surmount this problem. However, in some instances the
contract negotiation costs are too high, and internal production is necessary. Consider
these terms in more detail
a. Specialized investment: An expenditure that must be made to all two parties to

exchange that has little or no value in any alternative use.
i) Example: Suppose you produce applications software (e.g., word-

processing programs). A specialized investment would be the production of code that
enabled the program to work in a Windows XP environment. This extra code would be
useless if you wanted to sell your software to the makers of Apple Computers.
ii) Types of Specialized Assets
-Site Specificity: Locating your plant close to a particular input.

(Example: Locating an electricity plant close to a coal mine since it is less expensive to
ship electricity than coal. The arrangement would make little sense if coal from the mine
was not purchased by the electricity plant)
- Physical-Asset Specificity: The production or acquisition of specialized
physical capital in order to use an input. For example, for a bicycle maker, a special
machine needed to make wheel rims that work with a particular tire would be a
specialized physical asset.
- Human capital: Workers learning specific skills to use a particular
product. (Example, learning how to use products on the MS office suite)
iii. A relationship-specific exchange. This occurs when the parties to a

transaction have made specialized investments. Notice that specialized investments make
impossible the satisfaction of the many-buyers/ many-sellers assumption underlying
competitive market theory. (One buyer or seller will always be better suited than others
to buy or sell the input). Thus the presence specialized investment can create a need for
contracting.
b. Transactions Costs. The costs of contracting are importantly affected by

specialized investment, for three reasons
i.) Costly Bargaining. As mentioned above, specialized investment means

that there are only a few parties that may efficiently engage in a buyer/seller relationship.
Consequently, there is no “market price.” In fact, there is often a lot of difference
between the minimum price necessary to induce supply, and the maximum acceptable
purchase price, creating considerable room for bargaining.
ii) Underinvestment. Either the buyer or the seller may under-invest in the
specialized inputs. (Who would spend a lot of time learning how to use UNIX, for
example, if the university might shift exclusively to networked computers?)
102
iii) Opportunism. Once a firm has engaged in a specialized investment,
the firm on the other side of the bargain has an incentive to take advantage of the sunk
cost expenditure. (Suppose you spend $300 for three nights in an isolated resort hotel,
meals not included. How much do you think they will charge for meals?)
A comment on opportunism: When one side of a bargain tries to take advantage of the
specific investment made by another, a hold-up problem is created. Avoiding hold-up
problems is often a reason for more formal arrangements, such as contracts or even
internal production.
B. Optimal Input Procurement. Now we consider factors affecting the optimal input
method. In general, more formal arrangements are called for as the relationship-specific
capital is increased.
1. Spot Exchange. This is the most straightforward purchasing method. Given many
buyers and sellers, a homogenous input, and no relationship-specific capital, input prices
are determined by the intersection of market supply and market demand schedules.
However, reasons often exist that would induce a manager to bear the expense of
drafting a contract: Specialized investments are insidious. For example, suppose you
retail fresh fish in a cafe/restaurant store, and you need 500 pounds of fresh fish at 8:00
a.m. each day. Even though fish are homogenous, the size of the input need creates
“hold-up” opportunities for both the buyer and the seller.
-The fish seller, with a truck full of fish may refuse to unload the product unless a
premium is paid.
- The fish buyer (the restaurant owner), may call several trucks to deliver fish at
once, and then bargain with the one offering the lowest price.
2. Contracts. When hold-up opportunities become high relative to the costs of negotiating
a contract, contracting becomes optimal. Despite the costs of contract negotiation,
formalizing a relationship into a contract can resolve numerous problems. A good
contract, for example, eliminates the incentives to skimp on specific investments in
capital and labor. (e.g., You will spend more on training workers that will be around for
three or four years).
a. Optimal contract length. Once the decision has been made to negotiate a
contract, the question of optimal contract length becomes a question. Optimal length is
determined by the marginal cost of writing the contract, and the marginal benefit of
extending contract terms.
i. Marginal costs increase with time. As the timeframe expands, more
contingencies must be considered, increasing the negotiation costs.
ii. Marginal benefits include avoided transactions costs or bargaining and
opportunism. These may be temporally related, but for the present, assume that they are
constant.
Then a graphical representation of the optimal contract term problem is illustrated

as follows:
103
$
MC
MB
L* Time
b. Some comparative statics effects.

i. Optimal contract length will increase if the level of specialized investment
increases. (As could be seen by an upward shift of the MB schedule).
ii. Changes in the costs of writing contracts would also affect the optimal length.
For example, an increasingly uncertain environment would shift MC up. On the other
hand, an increasingly standardized product and a more established market for the final
product would shift MC down, extending the optimal contract.
3. Vertical Integration. When specialized investments generate transactions costs, and

when the economic environment is plagued by uncertainty, vertical integration becomes
necessary. The advantage of vertical integration is that the “middleman” is avoided,
reducing the latitude for opportunism. The cost is that the firm must develop expertise in
development of a more primitive stage of the production process for its product. This
often involves building a costly production facility, and often requires that the firm
engage in some process that has little to do with their primary area of expertise.
4. The Economic Trade-Off. A summary of the relevant decision calculus is illustrated

below.
Spot Exchange
No
Large spec-
ialized invest-
ments relative
to contracting Yes
cost? Complex con-
tracting environ-
ment relative to
cost of vertical
integration?
No Yes
Contract Vertically Integrate.
104
Spot exchange is optimal when there are few “hold-up” opportunities, or where the costs
of those opportunities are small relative to contracting costs. When specialized
investments become large, contracting or vertical integration is desirable. The choice
among these latter alternatives depends on the complexity of the economic environment
relative to the costs of integration.
Final comments.
When a contract is called for, a formal contract is not always necessary., Despite
considerable specific investment, it is not always necessary to resort to written contracts.
Buyers, for example often can “punish” opportunistic behavior by not purchasing from a
seller again, and by spreading the word that they were treated badly. These reputational
considerations can play a large role in unwritten, but highly efficient contracts.
Review Problem: Suppose you manufacture inboard motor-boats, and you agree
to purchase 100,000 motors from Johnson Motor Company for $1000 per motor, in two
years time. Feeling that you are protected from opportunism, you customize your boat
design to accommodate the Johnson motors. In the mean time, Johnson finds itself on the
verge of bankruptcy, and says that it will go broke if the company doesn’t receive $1500
per motor.
a) Was the decision to contract a bad one?
b) What should you do?
c) Should this situation have been avoided?
105
B. Getting the Most Out of Human “Factors” The second portion of this chapter deals
with the issue of the optimal compensation structure for labor. Standard production
theory assumes that all employees work efficiently, all the time. Of course this is not true.
Workers in factories “shirk”. Managers try to maximize things other than the PDV of the
firm. Sports players attempt to do something other than “win”. Of course, no human
factor is efficient all of the time. However, one can improve the motivation of employees
by constructing contracts that align the interests of employees and management.
Importantly, this task is non-trivial.
Example: How do you structure the contract of a basketball player? Flat salary, points
scored? Assists? Winning?
In general there are a number of dangers to attend to .

a) Stock. Useful for a CEO, of limited use when employees cannot themselves
affect materially the profitability of the firm.
b) Flat salary: Does motivate stellar effort, but can provide needed security.
c) Time clocks and monitoring: Generally, people do not respond well to
“sticks:” Time clocks can be important when an entire group must be present
to initiate a task. If monitoring is to be done, it must be random
d) Piece rate compensation: A good scheme when quality is not an issue. (great
for catching chickens. Terrible for paintings or poems.
e) Sales commissions. Great unless costs are a problem. Also sales workers may
undermine each others’ efforts.
Conclusion: Motivating employees is a nontrivial task. But notice also, that most people
really want to do a good job. Be careful to not undermine good intentions.
Lecture 29
REVIEW___________________________________________________:

C. Overview and Motivation
D. Optimal methods of obtaining inputs
a. Spot, Contract and Vertical Integration
b. Specialized investments and hold up problems
c. Optimal plan: Purchase on the spot market unless you have
unusual needs. Then contract. Vertically integrate only if
contract terms become too complex.
Preview__________________________________________________________
E. Getting the Most out of Human Factors.
Lecture____________________________________________________________
106
V. The Organization of the Firm: Optimal Contracting, and Motivating Resources
to Work Efficiently (Chapter 6)
C. Getting the Most Out of Human “Factors” The second portion of this chapter deals
with the issue of the optimal compensation structure for labor. Standard production
theory assumes that all employees work efficiently, all the time. Of course this is not true.
Workers in factories “shirk”. Managers try to maximize things other than the PDV of the
firm. Sports players attempt to do something other than “win”. Of course, no human
factor is efficient all of the time. However, one can improve the motivation of employees
by constructing contracts that align the interests of employees and management.
Importantly, this task is non-trivial.
Example: How do you structure the contract of a basketball player? Flat salary, points
scored? Assists? Winning?
In general there are a number of dangers to attend to .

f) Stock. Useful for a CEO, of limited use when employees cannot themselves
affect materially the profitability of the firm.
g) Flat salary: Does motivate stellar effort, but can provide needed security.
h) Time clocks and monitoring: Generally, people do not respond well to
“sticks:” Time clocks can be important when an entire group must be present
to initiate a task. If monitoring is to be done, it must be random
i) Piece rate compensation: A good scheme when quality is not an issue. (great
for catching chickens. Terrible for paintings or poems.
j) Sales commissions. Great unless costs are a problem. Also sales workers may
undermine each others’ efforts.
Conclusion: Motivating employees is a nontrivial task. But notice also, that most people
really want to do a good job. Be careful to not undermine good intentions.
Lecture 30
REVIEW___________________________________________________:
V. The Structure of the Firm
C . Getting the Most out of Human Factors.
Preview__________________________________________________________
VI. Chapter 7. The Nature of Industry (Introduction)

A. Market Structure
a. Definition
b. Types of Structures
i. Competition
ii. Monopoly
107
iii. Monopolistic Competition
iv. Oligopoly
B. A Paradigm for Analyzing Markets
VII. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically

A. Competition.
1. Assumptions
2. Optimal short run decisions:
B. Monopoly
Lecture____________________________________________________________
VI. Chapter 7. The Nature of Industry. To date, we have considered in some detail
demand considerations for a firm, and then a variety of cost considerations for a firm.
Our next project is to use these tools to talk about the optimal behavior of firms in the
market. These decisions are affected importantly by the structure of the industry in
which a firm competes. Chaper 7 overviews some of the candidate structures.
A. Some terminology
1. Market Structure Refers to the number of competitors in an industry, the relative size
of the firms, as well as demand conditions and entry and exit requirements. When a
market has very few players, it is said to be concentrated.
a. Market definition. When attempting to characterize the structure of a particular

industry, it is critically important to pay attention to the appropriate market definition. A
market is defined as a collection of products/geographic areas where cross-elasticities of
demand and supply are sufficiently high so that unilateral price changes by one producer
causes enough of a response to make the action unprofitable.
i. Some industries that are not concentrated at the national level, involve
very concentrated markets. Example: Public Utilities.
ii. Other industries that are quite concentrated at the national level involve
relatively unconcentrated markets, due to international competition. Example: The
automobile industry.
B. Market structures.
i. Competitive. A market is competitive when (a) There are many buyers
and many sellers; (b) The product is homogenous; (c) There is perfect information and
(d) Entry and exit is easy.
Example: Agriculture.
108
Observation: Competitive markets are commodity markets. Managers in
such markets waste very little money on advertising (0ther than product advertising in
general). Most efforts involve minimizing costs.
ii. Monopolistic Competition. A market structure where (a) There are

many buyers and many sellers; (b) Products are differentiated; (c) There is perfect
information and (d) Entry and exit is easy.
Examples: Gasoline, Fast Food, Restaurants.
Observation: As we will see in the coming lectures, monopolistically
competitive producers are able to post prices above costs because they face a down-
sloping demand curve for their product. Managers in these industries spend considerable
resources on advertising, as well as on introducing new product variants, in an effort to
decrease demand elasticity.
iii) Monopoly A market structure characterized by a single producer,

whose position is protected by significant barriers to entry and/or exit.
Examples: Electric utilities, a movie theatre in small town.
Observation: Monopolists have both pricing and output discretion. When
regulated (as is often the case) price and output determination is done in conjunction with
regulatory authorities.
iv) Oligopoly. A market structure characterized by few sellers, who are

strategically aware of the actions of their rivals, and some difficulty in entry and/or exit.
Notice that in oligopolies, products can be homogenous or differentiated products, and
information can be perfect or imperfect.
Examples: Brewing, automobile production, breakfast cereals, soft drinks.
Observation: Oligopoly is one of the most pervasive industrial structures in the

United States, and in modern capitalistic economies in general. The strategic nature of
decisions makes the analysis of decisions in an oligopolistic environment considerably
more complicated than the other structures, and often more interesting. We will devote
some attention to decision-making in an oligopoloistc environment if time permits.
2. Conduct. A general term used to describe the actions of firms. Behavior classified as
firm conduct involves most of the decisions made by management, including pricing,
advertising, research and development expenditures and output.
3. Performance. This term encompasses all elements pertaining to the social desirability
of outcomes for an industry. Profitability, the degree of innovation, the amount of
consumer and producer surplus extracted are all performance measures.
C. A Model for Industrial Performance. Analyzing Industrial performance is an area of

economics called industrial organization. The first generic model of industrial
performance was articulated by Joseph Bain and his colleagues at Harvard University in
109
the 1940’s. The Paradigm was simple, if somewhat deterministic: Structure gives rise to
certain types of conduct. Conduct, in terms generates observed performance.
In this “Structure-Conduct-Performance” paradigm, the structure of the industry
was the primary determining element. It is widely recognized in the “new industrial
economics” that the interrelationships between three components are involved. Conduct,
for example can lead to new basic developments which confer market power on firms.
Similarly, the adaptation of existing technology can eliminate the power of a large
incumbent.
Nevertheless, despite the fact that underlying elements of an industry may change,
it remains true that many of the problems faced by managers are colored by the type of
industry in which the firm competes.
Lecture 30
REVIEW___________________________________________________:

C. Market Structure
a. Definition
i. Competition
ii. Monopoly
iv. Oligopoly
D. A Paradigm for Analyzing Markets
Preview__________________________________________________________

A. Competition.
1. Assumptions
Lecture____________________________________________________________
VI. Chapter 8. Managing in Competitive, Monopolistic, and Monopolistically

A. Introduction. This chapter considers the nature of optimal decisions in the three market
structures that do not involve strategic considerations. Although we will discuss the role
of the manager in each of these contexts, our primary task in this chapter is characterizing
110
optimal decisions in each case. Both graphical and algebraic tools will be used to
develop solutions in each case.
In overview, three considerations are relevant in each of the structural situations.
a) The optimal quantity

b) The optimal price
c) The determination of profits and losses.
The answer to each question involves the same calculation in each case.
a) To determine the optimal quantity compare Marginal Revenue (MR) with

Marginal Costs (MC)
b) To determine the optimal price, find the Average Revenue (AR) at the optimal
quantity.
c) To identify profits or losses, find the difference between P and ATC at the
optimal quantity, then multiply this difference by the quantity.
We consider each structure separately, since implications differ somewhat, due to

changes in the industrial structure.
B. Perfect Competition. Recall that in this case, there are many producers of a
homogenous good. The price that any individual firm may charge is tightly constrained
by the identical products of rivals. For this reason, the demand curve facing an individual
competitor is determined by the intersection of market supply and market demand curves.
P P
S
Df
Q Q
Market Firm
1. Short Run Decisions. We’ve already discussed this at some length. To review,
optimal short run decisions are made by comparing the above firm demand curve with
costs for the firm. Consider a representative case.
P MC
............. Df = AR = MR = P
. . PROFITS . . . . . ATC
AVC
111
Q
Q*
In the case of the competitive firm, Df = AR = MR = P
i) Optimal quantity: Q* is determined by the point where MR = MC. That is the

dashed vertical line extending down from the origin.
ii) The optimal price: Since AR = MR = P, the price is, trivially, P
iii) Determination of profits or losses. At Q*, profit per unit is P-ATC. Thus, total
profits are
 = (P-ATC)Q*.
Observation: Optimal profits may also easily be illustrated on a TR, TC chart.
Of course, as we’ve seen previously, demand may cross the average cost curves at any
point. This gives rise to a number of possible outcomes, detailed below:
P MC
ATC
AVC
Loss Df = AR = MR = P
Q* Q
Production at a loss.
P MC
ATC
AVC
Df = AR = MR = P
Q
No Production.
i) Observations.
112
- The competitive firm will produce at a loss in the short run. This is due
to the existence of fixed costs. As long as the firm can cover variable costs and make
some contribution of fixed costs, then production is optimal.
2. Intermediate-Run Decisions for the Competitive Firm. An important feature of

competitive firms is that they are driven to the point of zero economic profits. Recall that
in a competitive market entry and exit is costless. Recall also that the market supply
schedule is the horizontal sum of individual supply schedules. Thus the entry of
additional competitors will shift the market supply schedule out, and the exit of some
incumbent competitors will shift the market supply schedule in. These changes will drive
the price (or the individual demand curve faced by each firm) down or up.
P S2 P
S0
exit S1
Df
entry
D
Q Q
Market Firm
Thus, in the long run, for a competitive industry, price will be driven to MC, or
the minimum point on the AC curve
P MC
AC
Df = AR = MR = P
Example: (Continuing from above). Again assuming
TC = 100 + 5Q + .5Q2
What price do you think this firm will be forced to charge in the intermediate run?
3. Long Run (planning horizon) decisions for competitive firms. One additional
characteristic of competitive firms is that they are driven to the efficient scale of
operation: Suppose, for example, that there are economies of scale. Every firm has an
113
incentive to exploit the economies to earn higher profits. But all survivors must also
expand, for any plant that doesn’t exploit all economies of scale will have higher costs
than larger, efficient rivals who do exploit the economies.
MC
P S2 P ATC1
S0
1
S
Df
D
Q Q
Market Firm
The ‘Carrot’ of increased profits from expansion.
Later, when the market price falls, this is the ‘stick’ of losses from firms that fail to
expand. Thus, firms have an incentive to exploit all available economies of scale.
Similarly, firms are motivated to contract when they realize diseconomies of scale.
MC
P S2 P ATC1
S0
S1
Df
D
Q Q
Market Firm
The thing that is different about the case of contraction is that when firms contract other,
smaller firms enter the industry to drive prices down. This is what happened in the 1990’s
with the move to ‘downsize’ many firms.
Lecture 31
REVIEW___________________________________________________:

114
A. Competition.
1. Assumptions
Preview__________________________________________________________
REVIEW
Lecture____________________________________________________________
Lecture 33
REVIEW___________________________________________________:

A. Competition.
1. Assumptions
Preview__________________________________________________________
B. Monopoly
a. Optimizing with Demand Curve
C. Monopolistic Competition
. 1. Assumptions
4. Observations.
a. Social cost of product differentiation
b. Optimal Advertising decisions.
115
Lecture____________________________________________________________
Now we turn our attention to the case exactly opposite to the competitor: The monopolist.
The insight critical to understanding monopoly is that for one reason or another (reasons
that we will discuss momentarily) the monopolist is the market. Cost conditions, on the
other hand do not necessarily differ) Thus, to analyze optimizing decisions for the
monopolist, we must combine the market demand curve with the firm’s supply curves.
.
P
S MC ATC
Pc P*
c =0
D
Market Q Firm Q* Q
1. Reasons for monopoly: A single firm may come to dominate a market for a variety of
reasons.
a) Economies of scale. If it is the case that production is characterized by economies of

scale over range under the market demand curve, then only a single firm can efficiently
exist in an industry. These types of cases are typically regulated monopolies, such as
electric utilities and water and sewer service.
b) Patents. Many monopolies are the consequence of government activity. If an inventor

develops a cost saving technology, or a unique product, and secures a defensible patent
for the invention, the inventor has a legal monopoly for 17 years following the patent.
This monopoly power is provided as an incentive for creative activity. In the absence of
patents, new developments would be copied by firms that did not incur the product
development costs, undercutting the incentive for new product development.
c) Economies of Scope and Cost Complementarities. If firms enjoy economies of scope,

and particularly cost complementarities, they can produce a product more cheaply than
any rival, because costs are defrayed by the production of the complementary product.
116
2. Characterizing the problem for a monopolist.
a. Demand. Critically, when a firm faces a downsloping demand curve, P=AR no
longer equals MR. This is true as long as the monopolist cannot price discriminate, or
charge different prices to different consumers. In this case, the Marginal Revenue is
different from P = AR. The reason is that in order to sell additional units, the firm must
lower the price, causing the firm to lose sales on units that would have sold at the higher
price.
Po
P1 MR for the range Po - P1
D = AR= P
Qo Q1 MR
In terms of the above graph, the marginal revenue from lowering the price from
Po to P1 is the change in total revenues over that range. Essentially, it is the “quantity
box” less the “price box.”
b. Costs and Monopoly Supply: As we will demonstrate formally in a moment, for

any linear demand curve, the MR curve has exactly twice the slope of the demand curve.
There is no well-defined supply curve for the monopolist. Unlike the competitor, the
monopolist does not produce goods until P = MC. Thus, the MC curve is not a supply
curve. Rather, willingness-to-produce is the combination of MC and the demand curve.
2. Optimization for the Monopolist.

a. A Homogeneous Product Monopolist, with a down-sloping demand curve.
Placing the market demand curve over the cost curves for the firm generates, the
optimizing decisions for the monopolist follow the same rules as for a competitor. (For
simplicity, AVC is again suppressed.)
P
MC
....... ATC
. Profits . .
........
D = AR = P
Q
Q* MR
117
i) The optimal quantity Q* is determined by the intersection of MR and
MC curves.
ii) The optimal price is the intersection of the demand curve and the
vertical line extending up from AR.
iii) Profits are the difference between the price, and ATC, multiplied by
Q*
An algebraic example. Suppose you are a monopolist of a firm. Your

total cost and inverse demand curves are, respectively
TC = 50 + .5Q2
P = 200 - 2Q
a. What is the marginal revenue curve for the monopolist?

MR = 200 – 4Q
b. What is the optimal quantity for the monopolist?
MR = MC
200 – 4Q = Q
Q = 40
P = 200 – 2(40) = 120
c. Determine monopoly profits.
 = TR - TC
= 120(40) - [50 + .5(40)2]
= 4800 - 850
= 3950
Lecture 34
REVIEW___________________________________________________:

B. Monopoly
a. Graphically
b. Analytically
Preview__________________________________________________________
. 1. Assumptions
118
4. Observations.
Lecture____________________________________________________________
4. The Social Costs of Monopoly: The social costs of monopoly. There is no entry and
exit, so monopoly profits can be permanent.
a) Monopoly pricing is inefficient. The graph below allows a comparison
between the monopolist, and a competitor with similar cost curves. (Recall that a
competitor would be forced to produce where MC = ATC.)
Monopoly Profits
Pm MC
ATC
c
P .
D = AR = P
MR Q
Qm Qc
Continuing with the above example, what would a competitor be forced to charge? MC =
ATC Calculate profits, price and ATC.
b) Results: Compared to a competitor, a monopolist
i) charges a higher price,
ii) produces a lower quantity
iv) Earns persistent economic profits.
A numerical example. Suppose
P = 90 – Q and TC = 400 +10Q + Q2

MR = 90 – 2Q, MC = 10 + 2Q
Thus, 80 = 4Q and Q = 20
P = 70
Profits are 70(20) – [400 +10(20) + 202]

1400 - 1000
400
Compare outcomes to the competitor in a LR equilibrium. The competitor will produce

where MC = ATC. ATC = 400/Q + 10 + Q, or
119
10 + 2Q = 400/Q +10 + Q
Q = 20
P = 50
Profits equal 0
Notice, with market demand of 90-Q, Q must equal 40 for P to equal 50. Thus, a second
firm must exist in the market in a competitive equilibrium.
Note: It is possible to conjure up numbers where quantity is not lower for the monopolist
than for the competitor (we are comparing a single firm to multiple firms in the market,
so using a single cost curve is not the best example). However, price will definitely be
higher.
Lecture 35
REVIEW___________________________________________________:

B. Monopoly
a. Graphically
b. Analytically
The monopolist posts a higher price, produces a smaller
quantity and earning economic profits.
Example:
P = 124 – 2Q and TC = 625 + 4Q + Q2
 = TR - TC
= (124 – 2Q)Q - (625 + 4Q + Q2)
MR = 124 – 4Q
MC = 4 + 2Q
Optimum: 120 = 6Q
Q = 20
P = 84
 = 84(20) – [625 + 4(20) + 202]
= 1680 – 1115
= 565
Compare to a Competitor, who will produce where
MC=ATC
4+2Q = 625/Q + 4 + Q
625 = Q2
25 = Q
P = 4 + 2(25) = 54
120
But notice that at this price, the market would produce 124-2(25) = 76 units, or roughly 3
firms would compete.
Preview__________________________________________________________
. 1. Assumptions
4. Observations.
Lecture____________________________________________________________
C. Monopolistic Competition. The third structural model we consider combines

important components of the preceding two models.
1. Assumptions
(c) Products are differentiated.
As indicated at the beginning of class, examples of monopolistic competition
include restaurants and beer, soft drinks, and many food products.
2. Characterization. Due to product differentiation monopolistic competitors face

downsloping demand curves. Thus in the optimum, monopolistically competitive firms
will not produce at the point where ATC = MC, as in the competitive case. However, due
to entry and exit, all profits will be driven to zero.
a. Short Run Decisions. In the short run, the decision-calculus is exactly as the
monopolist.
P
MC
....... AC
. Profits . .
........
D = AR = P
Q
Q* MR
Optimal quantity Q* is determined by the intersection of Marginal Revenue and Marginal

cost curves. The optimal price is the intersection of the vertical extending from Q* and
the demand curve. Profits are the difference between AR and ATC multiplied by the
number of units produced.
121
b. Long Run Decisions. Due to free entry and exit, however, profits in a monopolistically
competitive firm are driven to zero. The dynamic motivating this outcome involves shifts
in the firm’s demand curve. As new competitors enter the market, the monopolistic
competitor still has his or her “following”, however, some consumers will switch to one
of the entrants, shift the demand curve for the firm inward. Inward shifts of this nature
will persist until the demand curve is just tangent to the ATC curve at the optimum.
MC
. .. AC
..
D’ = AR = P
Q
Q* MR’
3. Implications of Product Differentiation.

a. Product Differentiation and Social Welfare. Notice that although
monopolistically competitive firms earn zero economic profits, MC does not equal ATC
in the long run. Some would argue that this is a social cost associated with this industry
structure. Others, however, would (I think quite reasonably) contend that the welfare loss
is the cost of product differentiation. Consumers value differentiation, and if they did
not, homogenous product competitive industries would prevail.
b. The nature of Managerial Decisions and the Industry Structure. Note the
difference in managerial decisions in each industry structure. In the competitive industry,
the primary focus of managerial decisions will be on reducing costs. Monopolists, on the
other hand, are frequently regulated. Even if not, they are concerned with pricing as well
as output level decisions. Finally, the monopolistic competitor will typically engage in
considerable advertising, and new product development in order to make demand more
inelastic, and to capture short term profits.
Lecture 37
REVIEW___________________________________________________:
VIII. Chapter 11. Pricing Strategies.
122
a. Basic Case
P = MC/[1+1/].
Preview__________________________________________________________
c. Group Division (3rd degree price discrimination.
.
Lecture____________________________________________________________
A. Basic Pricing Strategies for Firms with Market Power.

1. Optimal Pricing for a monopolist or monopolistic competitor. Generally
speaking, firms with downsloping demand can raise prices above the competitive
level. This applies both to monopolistic competitors as well as to monopolists.
a. Basic Case. With perfect demand information, the firm can

maximize profits by setting MR equal to MC to find the optimal quantity.
Then the firm inserts Q into the price function to find the optimal price.
We just reviewed this above. One important problem with this approach
is that firms rarely have complete demand information.
b.. Optimization without a demand curve. As we noted earlier in the

semester, often times we don’t have a good estimate of the demand curve.
Rather, we must rely elasticity information to draw inference about
optimal outcomes. Fortunately, this is not too difficult. Recall, a
monopolist optimizes where MR = MC. MC should be known. Let’s
consider MR.
TR = P(Q)Q. Taking the derivative w.r.t. Q yields
dP
MR  QP
dQ
Pull out P from the RHS and we have

1 1
MR  P[  1]  P[ ]
 
Now in an optimum MR = MC, thus
MC = P(1/ + 1)
Or
123
P = MC/(1+1/)
This is a useful expression, since it allows us to determine the optimal markup

with only information regarding price elasticity of demand.
B. Strategies that Yield Greater Profits. However, if firms with downsloping demand are
not constrained to charge the same price to all consumers, even higher profits are
available. We start with price discrimination,
1. Price Discrimination: The practice of charging different prices to consumers for the
same good. The below figures illustrate maximum profits available from posting a
uniform price:
P MC
Qm Q
MR
Now, if the firm is restricted to posting a single price, then the Qm will be produced, and
the maximum profits than can be realized is the area in the shaded box. However, more
surplus is available: Consumers take home the triangle above the shaded box at the top
of the figure. Also, due to the inefficiently high price, fewer units are sold than would
have been sold at the competitive price, causing an additional welfare loss.
a. First-degree price discrimination: The practice of charging different prices to

consumers for the same good.
Suppose that the firm could successfully size up every consumer that came into their
shop, size them up, and charge them their limit price for the good. The, the efficient
quantity would be produced, and the firm would enjoy the entire surplus.
P MC
124
Qe Q
MR
Perfect price discrimination requires satisfaction of two conditions

a. The firm must be able to assess accurately the maximum willingness to
pay of each consumer
b. The firm must be able to prevent arbitrage, or the resale of units from
low value consumers to high value consumers.
In practice, the first of these conditios is difficult to satisfy with any precision However,
first degree price discrimination is often attempted in markets where the resale is
impossible, and where the item exchanged is very costly (e.g. real estate or automobiles)
or where the consumer knows little about the cost of the service (automobile repairs)
Lecture 37
REVIEW___________________________________________________:
a. Basic Case
P = MC/[1+1/].
Preview__________________________________________________________
3.
Lecture____________________________________________________________
B. Strategies that Yield Greater Profits.
The second of these conditions can be problematic, but ini practice, the first is typically a
condemning problem. However, it is fairly conventional in a number of markets,
including mechanical repairs, automobiles, and real estate to make an effort at first
degree price discrimination.
125
Other methods of price discrimination are more typical.
2. Second Degree Price Discrimination: One standard alternative is to offer all consumers
a schedule that decreases with quantities purchased. This is second degree price
discrimination: The practice of posting a discrete schedule of declining prices for
different ranges of quantities.
Example: Suppose Best Buy sells a first CD for $15, and then additional CD’s for $10.
Suppose that the MC of selling the CD’s was $5 each. Suppose that your demand is such
that you would pay up to $15 for a first CD and $10 for a second CD.
If they charged $10 each they would earn $10, and if they charged $15 each they would
earn $10.
P MC
$15
$10
$5
Qe Q
MR
c. Third Degree Price Discrimination: The practice of identifying different types of

consumers, and charging different prices to each group.
This is a very standard practice in entertainment goods (such as food, movies and
sporting events): “Senior citizen’s discounts,” “Student’s discounts”, etc. appear to be a
way for the firm to help out particular groups of people. In fact, it is also a way to
increase profits. By separating low-value buyers from the high value buyers, and
charging different prices, the firm makes sales it would otherwise forego.
Successful third degree price discrimination requires two things

1. High and low value groups must be separable. (This is often pretty easy.
Senior citizens can be required to show a driver’s license, etc.)
2. There must be a way to prevent one group from reselling to the other. (If this
is not prohibited, then arbitrage will eliminate sales in the high-value market).
Optimal pricing under third degree price discrimination is easily motivated graphically.
Just identify the demand curves for the separate groups, and optimize with respect to each
group.
P P
126
MC MC
D D
Q Q
MR1 MR2
Manipulating the elasticity formula presented earlier for the case of a monopolist, this can
be algebraically expressed as
MC = MR1 = MR2
= P1[(1+1)/1] = P2[(2+1)/2]
Solving for prices
P1 = MC/[1+1/1]
P2 = MC/[1+1/2] = 1P
Example: Suppose you are selling popcorn in a movie theatre. Theatre-goers are
prohibited from bringing in food from home, so you have some market power. Suppose
that the price elasticity of demand for students is -2, while the price elasticity of demand
for the general public is -1.5. If popcorn costs $.25 per box to prepare, box and sell, what
price should be charged to each group?
Answer: Let group 1 be the general public, and let group 2 be students. Then
P1 = .25/[1+1/-2] = .50
P2 = MC/[1+1/-1.5] = .75
= .50
2. Two Part Pricing: The practice of charging a per unit cost that equals marginal cost,
plus a fixed fee equal to the consumer surplus each consumer receives at the MC price.
This is a second scheme that allows firms with some market power to increase profits. It
is typically employed by athletic clubs and discount centers (buying clubs),where an
initiation fee is charged, along with some (possible zero) usage fee. The profitability of
two part pricing is easily seen in an illustration
P P
127
MC MC
D D
Q Q
MR1 MR2
Single Price Monopolist Two part pricing
If a firm charges P=MC in the second case, but an initiation fee equal to the entire
consumer surplus triangle, profits are higher than they would be as a single price
monopolist.
Example: What would be the optimal initiation fee in the above example if the demand
curve was 10 - P, and the marginal cost of a “visit was $1?
Answer: The optimal quantity is 10 - 1 = 9. Thus the consumer surplus realized

from marginal cost pricing is (1/2)[10-1]9 = $40.50.
Lecture 38
REVIEW___________________________________________________:
Review Homework
Preview__________________________________________________________
Lecture____________________________________________________________
3. Commodity Bundling The practice of bundling several different products together and
selling them at a single “bundle price.” This is final scheme for increasing profits that we
will discuss. The potential profitability of bundling can be seen in the following
example.
Suppose a firm sells computers and monitors, but that different consumers value
the different products differently.
128
Consumer Valuation of computer Valuation of Monitor
1 2000 200
2 1500 300
Suppose, for simplicity that MC equals zero. If demand consisted of only these two
consumers, then the best the firm could do with single product, nondiscriminatory price is
1500 for the computers, and 200 for the monitors.
However, if the firm charged $1800 for the computer/monitor combination, it
could earn 100 more per sale.
Observe that effective first-degree price discrimination would be more profitable.

However, when it is impossible to distinguish consumers before the fact, this is a profit-
improving option relative to single-product pricing. Commodity pricing is a very
standard feature of big-ticket items, such as automobiles and new houses.
TEST
Test 1 Review
1. Economics

profits.
Acct = TR - TCExplicit
Econ = TR - (TCExplicit + TCImplicit)

PV =  FVt
129
(1+i)t
NPV =  FVt - Co
(1+i)t

Note: You should be able to graphically illustrate why the point where Marginal Benefits
equals Marginal Costs maximizes the difference between Total Benefits and Total Costs.
130
1. Overview
B. The Demand Side.
C. The Supply Side.
Note: You should be able to look at a linear demand or supply function, and, with
appropriate information about the nonprice parameters, be able to generate demand and
supply curves. Given a price you should be able to calculate consumer and producer
surplus.

1. Definition.
Price floors
Price Ceilings
131
1. Motivation
2. Calculations
 = (Q1-Q0)(P1+P0)
(P1-P0)(Q1+Q0).

 = (dQ/dP)(P/Q)
 = %Qd/%P

b. Exceptions
TR is maximized at the point where || = 1
No firm maximizes profits on the inelastic portion of their demand
curve.
a. Availability of substitutes
b. Price Relative to Income
c. Time

xy = %Qx/%Py
xy> 0 implies substitutes
xy< 0 implies complements
xy = 0 implies unrelated goods.
I = %Q/%I
I > 1 normal, cyclical good
1> I > 0 normal, noncyclical good
I< 0 inferior good.
132
3.Other Elasticites. Advertising elasticity
A = %Q/%A
For any successful advertising campaign, A >0

1. Linear Demand functions. Given
Qx = a + bP + cI + dPy
 = b(Q/P) I = c(Q/I) xy =d(Qx/Py)
2. Logrithmic Demand. Given
Qx = aPbIcPyd
=b I = c xy =d
Note: An equivalent expression for this function is

ln Qx = lna + blnP+ clnI + dlnPy
Review Outline.
E303 Second Examination
Spring 2006
III. Quantitative Demand Analysis (Continued)

2. Forecasting
A. Introduction:

i. VMP and PL
ii. Shifts in the VMP schedule.
C. Costs.
133
2. Short run costs.
a. Cost curves
3. Long-Run Costs
c. Returns to Scaels: Measuring Scale Economies
V. The Organization of the Firm. Ch. (6.)
A. Overview and Motivation. The optimal structure of the firm is narrow and
focused. All inputs would be purchased, and all outputs would be sold on spot
markets.

1. Options
a. Spot
b. Contract

b. Underinvestment
3. Decision Rule
a. Spot is optimal unless the costs of opportunism are too high.
b. The choice between contractual arrangements and internal
production are determined by the contracting costs, particularly
the relative uncertainty of the contracting environment.
C.Getting the Most out of Human Factors.

a. Profit Sharing.
b. Revenue Sharing.
c. Piece Rates.

E. Market Structure
134
a. Definition
i. Competition
ii. Monopoly
iv. Oligopoly
F. A Paradigm for Analyzing Markets

A. Introduction
a. Rule for determining optimal quantity (Compare MR to MC)
b. Rule fro determining profits and losses (Compare AR to ATC)
B. Competition
a. Assumptions
b. Optimal Short Run Decisions
c. The Intermediate run (entry but no expansion)
d. The Long run (expansion but no entry)
C. Monopoly
a. Assumptions
Optimal Decisions
Problem Set #1 KEY
1. To attract Walt Snore to the job of CEO of Good Sleep Inc. Walt is given the
following (a) a signing bonus of $750,000. (b) In addition to his salary Walt will
be paid a bonus of $750,000 in any year that company return on assets exceeds
7%. Also (c) Walt receives 500 shares per annum of the stock, which he may not
sell for 5 years. Comment on the likely effectiveness of each of these components
of as a means to mitigate the principle-agent problem.
Most Likely: Stock
Least Likely: Signing Bonus
Reason: The signing bonus doesn’t induce effort. The earnings bonus helps
some, but is imperfect, the restricted sale stock does promote attention to the
long term value of the firm.
2. Good Sleep anticipates the following earnings for the next 5 years.
Years in the Future Anticipated Profit

1 22
2 24
135
3 26
4 28
5 30
If the discount rate is 10% and the machine costs $90 (000), what is the net present value
of the machine? Is it a good purchase?
PV = 22/(1.1) + 24/(1.1)2+ 26/(1.1)3 + 28/(1.1)4+ 30/(1.1)5= $97.120

NPV = $97,120 – 90,000
= $7,120
Good purchase YES
136
3. Joe Holiday has the opportunity to operate a business renting beach umbrellas
next summer. He will operate the concession for 3 months. Looking at weather
patterns, Joe observes that rain is frequent along this stretch of beach, and on
average, there are only 60 rentable days in a summer. In each of these days, Joe
believes he can rent 40 umbrellas per day at $7 per rental. Joe will run the
concession by himself day, and must pay Beachcomber Enterprises $9,000 for the
concession (the use of the umbrellas and for the beachfront rental location).
Suppose Joe could earn $4500 working construction.
a. What are Joe’s Accounting Profits for undertaking the business? What are
his Economic Profits
A = TR - TCEX
= 60(40$7) - $9,000
= $16,800 - $9,000
= $7,800
E = TR - TCEX - TCIM
= $16,800 - $9,000 - $4,500
= $3,300
b. Can Joe expect economic profits from the venture? If so, to what are these
profits attributable?
Yes, he can expect positive economic profits. This is a return to his risk-taking (it might,
after all, rain all summer!) or to locational rents (he may have the only stand on the
beach)
Problem Set #1
4. To attract Walt Snore to the job of CEO of Good Sleep Inc. Walt is given the
following (a) a signing bonus of $750,000. (b) a bonus of $750,000 in any year
that company return on revenues exceeds 7%, and (c) receives 500 shares per
annum of the stock, which he may not sell for 5 years. Which of these
components best mitigates the principle-agent problem? Which is does the least?
Why?
Most Likely:_____________
Least Likely:____________
Reason: _________________________________________________________________
________________________________________________________________________
137
5. Good Sleep Inc. is considering the purchase of a new mattress assembler that
allows the construction of multiple firmness levels in the same mattress. Good
Sleep anticipates the following 5-year earnings stream from the sale of this
mattress.
Years in the Future Anticipated Profit (‘000’s)

1 22
2 24
3 26
4 28
5 30
If the discount rate is 10% and the machine costs $90 (000), payable at once, what is the
net present value of the machine? Is it a good purchase? (Write out the net earnings
stream to generate your answer )
Net Present Value__________________________________________________
Good purchase?:______
138
6. Joe Holiday has the opportunity to operate a business renting beach umbrellas
next summer. He will operate the concession for 3 months. Looking at weather
patterns, Joe observes that rain is frequent along this stretch of beach, and on
average, there are 60 rentable days in a summer. In each of these days, Joe
believes he can rent 40 umbrellas per day at $7 per rental. Joe will run the
concession by himself day, and must pay Beachcomber Enterprises $9,000 for the
concession (the use of the umbrellas and for the beachfront rental location).
Suppose Joe could earn $4500 working construction.
a. What are Joe’s Accounting Profits for undertaking the business? What are
his Economic Profits
Accounting profits (A):___________________________________________________
Economic profits (E):___________________________________________________
b. Can Joe expect economic profits from the venture? If so, to what are these
profits attributable?
Positive economic profits? ( Y / N )
Justification: _________________________________________________________
Problem Set #2 (Note: On this problem, you may use EXCEL to generate numbers, but
please fill in your answers
1. Consider the total profit function
= TR - TC
= (10 –Q)Q –.25Q2
a. Create a table that shows Total Revenue, Total Cost and Total Profit, (in your
table, let quantity run from 0 to 8 in increments of 1.) Indicate in your table where total
profits are maximized
Q TR TC T
Profit
0 0 0 0
1 9 0.25 8.75
2 16 1 15
3 21 2.25 18.75
4 24 4 20
139
5 25 6.25 18.75
6 24 9 15
7 21 12.25 8.75
8 16 16 0
b. Next illustrate the relationship between TR, TC and total profit in the
coordinate axes below
30
25 MR
20 Profit Max
TR
15
TC
10
5
MC
0
0 5 10
On your graph,
-highlight the point where total revenues are maximized.
-show how profits may be seen.
-highlight the point where total profits are maximized
c. Next, create a table showing marginal revenues, marginal costs and marginal
profits. Indicate in this table where TOTAL profits are maximized
Q MR MC M PRO
0 10 0 10
1 8 0.5 7.5
2 6 1 5
3 4 1.5 2.5
4 2 2 0
5 0 2.5 -2.5
6 -2 3 -5
7 -4 3.5 -7.5
8 -6 4 -10
140
d. Finally, in the coordinate axes below create a graph that illustrates the
relationships between marginal revenue and marginal cost.
- show the point where TOTAL profits are maximized
- show the point where marginal profits are zero.
.
M PR0 = 0
12
10
8
6 MC
4
MR
2
0 MR
-2 0 5 10
-4 MR
-6
-8
141
2.Take the derivatives of the following functions. Do not simplify.
a. f(x) = 10 f’(x) = ___0___________________________
b. f(x) = 20x2 f’(x) = ___40x_________________________
c. f(x) = 30x f’(x) = ____30_________________________
d. f(x) = 20x + 30x3 f’(x) =___20+90x2_____________________
e. f(x) = (10 + 15x2)(3x – 4x3) f’(x)

=_30x(3x – 4x3)+ (3-12x2)(10 + 15x2)_____________________________
f. f(x) = 10/x2 f’(x) =___-20/x3________________
Problem Set #2 (Note: On this problem, you may use EXCEL to generate numbers, but
please fill in your answers in the table below.)
1. Consider the total profit function
= TR - TC
= (10 –Q)Q –.25Q2
a. Create a table that shows Total Revenue, Total Cost and Total Profit, (in your
table, let quantity run from 0 to 8 in increments of 1.) Indicate in your table where total
profits are maximized
Q TR TC T Profit
0
1
2
3
4
5
6
7
8
142
b. Next illustrate the relationship between TR, TC and total profit in the
coordinate axes below

Qty
On your graph,
-highlight the point where total revenues are maximized.
-show how profits may be seen.
-highlight the point where total profits are maximized
c. Next, create a table showing marginal revenues, marginal costs and marginal
profits. Indicate in this table where TOTAL profits are maximized
Q MR MC M Profit
0
1
2
3
4
5
6
7
8
d. Finally, in the coordinate axes below create a graph that illustrates the
relationships between marginal revenue and marginal cost.
- show the point where TOTAL profits are maximized
- show the point where marginal profits are zero.
.
MR,
143
MC
Qty
144
2.Take the derivatives of the following functions. Do not simplify.
a. f(x) = 10 f’(x) = _______________________________
b. f(x) = 20x2 f’(x) = _______________________________
c. f(x) = 30x f’(x) = _______________________________
d. f(x) = 20x + 30x3 f’(x) =_______________________________
e. f(x) = (10 + 15x2)(3x – 4x3) f’(x) =_______________________________
f. f(x) = 10/x2 f’(x) =_______________________________
Problem Set #3
1. The American Bagel Co. is considering opening a Bagel bakery and coffee shop near
Campus. In an effort to predict the profitability of this venture, their in-house consulting
team estimated that the daily demand for Bagels in the area to be the following
Q = -5P + 20Pp - 30Pc +5I
Where P = the price of bagels, Pp = the price of pastries (each), Pc = the price of coffee
(per cup), and I = Income (average annual per capita, for local residents in thousands of
dollars)
a. Comment on this estimated demand function. Are the parameters reasonable? Why or
why not? (Restrict your commentary to the signs of the parameters)
Reasonable Sign? (Y/N) Reason
P _________________________________________________
Pp _________________________________________________
Pc _________________________________________________
I __________________________________________________
145
b. Suppose that the price of pastries = $1, coffee costs $.50 per cup, and average per
capita income in the fan area is $12,000. Calculate the inverse demand curve (e.g.,
express price as a function of quantity).
Demand: __________________________________
Inverse demand _________________________________
c. What happens to the predicted number of bagels sold per day if the price of bagels is
increased from $1.00 to $2.00? Is this a change in demand or a change in quantity
demanded?
Initial Quantity: __________________________________
Terminal Quantity _________________________________
Change in Demand or Change in Quantity Demanded (Circle One)
146
d. Holding the price of bagels again at $1.00, what happens to the predicted number of
bagels sold per day if the price of coffee increases from $.50 to $1.00 per cup. Is this a
change in demand or a change in quantity demanded?
Initial Quantity: __________________________________
Terminal Quantity _________________________________
e. In the coordinate axes below, illustrate the changes that occurred above in parts c and d
above. (Note, your graph need not be precise)
e. Suppose that the price of Bagels is set at $1. How much consumer surplus do
consumers receive at that price?
Consumer Surplus: __________________________________
Problem Set #3
1. The American Bagel Co. is considering opening a Bagel bakery and coffee shop near
Campus. In an effort to predict the profitability of this venture, their in-house consulting
team estimated that the daily demand for Bagels in the area to be the following
Q = -5P + 20Pp - 30Pc +5I
147
Where P = the price of bagels, Pp = the price of pastries (each), Pc = the price of coffee
(per cup), and I = Income (average annual per capita, for local residents in thousands of
dollars)
a. Comment on this estimated demand function. Are the parameters reasonable? Why or
why not? (Restrict your commentary to the signs of the parameters)
Reasonable Sign? (Y/N) Reason
P _______Y__________________________Downsloping Demand Curve (d.m.u.)
Pp ______Y_________________________Pastries and Bagels are Substitutes
Pc ______Y_________________________Coffee is a complement__________
I _______Y________________________Food consumed at a café s probably a normal

good
b. Suppose that the price of pastries = $1, coffee costs $.50 per cup, and average per
capita income in the fan area is $12,000. Calculate the inverse demand curve (e.g.,
express price as a function of quantity).
Demand: Q = -5P + 20(1)- 30(.5)+ 5(12)

= -5P +65
Inverse demand _______P = 13 - Q/5______________________
c. What happens to the predicted number of bagels sold per day if the price of bagels is
increased from $1.00 to $2.00? Is this a change in demand or a change in quantity
demanded?
(Note: The appropriate was corrected via an email broadcast)
Quantity Changes from: 65-5(1)= 60 to 65 – 5(2) = 55
d. Holding the price of bagels again at $1.00, what happens to the predicted number of
bagels sold per day if the price of coffee increases from $.50 to $1.00 per cup. Is this a
change in demand or a change in quantity demanded?
For these problems you need a new demand curve

Q = -5P + 20(1)- 30(1)+ 5(12)
= -5P +50
148
Demand: Q = -5P + 20(1)- 30(1)+ 5(12)
= 50 – 5P
Inverse demand _P = 10 – Q/5________________
Before, at Pc = .50, Q = 60
Now, at P = 1, Q = 50
e. In the coordinate axes below, illustrate the changes that occurred above in parts c and d
above. (Note, your graph need not be precise)
(c)
(d)
e. Suppose that the price of Bagels is set at $1. How much consumer surplus do
consumers receive at that price?
The demand curve is _P = 13 - Q/5. When P=1, Q = 60. When P = 13, Q = 0.

Thus, we need to find the area of a triangle with a length of 60 and a height of 12
Consumer Surplus: _.5(12)(60) = 360_________________________
Problem Set #4. Equilibrium Analysis.
1. Consider the market for “popcorn crisps” a new product that you prepare fresh (like
popcorn) but that has the look and feel of a potato chip.
149
a. What relationship should characterize the relationship between the price of popcorn
crisps and the number of packages sold per month? Why?
Relationship: __ ___________________________
Reason: __ ______________
b. What relationship should characterize the relationship between the price of popcorn
crisps and the number of packages produced per month? Why?
Relationship: _ ____________________________
Reason: __ _____________
c. Suppose that Crisp-Makers of America, Local #458, a trade union that manufactures
the crisps, successfully negotiates a wage increase. Will this affect the supply of or the
demand for the crisps. How would the curve be affected?
Supply / Demand (circle one). Direction of adjustment: ________________
d. Relative to the initial equilibrium, identify the price and/or quantity adjustment. What
process causes the adjustment to the new equilibrium?
Equlibrium Price Change: Increase /Decrease /No Change (Circle One)

Equilibrium Quantity Change Increase /Decrease /No Change (Circle One)
Adjustment Process: _______________________________________________________
_______________________________________________________________________
150
3. Suppose that the free market equilibrium price of bourbon is $6.00 a bottle, and
that the government sets a price ceiling of $4.50 a bottle on bourbon. The most
likely result of this action is that:
a. there will now be an excess demand for bourbon

b. the market price of bourbon will remain at $6.00 a bottle.
c. there will be a large reduction in the quantity of bourbon demanded.
d. there will now be an excess supply of bourbon.
4. “The winds of the recent hurricanes in Florida are bringing soothing financial gain
to California citrus growers. Due to the extensive damage to the Florida citrus corp,
California citrus products are commanding their highest prices ever.”
Which of the following statements best explains the economics of the quotation?
a The supply of Florida oranges has increased, causing their price to

increase and the demand for the substitute California oranges to also
increase.
b. The supply of Florida oranges has decreased, causing the demand for
California oranges to increase and their prices to rise.
c. The demand for Florida oranges has been reduced by the hurricanes,
causing a greater demand for the California oranges and an increase in
their price.
d. The demand for Florida oranges has been reduced causing their prices to
fall and therefore increasing the demand for the substitute California
oranges.
5. Suppose that a new, influential research study proves conclusively that cigarette
smoking causes cancer in a way that causes people to start to pay more attention
to the warning that "cigarette smoking is injurious to health." At the same time,
suppose that new restrictions on the use of fertilizer dramatically raise tobacco
production costs. Using conventional supply and demand analysis, one would
expect the combined effect of these changes on the cigarette market to be:
a. an increase in equilibrium price, with the change in equilibrium quantity

uncertain
b. a decrease in equilibrium price, with the change in equilibrium quantity
uncertain.
c. an increase in equilibrium quantity, with the change in equilibrium price
uncertain.
d. a decrease in equilibrium quantity, with the change in equilibrium price
uncertain.
/ Problem Set #4. Equilibrium Analysis.
151
1. Consider the market for “popcorn crisps” a new product that you prepare fresh (like
popcorn) but that has the look and feel of a potato chip.
a. What relationship should characterize the relationship between the price of popcorn
crisps and the number of packages sold per month? Why?
Relationship: _Inverse___________________________
Reason: __Diminishing Marginal Utility ______________
b. What relationship should characterize the relationship between the price of popcorn
crisps and the number of packages produced per month? Why?
Relationship: _ Direct____________________________
Reason: __Law of Diminishing Returns (Crowding) _____________
c. Suppose that Crisp-Makers of America, Local #458, a trade union that manufactures
the crisps, successfully negotiates a wage increase. Will this affect the supply of or the
demand for the crisps. How would the curve be affected?
Supply / Demand (circle one). Direction of adjustment: __Supply will shift up and in __
d. Relative to the initial equilibrium, identify the price and/or quantity adjustment. What
process causes the adjustment to the new equilibrium?
Equlibrium Price Change: Increase /Decrease /No Change (Circle One)

Equilibrium Quantity Change Increase /Decrease /No Change (Circle One)
Adjustment Process: _At the initial price with new supply and old demand a shortage
exists_______
152
3. Suppose that the free market equilibrium price of bourbon is $6.00 a bottle, and
that the government sets a price ceiling of $4.50 a bottle on bourbon. The most
likely result of this action is that:
a. there will now be an excess demand for bourbon

b. the market price of bourbon will remain at $6.00 a bottle.
c. there will be a large reduction in the quantity of bourbon demanded.
d. the market price of bourbon will fall because the price ceiling will create
an excess supply.
4. “The winds of the recent hurricanes in Florida are bringing soothing financial gain
to California citrus growers. Due to the extensive damage to the Florida citrus corp,
California citrus products are commanding their highest prices ever.”
Which of the following statements best explains the economics of the quotation?
a The supply of Florida oranges has increased, causing their price to

increase and the demand for the substitute California oranges to also
increase.
b. The supply of Florida oranges has decreased, causing the demand for
California oranges to increase and their prices to rise.
c. The demand for Florida oranges has been reduced by the hurricanes,
causing a greater demand for the California oranges and an increase in
their price.
d. The demand for Florida oranges has been reduced causing their prices to
fall and therefore increasing the demand for the substitute California
oranges.
5. Suppose that a new, influential research study proves conclusively that cigarette
smoking causes cancer in a way that causes people to start to pay more attention
to the warning that "cigarette smoking is injurious to health." At the same time,
suppose that new restrictions on the use of fertilizer dramatically raise tobacco
production costs. Using conventional supply and demand analysis, one would
expect the combined effect of these changes on the cigarette market to be:
a. an increase in equilibrium price, with the change in equilibrium quantity

uncertain
b. a decrease in equilibrium price, with the change in equilibrium quantity
uncertain.
c. an increase in equilibrium quantity, with the change in equilibrium price
uncertain.
d. a decrease in equilibrium quantity, with the change in equilibrium price
uncertain.
Spring 2006 Problem Set #5
153
1. Chez What has recently opened a stand between the Commons and the School of
Business. They sell mostly breakfast items, particularly coffee, and croissants. The
operators are particularly concerned about the demand for croissants. In an effort to
assess the wisdom of their pricing strategy, they asked an economist client to estimate the
demand for croissants sold at Chez What. He came with the following information.
Q = 102-2P - 10Pc + 15Pa
Where P = the price of croissants, Pc = the price of coffee sold at Chez What, and Pa = the
price of coffee sold at the nearby Alpine bagel bakery
a. Suppose that the price of coffee at Chez What is $1 and that the price of coffee at the
Alpine Bagel Bakery is $2 per cup. Calculate the inverse demand curve (e.g., express
price as a function of quantity).
Demand: __________________________________
Inverse demand _________________________________
For parts b and c assume that the price of croissants is $1.
b. Calculate the point price elasticity of demand. Would Chez What increase profits by
Raising the price of croissants?
 ___________________________________
Raise Price? ___________________________________
c. Calculate the cross price elasticity of demand for croissants with respect to the price of
coffee. How is coffee related to croissants? Why?
XY ___________________________________
Relationship ________________________
154
2. Joe is evaluating the marketing strategy at his restaurant and inn. Suppose that in
response to a $2.00 off" sales promotion for Spaghetti dinners, Joe finds that nightly
dinner sales increase from 20 per night to 40. Normally, the dinners sell for $6.00.
a. What is the arc price elasticity of demand?
 = __________________________
b. Would Joe increase revenues by further reducing the price? What about
profits? Explain.
Price reduction prompts revenue increase Y / N / Can’t tell

Price reduction prompts profit increase Y / N / Can’t tell
Explanation _____________________________________________
3. Fred McCutchen a new employee at McCutchoni Frozen Foods estimates that the price
elasticity of demand for McCutchoni Frozen Pizzas to be -1.5, as compared to a price
elasticity of demand for frozen pizzas in general of -2.34. In light of the relative
inelasticity of McCutchoni Frozen Pizza's, Fred recommends raising the price to increase
sales revenues. You, a more experienced member of the firm, are suspicious of Joe's
estimate, and are skeptical of his recommended plan of action? Why? (Hint: Think about
the determinants of price elasticity of demand)
Reason to suspect Fred’s

estimate______________________________________________
Reason to doubt Fred’s plan of action _________________________________________
E303, Problem Set #5
1. Chez What has recently opened a stand between the Commons and the School of
Business. They sell mostly breakfast items, particularly coffee, and croissants. The
operators are particularly concerned about the demand for croissants. In an effort to
assess the wisdom of their pricing strategy, they asked an economist client to estimate the
demand for croissants sold at Chez What. He came with the following information.
Q = 102-2P - 10Pc + 15Pa
155
Where P = the price of croissants, Pc = the price of coffee sold at Chez What, and Pa =
the price of coffee sold at the nearby Alpine bagel bakery
a. Suppose that the price of coffee at Chez What is $1 and that the price of coffee at the
Alpine Bagel Bakery is $2 per cup. Calculate the inverse demand curve (e.g., express
price as a function of quantity).
Demand: Q = 102 – 2P – 10(1) + 15(2)

= 102 – 2P +20
= 122 – 2P
Inverse demand ____P = 61 - .5Q________________________
For parts b and c assume that the price of croissants is $1.
b. Calculate the point price elasticity of demand. Would Chez What increase profits by
Raising the price of croissants? ?
 ____dQ/dP (P/Q)___= -2(1)/120 = -.0167__________
Raise Price? ______Yes, the firm is on the inelastic portion of demand.
c. Calculate the cross price elasticity of demand for croissants with respect to the price of
coffee (at Chez What). How is coffee related to croissants? Why?
XY dQ/dPc (Pc/Q) = -10(1)/120_= -.0813___________
Relationship __Complements: Inverse relationship_________________
156
2. Joe is evaluating the marketing strategy at his restaurant and inn. Suppose that in
response to a $2.00 off" sales promotion for Spaghetti dinners, Joe finds that nightly
dinner sales increase from 20 per night to 40. Normally, the dinners sell for $6.00.
b. What is the arc price elasticity of demand?
 = _ (Q1-Q0)(P1+P0) = (20 – 40)(6+4) = -20(10) = -1.67

(P1-P0)(Q1+Q0) (4 – 6)(20+40) 120
b. Would Joe increase revenues by further reducing the price? What about profits?
Explain.
Price reduction prompts revenue increase Y / N / Can’t tell

Price reduction prompts profit increase Y / N / Can’t tell
Explanation Joe is on the elastic portion of demand. A price reduction will

increase revenues. However, the profitability of such an action cannot be discerned
absent cost information
3. Fred McCutchen a new employee at McCutchoni Frozen Foods estimates that the price
elasticity of demand for McCutchoni Frozen Pizzas to be -1.5, as compared to a price
elasticity of demand for frozen pizzas in general of -2.34. In light of the relative
inelasticity of McCutchoni Frozen Pizza's, Fred recommends raising the price to increase
sales revenues. You, a more experienced member of the firm, are suspicious of Joe's
estimate, and are skeptical of his recommended plan of action? Why? (Hint: Think about
the determinants of price elasticity of demand)
Reason to suspect Fred’s estimate: Elasticity for a group should be lower than for a
particular product in that group
Reason to doubt Fred’s plan of action: If McCutchoni is on the elastic portion of

demand, a price increase will reduce revenues.
E303, Problem Set #6
1. We-R-Food's, a restaurant consulting firm estimates that in the Southeastern United

States a 10% reduction in the price of fried potatoes will increase sandwich sales by 20%.
But they further estimate that a 10% reduction in the price of salads will decrease
sandwich sales by 15%.
157
a. What is the implied cross price elasticity of sandwiches with respect to changes in the
price of fried potatoes?
sandwiches ff = _________________________________________
b. What is the implied cross price elasticity of sandwiches with respect to changes in the
price of. salads?
sandwiches salads = _________________________________________
c. From your cross price elasticity estimates, what can you say about the relationship
between fried potatoes and sandwiches, and between salads and sandwiches at fast food
restaurants in the Southeastern United States? Why?
French fries and Sandwiches_______________________________
Reason ________________________________________________
Salads and Sandwiches_______________________________
Reason ________________________________________________
2. Suppose that for Mazda Miata's, the income elasticity I = 3.

a. What does the above information suggest about the kind of product a Mazda Miata is?
Why?
Kind of Product _______________________________
Reason ________________________________________________
b. Economists predict a strong rebound in economic performance this year, and predict
that
GNP will grow by 4%. What effect will this have on Miata sales?
Estimated percentage change in sales _______________________________

3. The demand for Sorby ZIP disks is given by the following equation
Q = 10P-3PH1.5I2.
158
Where P is the price of the ZIP disks
PH is the price of Hard disk drive space, and
I is income (in thousands of dollars)
a. What is the price elasticity of demand?
 = _______________________________
b. What is the income elasticity of demand? What does the income elasticity of demand
suggest about the kind of good Sorby disks are?
I = ______________________________
Kind of Good _____________________________________________.
c. Suppose that due to a recession in the market for information goods income for ZIP
disk users is projected to fall by 4% next year. How will sales be affected?
I = ____________________________________________________
Problem Set #6
1. We-R-Food's, a restaurant consulting firm estimates that in the Southeastern United

States a 10% reduction in the price of fried potatoes will increase sandwich sales by 20%.
But they further estimate that a 10% reduction in the price of salads will decrease
sandwich sales by 15%.
a. What is the implied cross price elasticity of sandwiches with respect to changes in the
price of fried potatoes?
sandwiches ff = __%Qs/%Pff = -20/10 = -

2______________________________________
159
b. What is the implied cross price elasticity of sandwiches with respect to changes in the
price of. salads?
sandwiches salads = _%Qs/%Psalads = -15/-10 = 1.5
c. From your cross price elasticity estimates, what can you say about the relationship
between fried potatoes and sandwiches, and between salads and sandwiches at fast food
restaurants in the Southeastern United States? Why?
French fries and Sandwiches___Complements, ________________________
Reason __xy<0_________________________________________________
Salads and Sandwiches__Substitutes_____________________________
Reason __xy>0______________________________________________
2. Suppose that for Mazda Miata's, the income elasticity I = 3.

a. What does the above information suggest about the kind of product a Mazda Miata is?
Why?
Kind of Product __Normal Cyclical Good_________________________
Reason __I>1_____________________________________________
b. Economists predict a strong rebound in economic performance this year, and predict
that
GNP will grow by 4%. What effect will this have on Miata sales?
Estimated percentage change in sales __ =%Q/%I thus, 3 = %Q/4 %Q = 12%
3. The demand for Sorby ZIP disks is given by the following equation
Q = 10P-3PH1.5I2.
Where P is the price of the ZIP disks
PH is the price of Hard disk drive space, and
I is income (in thousands of dollars)
a. What is the price elasticity of demand?
160
 = __-3_____________________________
b. What is the income elasticity of demand? What does the income elasticity of demand
suggest about the kind of good Sorby disks are?
I = ___2.___________________________
Kind of Good ____Normal, cyclical__________________.
c. Suppose that due to a recession in the market for information goods income for ZIP
disk users is projected to fall by 4% next year. How will sales be affected?
I = _%Q/%I. Thus, 2 = %Q/-4, %Q=-8
Problem Set #7
Regression Analysis
Consider the following data

Sales Adv
Yi Xi
3 1
4 2
6 3
5 4
7 5
6 6
5 7
9 8
10 9
9 10
1. Input this data on a spreadsheet. Using the regression option, generate regression
predictions. Write your results as an equation, as we did in class. In particular,
(a) Write the regression equation, with estimated coefficients,
161
(b) Below the regression equation, list in parentheses the standard errors of the coefficient
estimates
(c) To the right of the estimated equation write R2 =
^
Equation: ____Y_=___________________________________ R2 =
Std Errors ( ) ( )
2. Multivariate Regression. Now add to your above regression in a price variable, with
values: 8, 7.5, 7.25, 7.25, 6, 6.75, 6, 5, 4.4, 5.2. Estimate the new regression equation.
Print regression results. Write out the estimated demand function, as in 1 above.
Equation: ____Y_=___________________________________ R2 =
Std Errors ( )( )( )
3. Evaluating regression results: A Descriptive Statistic. With the data you generated
in (2) above do the following.
a. Interpret the R2. (In a sentence)
__________________________________________________________________
b. At an approximate 95% level of confidence, can you conclude that price affects
sales? Explain
Price Affects Sales? Y/N (circle one)
Reason: ____________________________________________________
Problem Set #7 Regression Analysis
Consider the following data

Sales Adv
162
Yi Xi
3 1
4 2
6 3
5 4
7 5
6 6
5 7
9 8
10 9
9 10
1. Input this data on a spreadsheet. Using the regression option, generate regression
predictions. Write your results as an equation, as we did in class. In particular,
(a) Write the regression equation, with estimated coefficients,
(b) Below the regression equation, list in parentheses the standard errors of the coefficient
estimates
(c) To the right of the estimated equation write R2 =
^
Equation: ____Y_=___2.733____+ 0.667Xi__________________ R2 = .757
Std Errors (0.827 ) ( 0.133 )
163
2. Multivariate Regression. Now add to your above regression in a price variable, with
values: 8, 7.5, 7.25, 7.25, 6, 6.75, 6, 5, 4.4, 5.2. Estimate the new regression equation.
Print regression results. Write out the estimated demand function, as in 1 above.
Equation: ____Y_=__17.68_ + 0.005 – 1.78 _______________________ R2 = 0.868

Std Errors ( 6.19) (0.133 ) ( 0.734)
3. Evaluating regression results: A Descriptive Statistic. With the data you generated
in (2) above do the following.
a. Interpret the R2. (In a sentence)
86.8% of the movement in the sales is explained by movements in price and

advertising.
__________________________________________________________________
b. At an approximate 95% level of confidence, can you conclude that price affects
sales? Explain.
Price Affects Sales? Y/N (circle one)
Reason: The interval about price, -3.52 to -0.048 doesn’t include 0.
Problem Set 8. E303

Davis, Spring, 2006.
1. Bill Smith is the new Director of Marketing at the Jonesfield Ham Company. In the
interest of assessing Jonesfield’s pricing policy, Bill examined sales data for the last 24
months, and estimated the following relationship
Q = 125 - 14P + 5Ps + 4I

(15) (2.8) (3.2) (3.6)
R2 = .71, MSE = 2.75
Where Q number of sugar cured hams sold in the Richmond area per month
P price per pound of the hams
Ps price per point of Smithfield salt-cured country hams
I Per capita income (in thousands of dollars.)
164
Assume that at present P = $3.50; Ps = $5.00, I = $12 (000).
1. Construct an approximate 95% confidence interval about the price variable. Does this
suggest that price is an important explainor of sales? Why or why not?
Interval ______________ to _____________
Price an important explainor of sales? Y / N. (circle one)
Explanation
__________________________________________________________________.
2. Construct an approximate 95% confidence interval about the income variable. Does
this suggest that income is an important explainor of sales? Why or why not?
Interval ______________ to _____________
Income an important explainor of sales? Y / N. (circle one)
Explanation
__________________________________________________________________.
3. Assume your answer to 2 was no. Should you eliminate the income variable from your
regression?
Eliminate? Y / N (circle one)
Explanation
__________________________________________________________________.
165
4. Using current values (e. g., P = $3.50; Ps = $5.00, I = $12 (000).)
a) forecast sales for the next month.
Forecast ______________
b) Provide an approximate 95% confidence band about your projection.
Interval ______________ to _____________
c) Aside from the width of the interval, what factor would tend to make you less
confident of your projection? Why?
Factors :_______________________
________________________
Reason that they would undermine your confidence in the forecast
________________________________________________________________________
Problem Set 8. E303 KEY

Davis, Spring, 2006.
1. Bill Smith is the new Director of Marketing at the Jonesfield Ham Company. In the
interest of assessing Jonesfield’s pricing policy, Bill examined sales data for the last 24
months, and estimated the following relationship
Q = 125 - 14P + 5Ps + 4I

(15) (2.8) (3.2) (3.6)
R2 = .71, MSE = 2.75
Where Q number of sugar cured hams sold in the Richmond area per month
P price per pound of the hams
Ps price per point of Smithfield salt-cured country hams
166
I Per capita income (in thousands of dollars.)
Assume that at present P = $3.50; Ps = $5.00, I = $12 (000).
1. Construct an approximate 95% confidence interval about the price variable. Does this
suggest that price is an important explainor of sales? Why or why not?
14 + 2(2.8) to 14 – 2(2.8)
19.6 to 8.4
Yes, price is an important explainor of sales. The interval does not include 0.
2. Construct an approximate 95% confidence interval about the income variable. Does
this suggest that income is an important explainor of sales? Why or why not?
4 + 2(3.6) to 4 – 2(3.6)
11.2 to -3.2
No, I cannot conclude that income is an important explainor of sales. The interval
includes 0.
3. Assume your answer to 2 was no. Should you eliminate the income variable from your
regression?
No. Eliminating relevant variables can create bias.
167
4. Using current values
a) forecast sales for the next month.
Q = 125 - 14(3.5) + 5(5) + 4(12)

= 125 – 49 + 25 + 48
= 149
b) Provide an approximate 95% confidence band about your projection.
149 + 2(2.75) to 149 – 2(2.75)

154.5 to 143.5
c) What would tend to make you less confident of your projection? Why?
Factors that make the future look different from the past, such as
- Independent variable values that deviate from their means
- Some probability of a change in the underlying legal or social environment
These factors are not included in the estimates
Fall 2005 KEY

1. Optimal Use of a Single Input. Julian Smyth is manages production at Taffy
Apple Inc., a company that produces a variety of taffy/fruit candies. Over the last
several months, he has varied then number of employees on his caramel apple
production line, and found the following relationship.
Labor TP MP MRP
5 100
6 150 50 250
7 230 80 400
8 300 70 350
9 360 60 300
10 410 50 250
11 450 40 200
12 480 30 150
a. In the column labeled MP, calculate the marginal product of labor. (Note,
make your first entry in row 6, as the change between 5 and 6 units of labor)
See listings under MP
168
b. Suppose the apples sell for $5 per (dozen) box. Calculate the Marginal
Revenue Product (MRP)
See listing under MRP
c. If labor costs $225 per day, how many laborers should the firm hire?
Number ______10___________________________________
169
2. Optimal Use of a Single Input. A Graphical Representation.
a. In the coordinate axes provided below, illustrate the general relationship
between MRP and the Price of Labor. Identify the equilibrium quantity of
labor to hire. (Note, your graph need not use the numbers in problem 3.
Just be certain to include ranges that illustrate gains from specialization
and the law of diminishing returns in your graph.
$
PL
MRP
L* Q
b. Suppose that the candy workers union agrees to way concessions, that
make the price of labor fall. In the coordinate axes below illustrate the
effect on the equilibrium quantity of labor
PL’
PL
L*’ L* Q
c. Finally, suppose that the price of caramel apples increases. Illustrate the
effect of this change on the equilibrium quantity of labor employed.
MRP*
MRP
L* L*’ Q
170
3. Optimal use of multiple inputs. In his shop, Julian Valenti retrofits sunroofs
into automobiles. The process can use a combination of skilled labor and
unskilled labor. Given his current mix of employees, the marginal product of the
last unit of skilled labor is 3 sunroofs per day, and the marginal product of the last
unit of unskilled labor is 1 sunroof per day. Current market rates for skilled and
unskilled labor is $40 and $10, respectively. Is Julian using a least cost
combination of inputs? If not, which of type of labor should he use relatively
more?
Comparison Expression: Compare __MPS/Ps_to MPU/PU_here 3/40 vs. 1/10___
Result:_Hire relatively more unskilled labor_________________________
Problem Set #9
Spring 2006
1. Optimal Use of a Single Input. Julian Smyth is manages production at Taffy

Apple Inc., a company that produces a variety of taffy/fruit candies. Over the last
several months, he has varied then number of employees on his caramel apple
production line, and found the following relationship.
Labor TP MP MRP
5 100
6 150 50 250
7 230 80 400
8 300 70 350
9 360 60 300
10 410 50 250
11 450 40 200
12 480 30 150
d. In the column labeled MP, calculate the marginal product of labor. (Note,
make your first entry in row 6, as the change between 5 and 6 units of labor)
e. Suppose the apples sell for $5 (per dozen) box. Calculate the Marginal
Revenue Product (MRP)
f. If labor costs $225 per day, how many laborers should the firm hire?
Number ___________________________________________
171
172
2. Optimal Use of a Single Input. A graphical representation.
a. In the coordinate axes provided below, illustrate the general relationship
between MRP and the Price of Labor. Identify the equilibrium quantity of
labor to hire. (Note, your graph need not use the numbers in problem 3.
Just be certain to include ranges that illustrate gains from specialization
and the law of diminishing returns in your graph.
$
b. Suppose that the candy workers union agrees to way concessions, that
make the price of labor fall. In the coordinate axes below illustrate the
effect on the equilibrium quantity of labor
Q
c. Finally, suppose that the price of caramel apples increases. Illustrate the
effect of this change on the equilibrium quantity of labor employed.
173
2. Optimal use of multiple inputs. In his shop, Julian Valenti retrofits sunroofs
into automobiles. The process can use a combination of skilled labor and
unskilled labor. Given his current mix of employees, the marginal product of the
last unit of skilled labor is 3 sunroofs per day, and the marginal product of the last
unit of unskilled labor is 1 sunroof per day. Current market rates for skilled and
unskilled labor are $40 and $10, respectively. Is Julian using a least cost
combination of inputs? If not, which of type of labor should he use relatively
more?
Comparison Expression:_______________________________________
Result:______________________________________________________
Problem Set #10

Costs of the Firm
1. Short run costs for the firm. Consider a firm with the following Fixed Costs and
Marginal Costs
0 15
1 3
2 2
3 1
4 2
5 5
6 9
7 14
8 20
a) Total Costs
a. Fill in the blanks for TVC and TC Construct a graph that illustrates the
TVC, TFC, and TC curves
b. On this graph, show how MC may be illustrated (at any arbitrary point)
b) Unit Costs
174
a. Fill in the blanks for AVC, AFC and ATC
b. Construct a graph that illustrates MC,AVC, and ATC
c. What is the relationship between AVC and ATC? Why?
Relationship _________________________
Reason: ____________________________.
d. What is the relationship between MC and AVC? MC and ATC? Why?
Relationship _______________________________
Reason: _________________________________
2. Production for a firm in the Short Run.

a. In general, how should the firm determine the optimal output level?
Rule:_________________.
b. Referring again to table 1, if the price is $10 per unit, how much should
the firm produce? Illustrate this result in your unit cost figure. Is the firm
earning economic profits at that level of output?
c. What is the minimum price at which the firm would produce? Why?
Shutdown point:_________________________________________
d. When does the firm breakeven? Why?
Breakeven point:____________________________________________.
Problem Set #10

Costs of the Firm
175
3. Short run costs for the firm. Consider a firm with the following Fixed Costs and
Marginal Costs

0.00 15.00 0.00 15.00
1.00 15.00 3.00 18.00 3.00 15.00 3.00 18.00
2.00 15.00 5.00 20.00 2.00 7.50 2.50 10.00
3.00 15.00 6.00 21.00 1.00 5.00 2.00 7.00
4.00 15.00 8.00 23.00 2.00 3.75 2.00 5.75
5.00 15.00 13.00 28.00 5.00 3.00 2.60 5.60
6.00 15.00 22.00 37.00 9.00 2.50 3.67 6.17
7.00 15.00 36.00 51.00 14.00 2.14 5.14 7.29
8.00 15.00 56.00 71.00 20.00 1.88 7.00 8.88
c) Total Costs
a. Fill in the blanks for TVC and TC Construct a graph that illustrates the
TVC, TFC, and TC curves
80.00
TC
70.00
60.00 TVC
50.00
MC
40.00
30.00
20.00 TFC
10.00
0.00
0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00
b. On this graph, show how MC may be illustrated (at any arbitrary point)
At any point, MC is the slope of the line tangent to the curve
d) Unit Costs
a. Fill in the blanks for AVC, AFC and ATC
See table above
176
b. Construct a graph that illustrates MC,AVC, and ATC
25
MC
20
15
ATC
10
AVC
5
0
0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00
c. What is the relationship between AVC and ATC? Why?
Relationship _The curves approach each other as quantity expands.
Reason: The difference between them is AFC
d. What is the relationship between MC and AVC? MC and ATC? Why?
Relationship MC cuts both AVC and ATC at their minimum points
Reason: The Marginal Drives the average
Production for a firm in the Short Run.
a. In general, how should the firm determine the optimal output level?
Rule:_Compare MR (price) to MC________________.
b. Referring again to table 1, if the price is $10 per unit, how much should
the firm produce? Illustrate this result in your unit cost figure. Is the firm
earning economic profits at that level of output?
The firm should produce 6 units. The firm is earning profits because at a price of $10 AR
(=P) exceeds ATC.
177
c. What is the minimum price at which the firm would produce? Why?
Shutdown point:_When price is such that P=MC = AVC. Here at an output of 4, (and
AVC=MC = 2
At prices below $2, the firm would not only lose it’s fixed costs, but it would also be
paying variable costs to produce
d. When does the firm breakeven? Why?
Breakeven point: When price is such that P = MC = ATC. At this point the firm just
covers all costs of operation.
Problem Set #11
1. Characterizing Cost Functions Analytically. Consider the Cost function
TC = 100 +10Q + Q2
a. What are the fixed costs for this relationship? What are Variable Costs?
Fixed Costs: ____100__________________________________
Variable Costs: _10Q + Q2 ________________________________
b. What is the marginal cost function?
Marginal Cost: ___10+2Q___________________________________
c. Identify Expressions for Average Variable and Average Total Cost
Average Variable Costs: __ 10+Q_________________________________
Average Total Costs: ____ 100/Q + 10 + Q________________________________
d. Finally, identify the output levels where AVC and ATC are minimized.
178
AVC min: ___0___________________________________
100/Q + 10 + Q = 10 + 2Q
100/Q = Q
ATC min: _Q = 10_________________________________
2. Sunk Cost vs. Fixed Cost: Radio broadcaster CoolPlay Inc., paid $50,000 for an
operating license last year, and the company is not meeting its advertising revenue
expectations. Currently, they company is taking in $6,000 per month in revenues and has
$5,000 per month in variable expenses. What difference does it make to CoolPlay if the
license is transferable (e.g., resalable) or not? Under which condition would CoolPlay
remain in the market longer (resalable or not resalable?)
Difference ___If the license is nontransferable, it is a sunk costs.
Condition Under Which CoolPlay will remain in the market longer?
Saleable/ Not Resalable (Circle one)
179
3. Long Run Costs for the Firm. Consider the following long run cost curve.
25
MES a. On the figure to the left,
20 identify the range of the LRAC
LRAC where the firm enjoys
15
economics of scale What
10 factors might allow a firm to
enjoy economies of scale?
5
Economies of Scale Diseconomies of Scale
0
0 2 4 6 8 10
Reasons for scale economies: __Gains from specialization. Physical relationships
b. Identify the range of the LRAC where the firm suffers diseconomies of scale. What
factors would result in diseconomies of scale
Reasons for diseconomies of scale: Transportation Costs, Managerial Inefficiency
(‘Crowding’)
c. What is MES on the above figure? Suppose that at an average cost of $10 per unit
demand is such that the industry could sell 40 units. What is the maximum number of
firms that are sustainable in this market? Why?
Maximum number of sustainable firms: __If MES is 4, the industry could suppose 10
firms (students might see MES at 3 units as well.) Firms must operate at MES to
efficiently survive.
4. Returns to Scale. Jake’s Free Runoff Bottled Water Company Produces with the
Long Run Production Function
Q = (KL)2/3
Currently K = 4 and L = 4. If Jake’s doubles inputs to K=8 and L=8, will it realize
increasing, constant or decreasing returns to scale (circle one)?
As a result, does Jake’s enjoy economies of scale, diseconomies of scale, or does Jake’s
appear t be operating at Efficient Scale? (circle one)
180
Problem Set #12
1. Multi-Product Production. Consider the following cost relationship for a

firm that can produce 2 products, Q1 and Q2.
C(Q1, Q2) = 300 + 5Q1 + 5Q2 + Q1Q2
a. Does the firm exhibit cost complementarities? Explain.
Cost Complementarities? (Y / N) __________________________
b. At an output level Q1 = 20 and Q2 = 20 does the firm exhibit economies of

scope?
Explain
Economies of Scope? (Y/ N) Justification: ____________________________
2. Input Acquisition. The Roasted Pepper Pizza Company features roasted fresh
peppers and goat cheese on its Mediterranean Style Pizzas. The local company
purchases 200 pounds of fresh peppers 250 pounds of goat cheese from a local
Grocery wholesaler each day at the market price.
a. What kind acquisition is this? (Circle One)
Spot Market Purchase, Contract or Vertical Integration
b. What features of this transaction suggest that a contractual arrangement

might be a good idea? What problem would a contract alleviate?
_________________________________________________________
_________________________________________________________
181
3. Compensation Issues. Stevens Cards produces and sells a low-volume high-end
holiday cards. The company is particularly well-known for the elegant poems
printed on the inside of the cards. At present the company compensates poets on
a per-poem basis. On the other hand, company executives, disguised as
customers monitors sales people, who are paid an hourly fee.
a. How might the company alter its compensation package for the poets to
improve firm performance? Why would such an alteration help?
Alteration:_______________________________________________
Why the alteration may help:________________________________
________________________________________________________
b. How might the company alter its compensation for sales-people to

improve firm performance?
Alteration:_______________________________________________
Why the alteration may help:________________________________
_________________________________________________________
182
Homework Problem Set #13 NEW
E303 Davis, Spring 2006
1. The Competitive Firm in the Intermediate Run.

a. In the two coordinate axes below, illustrate the relationship between
market supply and demand and optimizing decisions of a firm. Illustrate a
situation where the firm is earning economic profits.
P P
Market Q Firm Q
b. What dynamic tends to drive profits to zero? Illustrate this dynamic in the
same graph.
Dynamic:________________________________________________________
2. Finding the Competitive Price. Consider a firm with a TC function
TC = 49 + 7Q + Q2
What price would this firm charge if it was in a long run competitive
equilibrium? What Profits would it earn? Why?
Optimal Price _________________________________________________
Optimal Profits ________________________________________________
Reason: _______________________________________________________
_____________________________________________________________
183
3. The Competitive Firm in the Long Run. In the 1990’s many firms went through a
period of ‘downsizing’ that was induced by technological developments (in large
part, the computer spreadsheet).
a. In the right most panel of the two-panel graph below, illustrate the ‘carrot’
and the ‘stick’ that drives firms to ‘downsize’.
P P
Market Q Firm Q
b. Illustrate the market response to downsizing in the rightmost panel of the

above figure.
c. Explain how the market price can fall as firms reduce their scale of
operation.
Explanation___________________________________________________
Homework Problem Set #13 NEW

E303 Davis, Spring 2006
4. The Competitive Firm in the Intermediate Run.

a. In the two coordinate axes below, illustrate the relationship between
market supply and demand and optimizing decisions of a firm. Illustrate a
situation where the firm is earning economic profits.
P P
MC
S
184
Profits
S’
(b) P=MR
ATC
(a)
D
Market Q Firm Q* Q
b. What dynamic tends to drive profits to zero? Illustrate this dynamic in the
same graph.
Dynamic:___Entry causes supply to shift out, which drives down prices and profits
5. Finding the Competitive Price. Consider a firm with a TC function
TC = 49 + 7Q + Q2
What price would this firm charge if it was in a long run competitive
equilibrium? What Profits would it earn? Why?
ATC = 49/Q + 7 + Q = MC = 7 + 2Q
Q=7
Optimal Price ________P = MC = 7 + 2(7) = 21________________
Optimal Profits  = 0 _______________________________________
Reason: __In an intermediate run competitive equilibrium entry and exit drive, P = ATC.
185
6. The Competitive Firm in the Long Run. In the 1990’s many firms went through a
period of ‘downsizing’ that was induced by technological developments (in large
part, the computer spreadsheet).
a. In the right most panel of the two-panel graph below, illustrate the ‘carrot’
and the ‘stick’ that drives firms to ‘downsize’.
P P
S1
MC1 ATC1
MC2 ATC2
S1 Profit (Carrot)
Market Q Firm Q
b. Illustrate the market response to downsizing in the rightmost panel of the

above figure.
Market supply will shift out.
c. Explain how the market price can fall as firms reduce their scale of
operation.
Explanation__ Entry will occur _________________________________________
Homework Problem Set #14

E303
Davis, Spring 2006
7. Monopoly Pricing. A Graphical Analysis. The two panel graph below illustrates
the relation between market forces and optimizing decisions for a firm in the
canned peaches market, a competitive industry.
a. In the rightmost panel illustrate the optimal output, price and profit levels
for the competitive firm.
186
S MC ATC
D
Market Q Firm Q* Q
b. Suppose that due to concerns regarding the paucity of domestic peach

producers the government gives to USAPeaches Inc. an exclusive right to
domestically produce and sell canned peaches. Circle the components in
the competitive chart that you would use to generate predictions for the
monopolist.
c. In the coordinate axis below, identify the optimal monopoly output,

monopoly price and monopoly profits. Compare these predictions to the
price and profit conditions for the firm as a competitor that you developed
in part a..
Q
Comparing Monopoly to Competitor. In each case, circle the one that is greater.
Output: Monopolist / Competitor _______________________________________
Price:__ Monopolist / Competitor _______________________________________
Profit: __ Monopolist / Competitor _______________________________________
187
8. Monopoly Pricing. An Analytical Example. Consider a firm with the demand
curve P = 500 – Q and a cost function TC = 2500 + 4Q2.
a. What is the marginal revenue function for this firm?
MR_________________________________________________________________
b. Intuitively, why is marginal revenue more steeply sloped than demand

(average revenue?)
Reason for Steeper MR Slope:____________________________________________
____________________________________________________________________
c. Identify the optimal level of output, price and profits for this firm.
Qm ________________ Pm__________________  m_____________________
d. Were this firm a member of a competitive industry, what would be the

quantity, price and profit level for the firm?
Qc _________________ Pc___________________  c_____________________
188
9. Monopolistic Competition. Schliezal Hickendorfer operates a small restaurant in
the fan that specializes in German/Chinese Cuisine. The market is
monopolistically competitive. The below demand and cost conditions illustrate
current market conditions for Schliezal.
MC
ATC
a. Identify short run output, price and profit conditions for Schiezal.
b. Why doesn’t the outcome in a define a long run equilibrium? What will
alter these predictions?
Change: __________________________________
c. Illustrate Schliezal’s long run competitive equilibrium output, price and

profits.
Problem Set #14

E303
Davis, Spring 2006
189
10. Monopoly Pricing. A Graphical Analysis. The two panel graph below illustrates
the relation between market forces and optimizing decisions for a firm in the
canned peaches market, a competitive industry.
a. In the rightmost panel illustrate the optimal output, price and profit levels
for the competitive firm.
P
S MC ATC
Pc P*
c =0
D
Market Q Firm Q* Q
b. Suppose that due to concerns regarding the paucity of domestic peach

producers the government gives to USAPeaches Inc. an exclusive right to
domestically produce and sell canned peaches. Circle the components in
the competitive chart that you would use to generate predictions for the
monopolist.
c. In the coordinate axis below, identify the optimal monopoly output,

monopoly price and monopoly profits. Compare these predictions to the
price and profit conditions for the firm as a competitor that you developed
in part a..
P
Monopoly Profit
MC
Pm ATC
D
MR
Qm Firm Q
Comparing Monopoly to Competitor. In each case, circle the one that is greater.
Output: Monopolist / Competitor _______________________________________
190
Price:__ Monopolist / Competitor _______________________________________
Profit: __ Monopolist / Competitor _______________________________________
11. Monopoly Pricing. An Analytical Example. Consider a firm with the demand
curve P = 500 – Q and a cost function TC = 2500 + 4Q2.
a. What is the marginal revenue function for this firm?
MR____500 – 2Q_________________________________________________
b. Intuitively, why is marginal revenue more steeply sloped than demand

(average revenue?)
Reason for Steeper MR Slope:_To sell more units the firm must reduce the price on unit
that would have sold at a higher price
c. Identify the optimal level of output, price and profits for this firm.
MR = MC P = 500 –Q  = TR - TC
500 – 2Q = 8Q = 500 – 50 = 450(50) – [2500 + 4(50)2]
10Q = 500 = 450 = 10,000
Q = 50
Qm __50_________ Pm___450_________  m___10,000__________
d. Were this firm a member of a competitive industry, what would be the

quantity, price and profit level for the firm?
MC = ATC P = MC = ATC
8Q =2500/Q +4 Q 2
Q = 625 = 8(25)
4Q2 = 2500 Q = 25 = 200
Qc _=25__________ Pc___200___________  c__=0___________
191
12. Monopolistic Competition. Schliezal Hickendorfer operates a small restaurant in
the fan that specializes in German/Chinese Cuisine. The market is
monopolistically competitive. The below demand and cost conditions illustrate
current market conditions for Schliezal.
P
Profits
MC
ATC
Pmc
D
MR
Qm Firm Q
a. Identify short run output, price and profit conditions for Schiezal.
See above
b. Why doesn’t the outcome in a define a long run equilibrium? What will
alter these predictions?
Change: Entry will shift in residual demand.
c. Illustrate Schliezal’s long run competitive equilibrium.
P
Profit =0
MC
ATC
Pm
D
MR
m
Q Firm Q
Problem Set #15
192
13. Joe Holiday is a monopoly provider of Fishing Reels in a remote fishing village
on a barrier island off the Gulf Coast. Currently he is selling is BassMaster reels
for $50 each. Joe doesn’t know the precise demand function for fishing reels, but
he estimates price elasticity of demand to be -2. If the reels cost Joe $30 each, is
he maximizing profits? If not, what would be the profit maximizing price?
Is $50 a profit maximizing price? Y/N (circle one)
Profit Maximizing Price_____________________________________
14. Consider the inverse demand relationship P = 21-Q. The total cost function is TC
= 50 – Q.
a. What is the optimal price, quantity and maximum profits available to the
seller, if the seller can post only a single price to all consumers?
Optimal Price_______________________
Optimal Profits ______________________
b) Illustrate in the coordinate axes provided below the maximal profits available to this
seller, if the seller is forced to post a single price.
193
15. Now suppose that the seller is free to post consider post different prices to each
different consumer.
a) Identify the profit maximizing quantity and maximal profits for the seller under
these circumstances.
Maximum Profits with Perfect Price Discrimination______________
b) Shade in the appropriate area in the figure below.
c) What are the two conditions must be satisfied in order for a seller to realize
maximum profits with perfect price discrimination? Why is each condition
necessary?
Condition 1: _____________________________
Condition 2:_____________________________
194
16. Consider again the demand relationships in (2) and (3) above, but suppose that the
demand relationship was for a single consumer who was considering joining a
health club. Describe the membership and acess fee structure that would optimize
profits. (Be explicit)
Membership Price: ____________________
Access Fee: __________________________
17. Suppose that Handsome Joe Hedley needs a new summer suit. He is willing to
pay up to $300 for a first linen suit, and $200 for a second. If suits cost Smith &
Co. Fine Clothiers $100 each, identify the sales quantity from setting price equal
to $300 and $200 what pricing structure would maximize profits?
Quantity Profits
Price $300:
Price $200
How might Smith use Second Degree price discrimination to increase profits? What
are the maximum profits available?
Pricing Strategy: ___________________________________
_________________________________________________
Maximum Profits: __________________________________
_________________________________________________
18. Suppose that an airline can divide travelers into economy class and business class.
The price elasticity of demand for the business class is -1.5, and for the economy
class is -3. If the marginal cost of a seat on an flight from Richmond to New
York is $20, what are the optimal prices for each group?
Business Class__________________________________
Economy Class__________________________________
195
Homework Problem Set #15 KEY
19. Joe Holiday is a monopoly provider of Fishing Reels in a remote fishing village
on a barrier island off the Gulf Coast. Currently he is selling is BassMaster reels
for $50 each. Joe doesn’t know the precise demand function for fishing reels, but
he estimates price elasticity of demand to be -2. If the reels cost Joe $30 each, is
he maximizing profits? If not, what would be the profit maximizing price?
Is $50 a profit maximizing price? Y/N (circle one)
Profit Maximizing Price_______P = MC/(1+1/) = 30/(1-1/2) = 60
20. Consider the inverse demand relationship P = 21-Q. The total cost function is TC
= 50 – Q.
a. What is the optimal price, quantity and maximum profits available to the
seller, if the seller can post only a single price to all consumers?
MR = 21-2Q = 1 implies that Q = 10, so P = 21-10 = 11 and profits are

($11(10) – [50-$1(10)] = $55.
Optimal Price______11_______________
Optimal Profits ____50________________
b) Illustrate in the coordinate axes provided below the maximal profits available to this
seller, if the seller is forced to post a single price.
$6
$1
5 Q
196
21. Now suppose that the seller is free to post consider post different prices to each
different consumer.
a) Identify the profit maximizing quantity and maximal profits for the seller under
these circumstances.
The firm would charge a different price to each consumer equal to their marginal
valuation. Profits would equal .5(21-1)(20) = 200
Maximum Profits with Perfect Price Discrimination_$150 (take out fixed cost)
b) Shade in the appropriate area in the figure below.
P
11
10 Q
c) What are the two conditions must be satisfied in order for a seller to realize
maximum profits with perfect price discrimination? Why is each condition
necessary?
Condition 1: - No resales: Low value sellers will drive price down via
resales
Condition 2:- Ability to size up willingness to pay______________.
197
22. Consider again the demand relationships in (2) and (3) above, but suppose that the
demand relationship was for a single consumer who was considering joining a
health club. Describe the membership and access fee structure that would
optimize profits. (Be explicit)
Membership Price: $200 (equal to consumer surplus)
Access Fee: $1 per unit (marginal cost).
23. Suppose that Handsome Joe Hedley needs a new summer suit. He is willing to
pay up to $300 for a first linen suit, and $200 for a second. If suits cost Smith &
Co. Fine Clothiers $100 each, identify the sales quantity from setting price equal
to $300 and $200 what pricing structure would maximize profits?
Quantity Profits
Price $300: 1 $200
Price $200 2 $200
How might Smith use Second Degree price discrimination to increase profits? What
are the maximum profits available?
Pricing Strategy: Charge a high price for a first suit, but then a lower price for
additional suits.
Maximum Profits: Charging $300 for the first suit and $200 for the second, Smith
earns $300.
24. Suppose that an airline can divide travelers into economy class and business class.
The price elasticity of demand for the business class is -1.5, and for the economy
class is -3. If the marginal cost of a seat on an flight from Richmond to New
York is $20, what are the optimal prices for each group?
P1 = 20/[1+1/-1.5] 60
P2 = 20/[1+1/-3] 30
198
199

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CyryxCollege, Maldvies

Lecture 2 Notes Problem Set 1 Problem Set 1Key

Lecture 3 Notes Problem Set 2 Problem Set 2 Key

Lecture 7 Notes Problem Set 3 Problem Set 3 Key

Lecture 10 Notes Problem Set 4 Problem Set 4 Key

Lecture 13 Notes Problem Set 5 Problem Set 5 Key

Lecture 15 Notes Problem Set 6 Problem Set 6 Key

Test 1 Review Outline

Lecture 17 Notes Problem Set 7 Problem 7 Key

Lecture 21 Notes Problem Set 9 Problem 9 Key

Lecture 22 Notes Problem Set 10 Problem 10 Key

Lecture 23 Notes Problem Set 11 Problem 11 Key

Lecture 27 Notes Problem 12

Lecture 30 Notes Problem 13 NEW Problem 13 Key

Test 2 Review Outline

Lecture 33 Notes Problem 14 Problem 14 Key

Lecture 36 Problem 15 Problem 15 Key (CORRECTED)

Review Outline for Final Examination

I. Chapter 1. The Fundamentals of Managerial Economics

B. Components of Effective Decision Making

II. Chapter Market Forces: Demand and Supply

B. The Demand Side.

C. The Supply Side.

D. Equilibrium. Putting Supply and Demand Together

III. Quantitative Demand Analysis

A. Price Elasticity of Demand

B. Other Demand Elasticities

C. Elasticities and demand functions

D. Estimating Demand: Regression Analysis.

B. The Production Function

V. Chapter 6. The Organization of the Firm.

A. Overview and Motivation.

B. Optimal Methods of Obtaining Inputs

VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically

A. Introductory Comments on Chapter 7.

B. Strategies that yield higher profits

I. Chapter 1. The Fundamentals of Managerial Economics

B. Components of Effective Decision Making

B. The Demand Side.

C. The Supply Side.

D. Equilibrium. Putting Supply and Demand Together

III. Quantitative Demand Analysis

A. Price Elasticity of Demand

B. Other Demand Elasticities

C. Elasticities and demand functions

D. Estimating Demand: Regression Analysis.

B. The Production Function

V. Chapter 6. The Organization of the Firm.

A. Overview and Motivation.

B. Optimal Methods of Obtaining Inputs

VI. Chapter 8. Managing in Competitive, Monopolistic and Monopolistically

A. Introductory Comments on Chapter 7.

B. Strategies that yield higher profits

I. Chapter 1. The Fundamentals of Managerial Economics

B. Components of Effective Decision Making

A first topic involves defining the scope of the course:

2. The Manager. A person who directs resources to achieve a stated goal.

B. Effective Management from an Economic Perspective. Economic “tools” are

a. Having a well-defined objective in mind when making an allocative decision is

b. Also, it is necessary to evaluate the constraints available in the decision

a) The function of economic profits. Accounting profits are not an incorrect

b) The difficulty of collecting implicit cost information. In fact, it is relatively

I. Chapter 1. The Fundamentals of Managerial Economics