BusEc2 - 2013 Fundamental Concepts

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Business Economics
Topic 2: Some fundamental Economic
concepts
Associate Professor Sarath Divisekera
17/07/2013
Business Economics Dr Sarath
Divisekera 2
Lecture Outline
Some fundamental Economic Concepts
Marginal Principle
Marginal Analysis & Economic Optimisation
Basic rules of optimisation
Comments on calculus
Some Fundamental Economic
Concepts
Some Fundamental Economic
Concepts
Equilibrium Analysis
Economic Agents are
Epitomisers
Assumption of Rationality
Ceteris Paribus and Marginal
Analysis
Constrained Choices
17/07/2013 3 Business Economics Dr Sarath Divisekera
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Equilibrium Analysis Equilibrium Analysis
Equilibrium Defined.
A situation where there is no tendency for
change.
What do we mean by a stable equilibrium?
We frequently assume market are in
equilibrium.
Is this true? If not, why make the assumption?
Why do we make this assumption?
Induction/ changes/policy
Optimising Economic Agents Optimising Economic Agents
What does this mean?
Economic agents (i.e., households, firms,
managers, etc.) have an objective that
they are trying to optimise.
Individuals assumed to maximise utility.
For-profit firms maximise profits or
minimise costs.
Not-for-profits may maximise output
levels.
Economic Optimisation Economic Optimisation
This is the goal of Business Economics
Help Businesses/Managers make
optimal decisions
Once statistical functions are
estimated, they can be optimised.
We will eventually do this mathematically.
Start with graphical treatment
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An Example of Optimisation
17/07/2013 Business Economics Dr Sarath Divisekera 7
Graph of output and
profit
Possible Rule:
Expand output until
profits turn down.
Will need to be careful
to identify global
maximum.
quantity B
MAX
GLOBAL
MAX
profit
A
Rationality of Economic Agents Rationality of Economic Agents
Optimisers choose alternative that
gives the greatest expected net
benefits
Does being rational imply you cant
be wrong?
Suppose you guessed point A?
An Example of Optimisation An Example of Optimisation
Point A is local
max., but not
global max.
You may have
guessed wrong.
As long as A was
your best guess at
the time, it
represented a
rational choice.
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quantity B
MAX
GLOBAL
MAX
profit
A
Business Economics Dr Sarath Divisekera
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Economic Agents are Typically
Constrained
Economic Agents are Typically
Constrained
Resource constraints
Physical and Financial
Legal constraints & Time constraints
Some constraints are binding, others are not.
Example of binding constraint.
Example of non-binding constraint.
May need to include constraints in our
models.
Ceteris Paribus Ceteris Paribus
What does Ceteris Paribus mean and
why is it important?
Is the Ceteris Paribus condition met in
the real world?
Can do it conceptually, mathematically,
and statistically
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Business Economics A/P Sarath
Divisekera 12
Functional Relationships
Demand; quantity demanded as a function of price
per unit, Q = D(P)
Inverse demand; P = P(Q)
Revenue; dollars of revenue as a function of quantity
sold, TR = R(Q) = PQ = P(Q)Q
Cost; dollars of cost as a function of quantity
produced, TC = C(Q)
Profit; dollars of profit as a function of quantity, =
(Q) = P(Q)Q - C(Q)
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Why use Functions?
If we know the functional form associated
with the particular economic problem (say
for example, to find the profit maximising
output levels), we can easily find the
optimal solution.
This can be done either by enumeration
(i.e., by calculating the profits associated
with each output levels), using calculus
and/or Marginal Analysis
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Functional Relationships
Functional relationships can be displayed Three ways:
TABLES (when data is discretely given)
GRAPHS (2 or 3 dimensional, Cartesian axes)
FUNCTI ONS (symbolic and mathematical)
Functions of Interest: Revenue
Recall Profit = R - C, and R = P*Q
Note that the price at which we can sell the
product depends on the prevailing market
conditions and assume this relationship can be
expressed as
P = 170 - 20Q; So R = P*Q
R = P * Q = (170 - 20Q)*Q = 170Q - 20Q
2
We call this Revenue Function
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Functions of Interest - Cost Functions
Similarly assume that the mathematically the
relationship between the cost and the output
can be expressed as
C = 100 - 38Q - the Cost Function
Given revenue and cost functions we
derive the Profit Function
= R - C = (170Q - 20Q
2
) - (100 + 38Q)
= -100 +132Q 20Q
2
Presentation of Functional Relationships: An example Profit
= -100 +132Q 20Q
2
Recall that Profit depends on Q, so simply substitute
values for Q.
Q = 1; then, = -100 +132*(1) 20(1)
2
= 12
Q = 2; then, = -100 +132*(2) 20(2)
2
= 84
Q = 3; then, = -100 +132*(3) 20(3)
2
= 116
Q = 4; then, = -100 +132*(4) 20(4)
2
= 108
And so on..
Try the same with Revenue & Cost Functions
Presentation: Profit Function as a Table
Qquantit
y
Price
P = 170 -
20Q
Revenue
R = P*Q
R = 170Q -
20Q
2
Cost
C = 100 - 38Q
Profit
R-C
1 150 150 138 12
2 130 260 176 84
3 110 330 214 116
4 90 360 252 108
5 70 350 290 60
6 50 300 328 -28
7 30 210 366 -156
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7
150
100
50
0
-50
-100
-150
0 1 2 3 4 5 6 7 8
Total Profit (Thousands of Dollars)
2
Q 20 Q 132 100
Profit Function as a Graph
Q
Qquantit
y
Profit
1 12
2 84
3 116
4 108
5 60
6 -28
7 -156
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Decision Problems
How many Gadgets should we produce?
Using what input combinations?
How to price our Gadgets?
Should we expand our capacity?
How to protect our markets from erosion?
Should we invest in R&D? What projects?
How to assess and deal with uncertainties?
How to decide how much to produce?
Well, you are the CEO of the Gadgets
International (GI).
Naturally, you want to maximise profit
and your problem is to decide how much
to produce.
Assume at present the weekly production
is 2 units (1 unit of Q = 50,000).
Should GI increase, decrease, or leave unchanged
its weekly production of Gadgets?
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Finding the Maximum Output
Recall that if we know the functional form
associated with the particular economic
problem (say for example, to find the profit
maximising output levels), we can easily
find the optimal solution.
This can be done either by
(a)enumeration (i.e., by calculating the
profits associated with each output levels),
(b) using calculus and/or
Marginal Analysis
What is Marginal Analysis
MA is thee process of considering
small changes in a decision (control
variable) and determining whether a
given change will improve the ultimate
objective
The Control Variable
To do marginal analysis, we can
change a variable, such as the:
quantity of a good you buy,
the quantity of output you
produce, or
the quantity of an input you use.
This variable is called the
control/decision variable .
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The Decision/Control Variable
Marginal analysis focuses upon
whether the control/decision
variable should be increased by
one more unit or not.
Key Procedure for Using Marginal
Analysis
1. Identify the control variable (cv).
2. Determine what the increase in
total benefits would be if one
more unit of the control variable
were added.
This is the marginal benefit of the
added unit.
Analysis
3. Determine what the increase in
total cost would be if one more
unit of the control variable
were added.
This is the marginal cost of the
added unit.
4. If the unit's marginal benefit
exceeds (or equals) its
marginal cost, it should be
added.
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Analysis
Remember to look only at the
changes in total benefits and
total costs.
If a particular cost or benefit
does not change, IGNORE IT !
Marginal Concepts
Marginal analysis looks at the change in any
set target (say profit) from making a small
change in the decision/control variable
Marginal Profit (MP) = in profit/ in
output/sales
MP is the change in profit resulting from a
small in crease in output
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0 1
0 1
Q Q Q
ofit Pr inal arg M
output / les ChangeinSa
ofit Pr Changein
ofit Pr inal arg M

Marginal Revenue (MR)
MR = in Revenue/ in
output/sales
MR is the amount of additional
revenue that comes with a unit
increase in output/sales
17/07/2013 30
0 1
0 1
Q Q
R R
Q
R
) MR ( venue Re inal arg M
venue Re Changein
) MR ( inalRvenue arg M

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Marginal Cost (MC)
MC = in cost/ in output
MC is the additional cost of
producing an extra unit of output.
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0 1
0 1
Q Q
C C
Q
C
) MC ( inalCost arg M
st ChangeinCo

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Divisekera 32
Another way to look at:
Marginal value as a slope
Marginal Value is the the slope of the
corresponding function
Marginal Profit is the slope of Profit function
Marginal Revenue is the slope of Revenue
function
Marginal Cost is the slope of the total cost
function
Marginal Concepts: An example
P Q TR
(P*Q)
MR TC MC Profit
TR-TC
MP
150 1 150 138 12
130 2 260 110 176 38 84 72
110 3 330 70 214 38 116 32
90 4 360 30 252 38 108 -8
70 5 350 -10 290 38 60 -48
50 6 300 -50 328 38 -28 -88
30 7 210 -80 366 38 -156 -128

12
150
100
50
0
-50
-100
-150
0 1 2 3 4 5 6 7 8
Total Profit (Thousands of Dollars)
Marginal Concept as a slope
Q = 1
= 32
Marginal Profit
32
1
32
2 3
84 116
Profit Marginal
Profit Marginal
ut Sales/Outp in Change
Profit in Change
Profit Marginal
0 1
0 1

Q
Q Q Q

17/07/2013
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Marginal Revenue (MR)
MR = in Revenue/ in
output/sales
MR is the amount of additional
revenue that comes with a unit
increase in output/sales
17/07/2013 35
0 1
0 1
Q Q
R R
Q
R
) MR ( venue Re inal arg M
venue Re Changein
) MR ( inalRvenue arg M

MR is the slope of the TR function
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Marginal Cost (MC)
MC = in cost/ in output
MC is the additional cost of
producing an extra unit of output.
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0 1
0 1
Q Q
C C
Q
C
st ChangeinCo

MC is the slope of the TC function
Back to the Question: Should
GI increase, decrease, or
leave unchanged its weekly
production of Gadgets?
We can determine the profit
maximizing Q* even if all we
know is the table for Marginal
Profit
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Marginal Rule for Profit
Maximisation
To maximize profit, keep producing
Gadgets as long as your marginal profit
from the last Gadget remains positive.
If your marginal profit from the last
Gadget produced is negative, cut back
production until a positive marginal
profit is restored.
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Basic Rules of Optimisation
Profit Maximisation
Maximum profit is
attained at the output
level at which
Marginal profit = 0.
To maximise profit, keep
producing as long as
your marginal profit from
the last unit
produced/sold remains
positive.
If your marginal profit
from the last unit
produced is negative, cut
back production until a
positive marginal profit is
restored.
Alternatively, when MR =
MC,
The Equi-Marginal Principle
150
100
50
0
-50
-100
-150
0 1 2 3 4 5 6 7 8
Profit is at a maximum when MP = 0
MP = /Q = 0
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Implication of the Marginal
Rule: The Equi-Marginal Principle
Since (Q) = R(Q) - C(Q)
Therefore = R - C
So M = MR - MC
If MR is a decreasing function of Q, or if MC is an
increasing function of Q, and if these curves
eventually cross [as is typical]
Then the Marginal Rule for Profit Maximization
implies: produce Q* to the point where MR still
just exceeds (or becomes equal to) MC.
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Finding Marginal Values
If we have a Table (say Profit) we can
calculate the marginal values (profit)
Alternatively, if we have the corresponding
Graph, we can find the point at which the
slope is zero.
What if we are given only the mathematical
form of the function?
Finding Marginal Values
Principle: If we know
the mathematical
function associated with
any economic
relationship, then the
corresponding Marginal
function can be
obtained by
differentiating the
original function
Example
= -100 + 132Q - 20Q
2
To find the profit
maximising output,
use the rule M = 0
M = 132 - 40Q =0
132 = 40Q; Q = 3.3.
Q 40 132
dQ
d
M

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Divisekera 46
Remember!
Calculus is a Friend, not a foe
A very convenient Language
A superbly efficient tool for calculating
marginal quantities, and for finding the
maxima and minima of functions
You already know what you need to know (I
guess).
If you have forgotten year 10 math, dont
worry, Everything needed will be taught.
17/07/2013
Divisekera 47
Comment on Calculus
The slope of the graph of a function is called derivative of the
function
If we want to find the slope, we differentiate that function.
There are seven rules of differentiation
dx
dy
x
y
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Rules of Differentiation: A quick review
Type of function Rule Example
Constant Y = c dY/dX = 0 Y = 5
dY/dX = 0
Line Y = cX dY/dX = c Y = 5X
dY/dX = 5
Power Y = cX
b
dY/dX = bcX
b-1
Y = 5X
2
dY/dX = 10X
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How to find a derivative How to find a derivative
a . Derivative of
constants
If the dependent
variable Y is a
constant, its derivative
w.r.t. X (independent
variable) is always
zero.
Example: y = 2
y = f(x) = 2;
dy/dx = 0
0
x
y = 2
y
How to find a derivative of power
functions
Let y = ax
b
;
Rule: The derivative of a power function,
(y = ax
b
) is equal to the exponent (b)
multiplied by the coefficient (a) times the
variable (x) raised to the power b-1'.
dy/dx = b.a.x
(b-1)
Example; Let b = 2 and a = 3, (y = 3x2 ) then,
dy/dx = 2.3.x
(2-1)
= 6x
Let b = 4, then, dy/dx = 4.3.x
(4-1)
= 12x
3

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Business Economics Dr Sarath Divisekera

Business Economics Dr Sarath Divisekera

Business Economics Dr Sarath Divisekera

Business Economics Dr Sarath Divisekera

Business Economics Dr Sarath Divisekera

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