Chapter 1
Managers, Profits, & Markets
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1-1
Learning Objectives
❖ Understand why managerial economics relies on microeconomics
and industrial organization to analyze business practices and
design business strategies.
❖ Explain the difference between economic and accounting profit and
relate economic profit to the value of the firm.
❖ Describe how separation of ownership and management can lead
to a principal-agent problem when goals of owners and managers
are not aligned and monitoring managers is costly or impossible for
owners.
❖ Explain the difference between price-taking and price-setting firms
and discuss the characteristics of the four market structures.
❖ Discuss the primary opportunities and threats presented by the
globalization of markets in business.
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1-2
Managerial Economics & Theory
❖ Managerial economics applies microeconomic
theory to business problems
~ How to use economic analysis to make decisions to
achieve firm’s goal of profit maximization
❖ Economic theory helps managers understand
real-world business problems
~ Uses simplifying assumptions to turn complexity into
relative simplicity
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1-3
Microeconomics
❖ Microeconomics
~ Study of behavior of individual consumers, business
firms, and markets
❖ Business practices or tactics
~ Routine business decisions managers must make to
earn the greatest profit under prevailing market
conditions
~ Using marginal analysis, microeconomics provides
the foundation for understanding everyday business
decisions
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1-4
Microeconomics
❖ Industrial organization
~ Specialized branch of microeconomics
focusing on behavior and structure of firms
and industries
~ Provides foundation for understanding
strategic decisions through application of
game theory
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1-5
Strategic Decisions
❖ Business actions taken to alter market
conditions and behavior of rivals
~ Increase/protect strategic firm’s profit
❖ While common business practices are
necessary for the goal of profitmaximization, strategic decisions are
generally optimal actions managers can
take as circumstances permit
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1-6
Economic Forces that Promote
Long-Run Profitability (Figure 1.1)
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1-7
Economic Cost of Resources
❖ Opportunity cost is:
~ What firm owners must give up to use
resources to produce goods and services
❖ Market-supplied resources
~ Owned by others and hired, rented, or leased
❖ Owner-supplied resources
~ Owned and used by the firm
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1-8
Total Economic Cost
❖ Total Economic Cost
~ Sum of opportunity costs of both marketsupplied resources and owner-supplied
resources
❖ Explicit Costs
~ Monetary opportunity costs of using marketsupplied resources
❖ Implicit Costs
~ Nonmonetary opportunity costs of using
owner-supplied resources
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1-9
Types of Implicit Costs
❖ Opportunity cost of cash provided by
owners
~ Equity capital (money provided to businesses
by the owners)
❖ Opportunity cost of using land or capital
owned by the firm
❖ Opportunity cost of owner’s time spent
managing or working for the firm
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1-10
Economic Cost of Using Resources
(Figure 1.2)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-11
Economic Profit vs. Accounting
Profit
Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
❖ Accounting profit does not subtract implicit
costs from total revenue
❖ Firm owners must cover all costs of all
resources used by the firm
~ Objective is to maximize profit
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-12
Maximizing the Value of a Firm
❖ Value of a firm
~ Price for which it can be sold
~ Equal to the present value of expected future
profits
❖ Risk premium
~ An increase in the discount rate to
compensate investors for uncertainty about
future profits
~ The larger the risk, the higher the risk
premium, and the lower the firm’s value
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1-13
Maximizing the Value of a Firm
❖ Maximize firm’s value by maximizing profit
in each time period
~ Cost & revenue conditions must be
independent across time periods
❖ Value of a firm =
𝑇
𝜋1
𝜋2
𝜋𝑇
𝜋𝑇
+
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=
2
𝑇
(1 + 𝑟) (1 + 𝑟)
(1 + 𝑟)
(1 + 𝑟)𝑡
𝑡=1
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-14
Some Common Mistakes
Managers Make
❖ Never increase output simply to reduce
average costs
❖ Pursuit of market share usually reduces
profit
❖ Focusing on profit margin won’t maximize
total profit
❖ Maximizing total revenue reduces profit
❖ Cost-plus pricing formulas don’t produce
profit-maximizing prices
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1-15
Principal-Agent Relationship
❖ Relationship formed when a business
owner (the principal) enters an agreement
with an executive manager (the agent)
whose job is to formulate and implement
tactical and strategic business decisions
that will further the objectives of the
business owner (the principal).
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-16
Separation of Ownership & Control
❖ Principal-agent problem
~ A manager takes an action or makes a
decision that advances the interests of the
manager but reduces the value of the firm.
❖ Complete contract
~ An employment contract that protects owners
from every possible deviation by managers
from value-maximizing decisions.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-17
Separation of Ownership & Control
❖ Hidden actions
~ Actions or decisions taken by managers that
cannot be observed by owners for any
feasible amount of monitoring effort.
❖ Moral Hazard
~ A situation in which managers take hidden
actions that harm the owners of the firm but
further the interests of the managers.
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1-18
Corporate Control Mechanisms
❖ Internal control mechanisms
~ Require managers to hold stipulated amount
of firm’s equity
~ Increase percentage of outsiders serving on
board of directors
~ Finance corporate investments with debt
instead of equity
❖ External mechanism
~ Corporate takeovers
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1-19
Price-Takers vs. Price-Setters
❖ Price-taking firm
~ Cannot set price of its product
~ Price is determined strictly by market forces of
demand & supply
❖ Price-setting firm
~ Can set price of its product
~ Has a degree of market power, which is the
ability to raise price without losing all sales
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1-20
What is a Market?
❖ A market is any arrangement through
which buyers & sellers exchange anything
of value
❖ Markets reduce transaction costs
~ Costs of making a transaction happen, other
than the price of the good or service itself
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1-21
Market Structures
❖ Market characteristics that determine the
economic environment in which a firm
operates
~ Number and size of firms in market
~ Degree of product differentiation among
competing firms
~ Likelihood of new firms entering market when
incumbent firms are earning economic profits
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1-22
Perfect Competition
❖ Large number of relatively small firms
❖ Undifferentiated product
❖ Price takers with no market power
❖ No barriers to entry
~ Any economic profit earned will vanish as new
firms enter
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1-23
Monopoly
❖ Single firm
❖ Produces product with no close
substitutes
❖ Protected by a barrier to entry
~ Allows the monopolist to raise its price without
concern that economic profits will attract new
firms
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1-24
Monopolistic Competition
❖ Large number of relatively small firms
❖ Differentiated products
~ Gives the monopolistic competitor some
degree of market power
❖ Price setters
❖ No barriers to entry
~ Ensures any economic profits will be bid away
by new entrants
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1-25
Oligopoly
❖ Few firms produce all or most of market
output
❖ Profits are interdependent
~ Actions by any one firm will affect sales and
profits of the other firms
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1-26
Globalization of Markets
❖ Economic integration of markets located
in nations around the world
~ Provides opportunity to sell more goods &
services to foreign buyers
~ Presents threat of increased competition from
foreign producers
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1-27
Summary
❖ Managerial economics applies concepts/theories from
microeconomics and industrial organization
~ Marginal analysis provides the foundation for everyday business
practices or tactics
❖ Opportunity cost of using any resource is what the firm owners
must give up to use the resource
~ Unlike economic profit, accounting profit does not subtract
implicit (opportunity) costs from total revenue
❖ With the separation of ownership and management, a principalagent problem can arise because owners cannot be certain that
managers are making decisions to maximize the value of the firm
❖ For price-taking firms, price is determined solely by market forces
of supply and demand, while price-setters have some degree of
market power to set price
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1-28
Chapter 2
Demand, Supply, & Market
Equilibrium
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1-1
Learning Objectives
❖ Identify demand functions and distinguish between a
change in demand and a change in quantity demanded
❖ Identify supply functions and distinguish between a
change in supply and a change in quantity supplied
❖ Explain why market equilibrium occurs at the price for
which quantity demanded equals quantity supplied
❖ Measure gains from market exchange using consumer
surplus, producer surplus, and social surplus
❖ Predict the impact on equilibrium price and quantity of
shifts in demand or supply
❖ Examine the impact of government imposed price
ceilings and price floors
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2-2
Demand
❖ Quantity demanded (Qd)
~ Amount of a good or service consumers are
willing & able to purchase during a given
period of time
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2-3
Demand
❖ Three types of demand relations:
❖ 1. General demand functions which show
how quantity is related to product price
and the other five factors that affect
demand.
❖ 2. Direct Demand functions which show
the relation between quantity demanded
and the price of the product with all other
factors held constant.
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2-4
Demand
❖ 3. Inverse demand functions which give
the maximum prices buyers are willing to
pay to obtain various amounts of the
product.
❖ Direct demand functions are derived from
general demand functions and inverse
demand curves are derived from direct
demand curves.
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2-5
General Demand Function
❖ Six variables that influence Qd
~ Price of good or service (P)
~ Incomes of consumers (M)
~ Prices of related goods & services (PR)
~ Taste patterns of consumers (T)
~ Expected future price of product (PE)
~ Number of consumers in market (N)
❖ General demand function
Qd = f(P, M, PR, T, PE , N)
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2-6
Demand
❖ Isolating the individual effect of a single
variable requires that all other variables
that affect Quantity Demanded be held
constant. Therefore, whenever we speak
of the effect that a particular variable has
on quantity demanded, we mean the
individual effect holding all other variables
constant.
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2-7
Demand
❖ Price: consumers are willing and able to
buy more of a good the lower the price of
the good and will buy less of a good the
higher the price of the good.
❖ Price and quantity demanded are
inversely related when all other factors
are held constant.
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2-8
Demand
❖ An increase in Income can cause the
amount of a good or service consumers
purchase either to increase or decrease.
❖ It depends on if the good or service is a
normal good or inferior Good.
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2-9
Demand
❖ Normal good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand more (less) of the good, holding all other
variables in the general demand function constant
❖ Inferior good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand less (more) of the good, all other factors
held constant
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2-10
Demand
❖ Goods and services may be related in
consumption in either of two ways:
❖ Substitutes or Complements
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2-11
Demand
❖ Substitutes
~ Two goods are substitutes if an increase
(decrease) in the price of one good causes
consumers to demand more (less) of the other
good, holding all other factors constant
❖ Complements
~ Two goods are complements if an increase
(decrease) in the price of one good causes
consumers to demand less (more) of the other
good, all other things held constant
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-12
Demand
❖ A change in consumers tastes or
preferences can change demand for a
good or service. (Organic, Environmental,
health benefits).
❖ When all other variables are held constant
a movement in consumer tastes toward a
good or service will increase demand and
a movement in consumers tastes away
from a good will decrease demand for the
good.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-13
Demand
❖ If consumers expect the price to be higher
in the future period, demand will rise in
the current period.
❖ If consumers expect the price of good to
decline in the future, demand will fall in
the current period.
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2-14
Demand
❖ An increase in the number of consumers
in the market will increase the demand for
a good and a decrease in the number of
consumers will decrease the demand for
a good, all other factors held constant.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-15
General Demand Function
Qd = a + bP + cM + dPR + eT + fPE + gN
❖ b, c, d, e, f, & g are slope parameters
~ Measure effect on Qd of changing one of
the variables while holding the others
constant
❖ Sign of the slope parameter shows how
variable is related to Qd
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-16
General Demand Function
❖ The intercept parameter “a” shows the value of
quantity demanded when all the other five
variables are all simultaneously equal to zero.
❖ The slope parameter “b” (of price) for example
measures the change in quantity demanded per
unit change in price.
❖ For example a price slope of -10 indicates that a
$1 increase in price causes quantity demanded
to decrease by 10 units.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-17
General Demand Function
❖ A demand function can be expressed as an
equation, a schedule or table (see Table 2.2), or
a graph (see Figure 2.1 for a showing of a
demand curve).
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-18
General Demand Function
Variable
Relation to Qd
Sign of Slope Parameter
P
Inverse
b = Qd/P is negative
M
Direct for normal goods
Inverse for inferior goods
c = Qd/M is positive
c = Qd/M is negative
PR
Direct for substitutes
Inverse for complements
d = Qd/PR is positive
d = Qd/PR is negative
T
Direct
e = Qd/T is positive
PE
Direct
f = Qd/PE is positive
N
Direct
g = Qd/N is positive
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2-19
Direct Demand Function
❖ The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant
~ Qd = f(P)
❖ Law of Demand (examples to the contrary
have never been observed)
~ Qd increases when P falls, all else constant
~ Qd decreases when P rises, all else constant
~ Qd/P must be negative
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2-20
Graphing Demand Curves
❖ A point on a direct demand curve shows
either:
~ Maximum amount of a good that will be
purchased for a given price
~ Maximum price consumers will pay for a
specific amount of the good (demand price)
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-21
A Demand Curve
(Figure 2.1)
Qd = 1,400 – 10P
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-22
Graphing Demand Curves
❖ Change in quantity demanded
~ Occurs when price changes
~ Movement along demand curve
❖ Change in demand
~ Occurs when one of the other variables, or
determinants of demand, changes
~ Demand curve shifts rightward or leftward (to
the right if demand increase and to the left if
demand decreases).
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2-23
Shifts in Demand
(Figure 2.2)
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2-24
Supply
❖ Quantity supplied (Qs)
~ Amount of a good or service offered for
sale during a given period of time
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-25
Supply
❖ Six variables that influence Qs
~ Price of good or service (P)
~ Input prices (PI )
~ Prices of goods related in production (Pr)
~ Technological advances (T)
~ Expected future price of product (Pe)
~ Number of firms producing product (F)
❖ General supply function
Qs = f(P, PI, Pr, T, Pe, F)
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2-26
Determinants of Supply
❖ The quantity of good or service offered for
sale is determined not only by the price of
the good or service but also by the 1.
Price of the inputs used in production, 2.
the Price of goods that are related in
production, 3. the level of available
technology, 4 the expectations of
producers concerning the future price of
the good and 5. the number of firms or
amount of productive capacity in the
industry.
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2-27
Supply – all other things being
equal
❖ 1. The higher the price of the product the
greater the quantity firms will produce.
❖ The lower the price of the product the
smaller the quantity firms will produce.
❖ The Price and Quantity supplied are in
direct relationship.
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2-28
Supply – all other things being
equal
❖ 2. An increase in the price of one or more
of the inputs used to produce the product
will increase the cost of production.
❖ Therefore, an increase in the price of an
input causes a decrease in production,
while a decrease in the price of input
causes an increase in production. (Profits)
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2-29
Supply – all other things being
equal
❖ 3. Changes in the prices of goods that are
related in production may affect producers
in either one of two ways: Depending on
whether the Goods are Substitutes
(Wheat and Corn)or Complements ( Oil
and Natural Gas, Nickel and Copper, Beef
and leather hides, bacon and pork chops).
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2-30
General Supply Function
❖ Substitutes in production
~ Goods for which an increase in the price of one
good relative to the price of another good causes
producers to increase production of the now
higher-priced good and decrease production of
the other good
❖ Complements in production
~ Goods for which an increase in the price of one
good, relative to the price of another good,
causes producers to increase production of both
goods
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2-31
Supply – all other things being
equal
❖ 4.Tecnology is the state of knowledge
concerning how to combine resources to
produce goods and services.
❖ An improvement in technology results in
one or more of the inputs used in making
the good to be more productive.
❖ Can make more goods with same amount
of inputs or the same amount of goods
with fewer inputs.
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2-32
Supply – all other things being
equal
❖ 5. If a firm expects the price of a good
they produce to rise in the future they may
withhold some of the good in the market,
thereby reducing supply of the good in the
current period.
❖ 6. The number of firms in the industry
increases or if the productive capacity of
existing firms increases, more of the good
or service will be supplied at each price.
(And Conversely)
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2-33
General Supply Function – in
linear function form
Qs = h + kP + lPI + mPr + nT + rPe + sF
❖ k, l, m, n, r, & s are slope parameters
~ Measure effect on Qs of changing one of the
variables while holding the others constant
❖ Sign of parameter shows how variable is
related to Qs
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
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2-34
General Supply Function
Variable
Relation to Qs
Sign of Slope Parameter
P
Direct
k = Qs/P is positive
PI
Inverse
l = Qs/PI is negative
Pr
Inverse for substitutes
Direct for complements
m = Qs/Pr is negative
m = Qs/Pr is positive
T
Direct
n = Qs/T is positive
Pe
Inverse
r = Qs/Pe is negative
F
Direct
s = Qs/F is positive
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2-35
Direct Supply Function
❖ The direct supply function, or simply
supply, shows how quantity supplied, Qs ,
is related to product price, P, when all
other variables are held constant
~
Qs = f(P)
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2-36
Graphing Supply Curves
❖ A point on a direct supply curve shows
either:
~ Maximum amount of a good that will be
offered for sale at a given price
~ Minimum price necessary to induce producers
to voluntarily offer a given quantity for sale
(supply price)
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2-37
A Supply Curve
(Figure 2.3)
Qs = -400 + 20P
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2-38
Graphing Supply Curves
❖ Change in quantity supplied
~ Occurs when price changes
~ Movement along supply curve
❖ Change in supply
~ Occurs when one of the other variables, or
determinants of supply, changes
~ Supply curve shifts rightward or leftward
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2-39
Shifts in Supply
(Figure 2.4)
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2-40
Shifts in Supply Curve
❖ A shift in supply only occurs when one of
the five determinants of supply changes in
value.
❖ An increase in supply causes a shift to the
right for the supply curve.
❖ A decrease in supply causes a shift to the
left for the supply curve.
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2-41
Supply and Demand Analysis
❖ The essential skill for doing demand and
supply analysis of real world markets is
the ability to identify correctly all of the
underlying demand and supply shifters
that are working to cause the market
prices and quantities to move higher or
lower.
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2-42
Market Equilibrium
❖ Equilibrium price & quantity are
determined by the intersection of
demand & supply curves
~ At the point of intersection, Qd = Qs
~ Consumers can purchase all they want
(equilibrium quantity) & producers can sell
all they want at the “market-clearing” or
“equilibrium” price.
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2-43
Market Equilibrium
(Figure 2.5)
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2-44
Market Equilibrium
❖ Excess supply (surplus)
~ Exists when quantity supplied exceeds
quantity demanded
❖ Excess demand (shortage)
~ Exists when quantity demanded exceeds
quantity supplied
~ There is no excess supply or demand at the
market equilibrium point.
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2-45
Value of Market Exchange
❖ Typically, consumers value the goods
they purchase by an amount that
exceeds the purchase price of the
goods
❖ Economic value
~ Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good
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2-46
Measuring the Value of
Market Exchange
❖ Consumer surplus
~ Difference between the economic value of a
good (its demand price) & the market price the
consumer must pay
❖ Producer surplus
~ For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
❖ Social surplus
~ Sum of consumer & producer surplus
~ Area below demand & above supply over the
relevant range of output
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2-47
Measuring the Value of
Market Exchange (Figure 2.6)
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2-48
Changes in Market Equilibrium
❖ Qualitative forecast
~ Predicts only the direction in which an
economic variable will move
❖ Quantitative forecast
~ Predicts both the direction and the
magnitude of the change in an economic
variable
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2-49
Demand Shifts (Supply Constant)
(Figure 2.7)
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2-50
Demand Shifts & Supply
Constant
❖ When demand increases and supply is
constant, equilibrium price and quantity
both rise.
❖ When demand decreases and supply is
constant, equilibrium price and quantity
both fall.
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2-51
Supply Shifts (Demand Constant)
(Figure 2.8)
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2-52
Supply Shifts & Demand
Constant
❖ When supply increases and demand is
constant, equilibrium price falls and
equilibrium quantity rises.
❖ When supply decreases and demand is
constant, equilibrium price rises and
equilibrium quantity falls.
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2-53
Simultaneous Shifts
❖ When demand & supply shift
simultaneously
~ Can predict either the direction in which
price changes or the direction in which
quantity changes, but not both
~ The change in equilibrium price or quantity
is said to be indeterminate when the
direction of change depends on the relative
magnitudes by which demand & supply
shift
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2-54
Simultaneous Shifts
❖ When demand and supply both shift
simultaneously, if the change in quantity
(price) can be predicted, the change price
(quantity) is indeterminate.
❖ The change in equilibrium quantity or
price is determined when the variable can
either rise of fall depending upon the
relative magnitudes by which demand and
supply shift.
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2-55
Simultaneous Shifts
❖ When both demand and supply increase,
a small increase in supply relative to
demand causes prices to rise, while a
large increase in supply relative to
demand causes a price to fall.
❖ When there is a simultaneous increase in
both demand and supply, equilibrium
output always increases. But the change
in equilibrium price is indeterminate.
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2-56
Simultaneous Shifts: (D, S)
P
S
S′
S′′
B
P′
P
P′′
•
A
•
•
C
D′
D
Q
Q′
Q′′
Q
Price may rise or fall; Quantity rises
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2-57
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
•
P
P′
P′′
•
B
•
C
D
D′
Q′ Q Q′′
Q
Price falls; Quantity may rise or fall
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2-58
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
•
C
•
P′
S
B
A
•
P
D′
D
Q′′
Q Q′
Q
Price rises; Quantity may rise or fall
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2-59
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
P
P′
•
C
S
A
•
B
•
D
D′
Q′′
Q′
Q
Q
Price may rise or fall; Quantity falls
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2-60
Ceiling & Floor Prices
❖ Ceiling price
~ Maximum price government permits sellers
to charge for a good
~ When ceiling price is below equilibrium, a
shortage occurs
❖ Floor price
~ Minimum price government permits sellers
to charge for a good
~ When floor price is above equilibrium, a
surplus occurs
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2-61
Ceiling & Floor Prices
❖ When the government sets a ceiling price
below the equilibrium price, a shortage or
excess demand results because
consumers wish to buy more units of the
good than producers are willing to sell at
the ceiling price.
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2-62
Ceiling & Floor Prices
❖ If the government sets a floor price above
the equilibrium price, a surplus or excess
supply results because producers offer for
sale more units of the good than buyers
wish to consume at the floor price.
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2-63
Ceiling & Floor Prices (Figure 2.12)
Px
Price (dollars)
Px
Sx
2
Sx
3
2
1
Dx
22
50 62
Quantity
Panel A – Ceiling price
Dx
Qx
32 50
84
Qx
Quantity
Panel B – Floor price
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2-64
Summary
❖ 6 variables influence demand: good’s price, income,
prices of related goods, consumers’ tastes, expected
future price, and number of consumers
~ Law of demand states that quantity demanded increases
(decreases) when price falls (rises), all else constant
❖ 6 variables influence supply: good’s price, input
prices, prices of goods related in production,
producers’ expectation of future price, number of firms
❖ Equilibrium price and quantity determined by
intersection of supply and demand curves
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on the units they purchase.
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2-65
Summary
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on units they purchase
~ Producer surplus arises because equilibrium price is greater
than the minimum price producers would be willing to accept
to produce.
~ Social surplus: sum of consumer surplus and producer surplus
❖ When both supply and demand shift simultaneously,
one can predict either the direction of change in price
or the direction of change in quantity, but not both
❖ A ceiling price (below equilibrium) results in a
shortage; a floor price (above equilibrium) results in a
surplus
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2-66
Chapter 3
Marginal Analysis for
Optimal Decisions
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1-1
Learning Objectives
❖ Define several key concepts and terminology related to
marginal analysis
❖ Use marginal analysis to find optimal activity levels in
unconstrained maximization problems and explain why
sunk costs, fixed costs, and average costs are irrelevant
for decision making
❖ Employ marginal analysis to find the optimal levels of
two or more activities in constrained maximization and
minimization problems
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3-2
Optimization
❖ A persons decision is optimal if it leads to
the best outcome under a given set of
circumstances. This is accomplished by
using Marginal Analysis.
❖ A person needs to determine the benefit
of a changing activity and compare it with
the cost associated with the change in
activity.
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3-3
Optimization
❖ Tactical Decisions
❖ Strategic Decisions
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3-4
Optimization
❖ An optimization problem involves the
specification of three things:
~ Objective function - what is to be maximized
or minimized (profit, satisfaction, value).
~ Activities or choice variables that determine
the value of the objective function –
production level for profits.
~ Any constraints that may restrict the values of
the choice variables – such as cost.
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3-5
Optimization
❖ We have discrete and continuous choice
variables.
❖ A Discrete Choice Variable can only take
on specific integer values.
❖ A Continuous Choice Variable can take
on any value between two points.
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3-6
Optimization
❖ Maximization problem
~ An optimization problem that involves
maximizing the objective function
❖ Minimization problem
~ An optimization problem that involves
minimizing the objective function
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3-7
Optimization
❖ Unconstrained optimization
~ An optimization problem in which the decision
maker can choose the level of activity from an
unrestricted set of values.
❖ Constrained optimization
~ An optimization problem in which the decision
maker chooses values for the choice
variables from a restricted set of values (such
as total costs).
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3-8
Choice Variables
❖ Activities or choice variables determine
the value of the objective function
❖ Discrete choice variables
~ Can only take specific integer values
❖ Continuous choice variables
~ Can take any value between two end points
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3-9
Marginal Analysis
❖ Analytical technique for solving
optimization problems that involves
changing values of choice variables by
small amounts to see if the objective
function can be further improved
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3-10
Net Benefit
❖ Net Benefit (NB)
~ Difference between total benefit (TB) and total
cost (TC) for the activity
~ NB = TB – TC
❖ Optimal level of the activity (A*) is the
level that maximizes net benefit
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3-11
Optimization
❖ The optimal level of activity does not
generally result in the maximization of
benefits.
❖ The optimal level of activity in an
unconstrained maximization problem
does not result in the minimization of total
costs.
❖ Only marginal benefits and marginal costs
are relevant in the decision process.
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3-12
Optimal Level of Activity
(Figure 3.1)
Total benefit and total cost (dollars)
TC
4,000
D
B
•
2,310
F
•
• D’
3,000
•
•
G
TB
2,000
NB* = $1,225
C
•
1,085
1,000
• B’
•C’
0
200
A
350 = A*
600
700
1,000
Level of activity
Net benefit (dollars)
Panel A – Total benefit and total cost curves
M
1,225
1,000
•c’’
•
•
600
0
d’’
200
350 = A*
•
600
Level of activity
A
f’’
1,000
NB
Panel B – Net benefit curve
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3-13
Marginal Benefit & Marginal Cost
❖ Marginal benefit (MB)
~ Change in total benefit (TB) caused by an
incremental change in the level of the activity
❖ Marginal cost (MC)
~ Change in total cost (TC) caused by an
incremental change in the level of the activity
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3-14
Marginal Benefit & Marginal Cost
Change in total benefit TB
MB =
=
Change in activity
A
Change in total benefit TC
MC =
=
Change in activity
A
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-15
Using Marginal Analysis to Find
Optimal Activity Levels
❖ If marginal benefit > marginal cost
~ Activity should be increased to reach highest
net benefit
❖ If marginal cost > marginal benefit
~ Activity should be decreased to reach highest
net benefit
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
3-16
Using Marginal Analysis to Find
Optimal Activity Levels
❖ Optimal level of activity
~ When no further increases in net benefit are
possible
~ Occurs when MB = MC
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3-17
Unconstrained Maximization with
Discrete Choice Variables
❖ Increase activity if MB > MC
❖ Decrease activity if MB < MC
❖ Optimal level of activity
~ Last level for which MB exceeds MC
~ To make the optimal decision for a discrete
choice variable, decision makers must increase
activity until the last level of activity is reached
for which marginal benefit exceeds marginal
cost.
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3-18
Irrelevance of Sunk, Fixed, and
Average Costs
❖ Sunk costs
~ Previously paid & cannot be recovered
❖ Fixed costs
~ Constant & must be paid no matter the level
of activity
❖ Average (or unit) costs
~ Computed by dividing total cost by the
number of units of activity
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3-19
Irrelevance of Sunk, Fixed, and
Average Costs
❖ Decision makers wishing to maximize the
net benefit of an activity should ignore
these costs, because none of these costs
affect the marginal cost of the activity and
so are irrelevant for optimal decisions
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3-20
Constrained Optimization
❖ The ratio MB/P represents the
additional benefit per additional dollar
spent on the activity
❖ Ratios of marginal benefits to prices of
various activities are used to allocate a
fixed number of dollars among activities
❖ It is marginal benefit per dollar spent
that matters in decision making.
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3-21
Constrained Optimization
❖ To maximize or minimize an objective
function subject to a constraint
~ Ratios of the marginal benefit to price
must be equal for all activities
~ Constraint must be met
MBA MBB MBC
MBZ
=
=
... =
PA
PB
PC
PZ
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3-22
Summary
❖ Marginal analysis is an analytical technique for solving
optimization problems by changing the value of a choice
variable by a small amount to see if the objective
function can be further improved
❖ The optimal level of the activity (A*) is that which
maximizes net benefit, and occurs where marginal
benefit equals marginal cost (MB = MC)
~ Sunk costs have previously been paid and cannot be recovered;
Fixed costs are constant and must be paid no matter the level of
activity; Average (or unit) cost is the cost per unit of activity;
these 3 types of costs are irrelevant for optimal decision making
❖ The ratio MB/P denotes the additional benefit of that
activity per additional dollar spent (“bang per buck”)
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3-23
Chapter 4
Basic Estimation Techniques
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1-1
Learning Objectives
❖ Set up and interpret simple linear regression equations
❖ Estimate intercept and slope parameters of a regression
line using the method of least‐squares
❖ Determine statistical significance using either t‐tests or
p‐values associated with parameter estimates
❖ Evaluate the “fit” of a regression equation to the data
using the R2 statistic and test for statistical significance
of the whole regression equation using an F‐test
❖ Set up and interpret multiple regression models
❖ Use linear regression techniques to estimate the
parameters of two common nonlinear models: quadratic
and log‐linear regression models
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4-2
Basic Estimation
❖ Parameters
~ The coefficients in an equation that determine
the exact mathematical relation among the
variables – for the cost function to be useful
for decision making we must know the values
of the parameters.
❖ Parameter estimation
~ The process of finding estimates of the
numerical values of the parameters of an
equation
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4-3
Regression Analysis
❖ Regression analysis
~ A statistical technique for estimating the
parameters of an equation and testing for
statistical significance.
~ Regression analysis uses data on economic
variables to determine a mathematical
equation that describes the relationships
between the economic variables.
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4-4
Regression Analysis
❖ Dependent variable
~ Variable whose variation is to be explained
❖ Explanatory variables
~ Variables that are thought to cause the
dependent variable to take on different values
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4-5
Simple Linear Regression
❖ True (Actual) regression line relates
dependent variable Y to one explanatory
(or independent) variable X
Y = a + bX
~ Intercept parameter (a) gives value of Y where
regression line crosses Y-axis (value of Y when X
is zero)
~ Slope parameter (b) gives the change in Y
associated with a one-unit change in X:
b = Y X
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4-6
Regression Analysis
❖ If Y = 2500 + 10X
❖ Then
❖ Y will change on average 10 units for
every 1 change in X
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4-7
Simple Linear Regression
❖ Regression line shows the average or
expected value of Y for each level of X
❖ True (or actual) underlying relation
between Y and X is unknown to the
researcher but is to be discovered by
analyzing the sample data
❖ Random error term
~ Unobservable term added to a regression model to
capture the effects of all the minor, unpredictable
factors that affect Y but cannot reasonably be
included as explanatory variables
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4-8
Fitting a Regression Line
❖ The purpose of a regression analysis is:
❖ 1. To estimate the parameters (a and b)
of the true (actual) regression line
(population regression line).
❖ 2. to test the estimated values of the
parameters to see if they are statistically
significant.
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4-9
Fitting a Regression Line
❖ Estimating “a” and “b” is equivalent to
fitting a straight line through a scatter of
data points on a graph.
❖ The data collected is on both the
dependent and explanatory variables.
❖ The objective of regression analysis is to
find the straight line that best fits the
scatter of data points (sample regression
line).
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4-10
Fitting a Regression Line
❖ Time series
~ A data set in which the data for the
dependent and explanatory variables are
collected over time for a single firm
❖ Cross-sectional
~ A data set in which the data for the
dependent and explanatory variables are
collected from many different firms or
industries at a given point in time
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4-11
Fitting a Regression Line
❖ The sample regression line is only an
estimate of the true regression line.
Naturally, the larger the size of the
sample, the more accurately the sample
regression line will estimate the true
regression line.
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4-12
Fitting a Regression Line
❖ Method of least squares – used for
Regression Analysis
~ A method of estimating the parameters of a
linear regression equation by finding the line
that minimizes the sum of the squared
distances from each sample data point to
the sample regression line (you want as tight
a fit as you can get).
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4-13
Fitting a Regression Line
❖ Parameter estimates are obtained by
choosing values of a & b that minimize
the sum of squared residuals
~ The residual is the difference between the
actual and fitted/predicted values of Y: Yi –
Ŷi
~ Equivalent to fitting a straight line through a
scatter diagram of the sample data points –
in order to minimize the sum of the squared
residuals.
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4-14
Fitting a Regression Line
❖ The sample regression line is an
estimate of the true (or population)
regression line
ˆ
Yˆ = aˆ + bX
~Where â and b̂ are least squares estimates
of the true (population) parameters a and b
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4-15
Sample Regression Line
(Figure 4.2)
S
Sales (dollars)
70,000
S
60,000
Sii =
= 60,000
60,000
ei
50,000
20,000
10,000
•
•
40,000
30,000
•
Sample regression line
Ŝi = 11,573 + 4.9719A
•
= 46,376
Ŝi Ŝ
=i 46,376
•
•
•
A
0
2,000
4,000
6,000
8,000
10,000
Advertising expenditures (dollars)
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4-16
Unbiased Estimators
❖ The estimates â & b̂ do not generally
equal the true values of a & b
~
â & b̂ are random variables computed using
data from a random sample
❖ The distribution of values the estimates
might take is centered around the true
value of the parameter
❖ An estimator is unbiased if its average
value (or expected value) is equal to the
true value of the parameter
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4-17
Unbiased Estimators
❖ We now turn to the task of testing
hypotheses about true (actual) values of
“a” and “b”, which are unknown to the
researcher, using information contained in
the sample to see if there is a significant
relationship or simply a relationship based
on randomness.
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4-18
Statistical Significance
❖ Do the coefficients mean anything? Do
they statistically explain the change in the
dependent variable?
❖ The farther away from 0 (+ or -) the
estimated coefficient is, the estimated
coefficient is considered Statistically
Significant.
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4-19
Statistically Significant
❖ If Y is indeed related to X, the true value
of the slope of the parameter will be either
a positive or negative number.
❖ Remember, if the coefficient is the change
in Y divided by the change in X, and the
coefficient is zero, then no change in Y
will occur when there is a change in X.
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4-20
Statistically Significant
❖ We need to test for the statistically
significance of a parameter because we
do not know the true value of the
parameters. i.e. they are a random
sample.
❖ Because of randomness in sampling,
different samples will result in different
values.
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4-21
Statistically Significant
❖ The estimator of the coefficient is
Unbiased if the average value of the
estimator is equal to the true value of the
parameter.
❖ Unbiased does not mean that any one
estimate of the coefficient is close to the
true value. Unbiased means that in
repeated samples, the estimates tend to
be centered around the true value.
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4-22
Statistical Significance
❖ Statistical significance
~ There is sufficient evidence from the
sample to indicate that the true value of the
coefficient is not zero
❖ Hypothesis testing
~ A statistical technique for making a
probabilistic statement about the true value
of a parameter
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4-23
Statistical Significance
❖ Must determine if there is sufficient
statistical evidence to indicate that Y is
truly related to X (i.e., b 0)
❖ Even if b = 0, it is possible that the
sample will produce an estimate b̂ that
is different from zero (Type I error)
❖ Test for statistical significance using
t-tests or p-values
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4-24
Statistical Significance
❖ A t-test is used to make a probabilistic
statement about the likelihood that a true
parameter value of a coefficient is not
equal to zero.
❖ The t-ratio indicates how much
confidence one can have that the true
value of a coefficient is actually larger
than zero. The larger the value the better.
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4-25
Statistical Significance
❖ First determine the level of significance
~ Probability of finding a parameter estimate to
be statistically different from zero when, in
fact, it is zero
~ Probability of a Type I Error
❖ 1 – level of significance = level of
confidence
~ Level of confidence is the probability of
correctly failing to reject the true hypothesis
that b = 0
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4-26
Statistical Significance
❖ The level of significance of a t-test is the
probability that the test will indicate the
coefficient is not equal to zero when in
fact it is equal to zero.
❖ For example a level of significance of .01,
.02, .05 assumes a willingness to accept
a 1, 2, or 5 percent probability of finding a
parameter to be significant when it is not
(99%, 98% or 95% confidence level).
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4-27
Performing a t-Test
b̂
❖ t-ratio is computed as t =
Sb̂
where Sb̂ is the standard error of the estimate bˆ
❖ Use t-table to choose critical t-value with
n – k degrees of freedom for the chosen
level of significance
n = number of observations
~ k = number of parameters estimated
~
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4-28
Performing a t-Test
❖ t-statistic
~ Numerical value of the t-ratio
❖ If the absolute value of t-statistic is
greater than the critical t, the parameter
estimate is statistically significant at the
given level of significance
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4-29
Using p-Values
❖ Treat as statistically significant only those
parameter estimates with p-values
smaller than the maximum acceptable
significance level
❖ p-value gives exact level of significance
~ Also the probability of finding significance
when none exists
~ One minus the p-value is the exact degree of
confidence that can be assigned to a
particular parameter estimate.
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4-30
Coefficient of Determination
❖ R2 measures the fraction of total variation
in the dependent variable (Y) that is
explained by the variation in X
~ Ranges from 0 (Explains none) to 1 (explains
all)
~ High R2 indicates Y and X are highly
correlated, and does not prove that Y and X
are causally related
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4-31
F-Test
❖ Used to test for significance of overall
regression equation (explained and
unexplained variations)
❖ Compare F-statistic to critical F-value
from F-table
~ Two degrees of freedom, n – k & k – 1 (# of
independent variables)
❖ If F-statistic exceeds the critical F, the
regression equation overall is statistically
significant at the specified level of
significance
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4-32
Multiple Regression
❖ Uses more than one explanatory variable
❖ Coefficient for each explanatory variable
measures the change in the dependent
variable associated with a one-unit
change in that explanatory variable, all
else constant
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4-33
Summary
❖ A simple linear regression model relates a dependent
variable Y to a single explanatory variable X
~ The regression equation is correctly interpreted as providing the
average value (expected value) of Y for a given value of X
❖ Parameter estimates are obtained by choosing values of
a and b that create the best-fitting line that passes
through the scatter diagram of the sample data points
❖ If the absolute value of the t-ratio is greater (less) than the
critical t-value, then is (is not) statistically significant
~ Exact level of significance associated with a t-statistic is its p-value
❖ A high R2 indicates Y and X are highly correlated and the
data tightly fit the sample regression line
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4-34
Summary
❖ If the F-statistic exceeds the critical F-value, the
regression equation is statistically significant
❖ In multiple regression, the coefficients measure the
change in Y associated with a one-unit change in that
explanatory variable
❖ Quadratic regression models are appropriate when the
curve fitting the scatter plot is U-shaped or ∩-shaped
(Y = a + bX + cX2)
❖ Log-linear regression models are appropriate when the
relation is in multiplicative exponential form (Y = aXbZc)
~ The equation is transformed by taking natural logarithms
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4-35
Chapter 6
Elasticity & Demand
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1-1
Learning Objectives
❖ Define price elasticity of demand and use it to predict
changes in quantity demanded and price of a good
❖ Explain the role price elasticity plays in determining how
a change in price affects total revenue
❖ Explain factors that affect price elasticity of demand
❖ Calculate price elasticity over an interval and at a point
on a demand curve
❖ Relate marginal revenue to total revenue and demand
elasticity and write the marginal revenue equation for
linear inverse demand functions
❖ Define/compute income elasticity of demand and
cross-price elasticity of demand
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6-2
Price Elasticity of Demand (E)
❖ Measures responsiveness or sensitivity
of consumers to changes in the price of
a good
Q
E=
P
❖ P & Q are inversely related by the law of
demand so E is always negative
~ The larger the absolute value of E, the more
sensitive buyers are to a change in price
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6-3
Price Elasticity of Demand
❖ When Managers lower or raise price, total
revenues will either rise or fall depending
on how responsive consumers are to the
price change.
❖ Managers need to know this information
in order to maximize profits for the
company.
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6-4
Price Elasticity of Demand
❖ Price Elasticity of Demand (E) is
calculated as the percentage change in
quantity (Q) demanded divided by the
percentage change in price (P).
❖ Elasticity is always negative because P
and Q are inversely related. It is the
absolute value of E that matters. Ignore
the negative sign.
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6-5
Price Elasticity of Demand
❖ Elastic Demand is greater than 1.
❖ Inelastic Demand is less than 1.
❖ Unitary Elastic Demand is equal to 1.
❖ Price elasticity of Demand in merely a
mathematical measure of how sensitive
quantity demanded is to a change in
price.
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6-6
Price Elasticity of Demand (E)
Table 6.1
Elasticity
Responsiveness
E
Elastic
%∆Q> %∆P E> 1
Unitary Elastic
%∆Q= %∆P E= 1
Inelastic
%∆Q< %∆P E< 1
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6-7
Price Elasticity of Demand (E)
❖ Percentage change in quantity demanded
can be predicted for a given percentage
change in price as:
%Qd = %P x E
❖ Percentage change in price required for a
given change in quantity demanded can be
predicted as:
%P = %Qd ÷ E
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6-8
Price Elasticity & Total Revenue
❖ Total revenue
~ Total amount paid to producers for a good or
service (TR = P x Q)
❖ Price effect
~ The effect on total revenue of changing price,
holding output constant
❖ Quantity effect
~ The effect on total revenue of changing
output, holding price constant
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6-9
Price Elasticity & Total Revenue
Table 6.2
Elastic
Unitary elastic
Inelastic
%∆Q> %∆P%∆Q= %∆P%∆Q< %∆P
Quantity effect
dominates
No dominant
effect
Price effect
dominates
Price
rises
TR falls
No change in TR
TR rises
Price
falls
TR rises
No change in TR
TR falls
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6-10
Factors Affecting
Price Elasticity of Demand
❖ Availability of substitutes
~ The better & more numerous the substitutes for a
good, the more elastic is demand
❖ Percentage of consumer’s budget
~ The greater the percentage of the consumer’s
budget spent on the good, the more elastic is
demand
❖ Time period of adjustment
~ The longer the time period consumers have to
adjust to price changes, the more elastic is
demand
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6-11
Calculating
Price Elasticity of Demand
❖ Price elasticity can be calculated by
multiplying the slope of demand (Q/P)
times the ratio of price to quantity (P/Q)
Q
100
Q P
Q
Q
=
=
E=
P
P
P Q
100
P
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-12
Calculating
Price Elasticity of Demand
❖ Price elasticity can be measured at an
interval (or arc) along demand, or at a
specific point on the demand curve
~ If the price change is relatively small, a point
calculation is suitable
~ If the price change spans a sizable arc along
the demand curve, the interval calculation
provides a better measure
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-13
Computation of Elasticity
Over an Interval
❖ When calculating price elasticity of
demand over an interval of demand, use
the interval or arc elasticity formula
Q Average P
E=
P Average Q
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-14
Computation of Elasticity at a Point
❖ When calculating price elasticity at a point
on demand, multiply the slope of demand
(Q/P), computed at the point of
measure, times the ratio P/Q, using the
values of P and Q at the point of measure
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-15
Elasticity (Generally) Varies Along
a Demand Curve
❖ For linear demand, price and Evary
directly
~ The higher the price, the more elastic is demand
~ The lower the price, the less elastic is demand
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-16
Marginal Revenue
❖ Marginal revenue (MR) is the change in total
revenue per unit change in output
❖ Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope
of the total revenue (TR) curve
TR
MR =
Q
❖ Inframarginal units
~ Units of output that could have been sold at a higher
price had a firm not lowered its price to sell the
marginal unit
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-17
Demand & Marginal Revenue
(Table 6.3)
TR = P Q
MR = TR/Q
Unit sales (Q)
Price
0
$ 4.50
$ 0.00
1
4.00
4.00
$ 4.00
2
3.50
$7.00
$3.00
3
3.10
$9.30
$2.30
4
2.80
$11.20
1.90
5
2.40
$12.00
$ 0.80
6
2.00
$12.00
0.00
7
1.50
$ 10.50
$ -1.50
--
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6-18
Demand, MR, & TR
Panel A
(Figure 6.4)
Panel B
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-19
Marginal Revenue
❖ Inframarginal Units are the units that
could have been sold at a higher price
had the firm not lowered price to sell the
marginal revenue.
❖ MR = Price minus the revenue lost by
lowering the price on the inframarginal
units.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-20
Marginal Revenue
❖ Marginal revenue is positive when the
effect of lowering price on the
inframarginal units is less than the
revenue contributed by adding the sales
at the lower price.
❖ MR is negative when the effect of
lowering price on the inframarginal units is
greater than the revenue contributed by
the added sales at the lower price.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
6-21
Demand, MR & TR
❖ When MR is positive, total revenue
increases as price declines (demand is
elastic over this range.
❖ When MR is negative, total revenue
decreases as price declines (demand is
inelastic over this range).
❖ If MR is zero, total revenue does not
change when quantity change (unitary
price elasticity.
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