session 2 - concepts

7/31/2019 Session 2 - Concepts

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BASIC ECONOMIC

CONCEPTS


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Session 2

Objectives

Key principles of managerial economics & their

applications

31 October 2012 Session 2 2


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KEY PRINCIPLES OF ECOMOMICS

Principle of Opportunity Cost

Discounting Principle

Time Perspective

Marginal Principle

Increment Principle

Risk and Uncertainty

Spillover Principle

Information Asymmetry



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The Principle of Opportunity Cost

An Opportunity Cost is

something what you sacrifice to get it.

the cost incurred by the loss of potential gains from other alternatives

when one action is taken, that is, that consideration of costs must include

consideration of other forgone opportunities.

A focus on opportunity cost rather than measures of accounting

cost is a central characteristic of economic reasoning.

E.g. when considering the potential profit from one investment,the calculation of costs should include income that would have

otherwise been received (such as income from a bank deposit).



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Economic CostsThe total opportunity costs of explicit and implicit resources

Explicit Costs

Market Supplied Resources

They are the direct payments made to others in the course of running

a business, such as wages, rent and materials

a firm spends $100 on electrical power consumed, their opportunity

cost is $100. The firm has sacrificed $100, which could have beenspent on other factors of production.

Implicit Costs

Owner Supplied Resources

which are those where no actual payment is made

For example, a firm pays $300 a month all year for rent on a warehouse that

only holds product for six months each year. The firm could rent the

warehouse out for the unused six months, at any price (assuming a year-long

lease requirement), and that would be the cost that could be spent on other

factors of production. it is one of the most big consumption31 October 2012 Session 2 5


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Economic Profit

= Total revenue Total Economic Cost

= Total Revenue Explicit Costs Implicit Costs

Accounting Profit

= Total Revenue Explicit Costs

Accounting Profit is larger than Economic Profit



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Marginal Principle

Marginal effect of a small or incrementalchange

Marginal principle is based on a comparison of the

marginal benefits and marginal costs of a particular

activity

Marginal Benefit- Additional benefit resulting

from an activity

Marginal Cost Additional cost resulting from

small increase in some activity



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The Marginal Principle

How to decide go or no-go by considering the marginal

benefits and marginal cost?

Increase the level of an activity if its marginal benefit exceeds its

marginal cost

Reduce the level of an activity if its marginal cost exceeds its marginalbenefit.

Go ahead if:

Marginal benefit > Marginal cost

If possible, pick the level at which the activitys marginal profit greater

than or equal to its marginal cost.



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Marginal cost is the change in total cost that arises when the quantity producedchanges by one unit

Marginal cost (MC) function = Derivative of the total cost (TC) function withrespect to quantity (Q).

Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)

As fixed costs do not vary with production quantity d FC/dQ=0

Note:

Marginal cost is not related to fixed costs. This can be compared with average totalcost or ATC, which is the total cost divided by the number of units produced and doesinclude fixed costs.



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Example:

The marginal cost of keeping a bookstore open for one morehour equals the additional expenses for workers and utilities.

If the marginal benefit is Rs.80 of additional revenue and themarginal cost is Rs30 of additional cost for workers andutilities, staying open for the additional hour increases thebookstores profit by Rs 50.

Applying the marginal principle, the bookstore

should stay open for one more hour if the marginalbenefit (the additional revenue) is at least as largeas the marginal cost (the additional cost).



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Equi-marginal Principle



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Incremental Principle

involves estimating the impact of decision

alternatives on costs and revenue, emphasizing

the changes in total cost and total revenue

resulting from changes in prices, products,procedures, investments or whatever may be at

stake in the decisions.



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Incremental Principle

A decision is profitable if

it increases revenue more than costs

it decreases some costs to a greater extentthan it increases others

it increases some revenues more than it

decreases others and

it reduces cost more than revenues



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Discounting Principle

Rupee tomorrow is worth less than a rupee

today

FV = PV*(1+r)t

Or

PV = FV/ (1+r)t

Incremental cost and incremental principle



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According to this principle, if a decision affects costs and revenues in long-run, all

those costs and revenues must be discounted to present values before valid

comparison of alternatives is possible. This is essential because a rupee worth of

money at a future date is not worth a rupee today. Money actually has time value.

Discounting can be defined as a process used to transform future dollars into an

equivalent number of present dollars. For instance, $1 invested today at 10%interest is equivalent to $1.10 next year.

FV = PV*(1+r)t

Where, FV is the future value (time at some future time), PV is the present value

(value at t0, r is the discount (interest) rate, and t is the time between the future

value and present value.



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Time Perspective


Long run

Short run

Short term decisions influences your long term

decisions and vice versa

Finance :short term and long termProduction:short term some resources are fixed.

Long term all the resources are fixed.


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According to this principle, a manger/decision maker should give due

emphasis, both to short-term and long-term impact of his decisions, giving

apt significance to the different time periods before reaching any decision.

Short-run refers to a time period in which some factors are fixed while

others are variable. The production can be increased by increasing the

quantity of variable factors. While long-run is a time period in which allfactors of production can become variable. Entry and exit of seller firms

can take place easily. From consumers point of view, short-run refers to a

period in which they respond to the changes in price, given the taste and

preferences of the consumers, while long-run is a time period in which the

consumers have enough time to respond to price changes by varying theirtastes and preferences



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The Spillover Principle

In some cases, the costs of producing or

consuming the good are not confined to the

producer and/or consumer of the good

So called Negative externality

Examples of Spillover Costs

1. Air pollution

2. Water pollution



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The Spillover Principle

In some cases, the benefits of producing orconsuming the good are not confined to the producerand/or consumer of the good

So-called Positive externality.

Examples of Spillover Benefits

1. Developing high-speed railway can also benefit to manysectors, e.g. tourism, logistics, insuranceetc.

2. A flood-control dam benefits everyone in the area

regardless of who pays for it. 3. If scientists discover a new way to treat a common

disease, everyone suffering from the disease will benefit.

4. If engineer discover a new clean energy, everyone willbenefit.



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Risk and Uncertainty

Risk refers to a situation in which there can be

more than one possible outcomes, and the

probability of each such outcome is known

(When I can identify the outcome of an event)

Uncertainty refers to a situation which may

have more than one possible outcome and the

probability of each outcome cannot be

ascertained.

(when I cannot identify the outcome of any

item)31 October 2012 Session 2 20


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Information Asymmetry

A situation in which one party in a transaction

has more superior information compared to

another.

Adverse Selection: immoral behavior that

takes advantage of asymmetric information

before a transaction

Moral Hazard: immoral behavior that takes

advantage of asymmetric information aftera

transaction31 October 2012 Session 2 21


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