Power Points Managerial Economics

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Managerial Economics ©Oxford University Press, 2006 All rights reserved

Chapter 1

Foundations of Managerial

Economics




What is Economics?

•What to produce

•How to produce

•How to distribute




Definition, scope and functions

Microeconomics Macroeconomics Decision Sciences

Managerial Economics




The BIG Picture

Product

Market

FirmsHouseholds

Factor

Market

Income spent

Goods demand

Inputs supplied

Income earned

Inputs demand

Factor costs

Goods supplied

R

e

v

e

n

u

e

Revenue earned




Objective of the Firm• Profit maximization

- economic profit:

total revenue minus total economic

costs

- economic costs are “relevant” costs




Invisible Hand

Furthering selfish interest

Furthers growth of the Nation




Problems in Managerial

EconomicsClassified into two broad categories:

• Those requiring „optimal‟ solutions

- Total, Average and Marginal

magnitudes

• Those requiring equilibrium solutions

- Supply – Demand Analysis




Graphical Solution to Supply- demand

Analysis

P

Q

D

DS

S




Algebraic Solution

P = 300 – Qd P = 60 + 2Qs

a = 300; b = 1; c = 60; d = 2

300 – Q = 60 + 2Q

Q* = 80 P* = 220




Total, Average, and Marginal

magnitudesQ P TR MR Q P TR MR

(=AR)

0 10 0 - 6 4 24 -11 9 9 9 7 3 21 -3

2 8 16 7 8 2 16 - 5

3 7 21 5 9 1 9 -7

4 6 24 3

5 5 25 1




Relation between Total, Average

and Marginal Magnitudes• When Total is rising, Marginal is positive

• When Total is falling, Marginal is negative

• When Total is maximum, Marginal is zero

• When Average falls/rises, Marginal

falls/rises at a faster rate




Concept of Margin

• Rate of Change

• Derivative- Calculus




Chapter 2

Household as a Consumer




The decision making process of

the consumer

Preference set Constraints

Optimal decision




Assumptions

• Completeness

• Transitivity

• Non satiation




Utility and Optimization

• Utility:

- reflects a rank ordering of preferences.

- is a magnitude indicating the direction of

preferences

• Optimization:

- Cardinal Approach and OrdinalApproach




Optimization

The Cardinal Approach• Utility is cardinally measurable and the

objective is to maximize utility

• The Law of Diminishing Marginal Utility

• Optimization Rule 1:

When only one good is consumed and is

available for free, consume till

MUx = 0




Optimization

• Optimization Rule 2:

When only one good is consumed and is

available for a price:Consume till MUx = Pricex

• Optimization Rule 3:When more than onegood is consumed and the goods‟ prices are

different:

Consume till MUx /Px = MUy /Py = MUz /Pz




Optimization- The Ordinal approach

• Rank ordering of preferences

• Combinations of goods

Two inputs required to arrive at optimal

combination:

1. Preference set2. Opportunity set




Preference Set- Indifference

Curves• Indifference Curve:

Combination of goods that yield the same level

of satisfaction.• Properties of Indifference curves:

- Slope downward

- Convex to the origin- Non intersecting




Shapes of Indifference curves

MRS decreasing MRS Constant=1 One fixed proportion

Normal substitutes perfect substitutes Complements




Opportunity Set

• Defined by Budget Constraint.

6x + 3y = 60

Given Px = 6 and Py = 3

Graphically,

-Px /Py is the Slope

10

Y

20

X




Consumer’s Equilibrium- The

Optimal Combination

e

x

y

At „e‟ slope of the budget line is equal to the slope

of the Indifference curve.




Consumer’s Equilibrium

• Slope of the budget line: - Px /Py

• Slope of Indifference curve: MUx/MUy

• Equilibrium : MUx/MUy = Px /Py

or MUx/Px = MUy/Py




Chapter 3

Comparative Statics and Demand




Meaning of “comparative statics”

• The analysis which enables us to arrive at new

optimal decisions when underlying assumptions

change




Changes in equilibrium when prices

change• Relative price changes get reflected in changes in

slope of the budget line.

• New point of tangency between the indifference

curve and the new budget line




Changes in equilibrium

• Joining all these points of tangency gives the

Price Consumption Curve. (PCC)

X

Y

PCC

Price of X is falling.




Derivation of the demand curve

• Data contained in the PCC:

- Optimal level of consumption of X

- Optimal level of consumption of Y- Prices of X and Y

• Demand curve for X requires –

- Price of X.- Quantity consumed of X.




Demand Curve

• Every point on the PCC gives the price of X and

quantity demanded/consumed of X

Thus,

Qx

Px



Managerial Economics ©Oxford University Press, 2006

All rights reserved

Shifts in and movements along a

Demand Curve

• Effect on demand of changes in its own price

results in movement along the demand curve.

• Effect on demand of changes in other factors

results in shifts in demand curve




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Changes in equilibrium when

income changes• Income changes show up as parallel shifts of the

budget line

• New points of tangency between indifference

curves and the new budget lines




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Changes in equilibrium

• Joining all these points of tangency gives

the Income Consumption Curve (ICC)

X

Y

ICC




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Slope of the ICC

• If the goods are „Superior‟, the ICC is

upward sloping

• If one of the goods is „Inferior‟, the ICC

is downward sloping




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Slope of the PCC

• If the goods are normal, PCC is upward

sloping

• If PCC is downward sloping, then one of them

is a Giffen Good




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Giffen good

Income effect

• Price effect +

Substitution effect• Substitution effect is inversely related to price.

• Income effect can be inversely related to

changes in income – Inferior Good• Income effect can be positively related to

income-Superior good




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Giffen Good

• If income effect is inverse and large enough to

offset the substitution effect, then it is a GiffenGood

• The Demand curve for Giffen Good will have apositive slope




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Elasticity

• Price Elasticity: Proportionate change in

quantity demanded due to a

proportionate change in price- ∆Qx/ ∆Px * Px/Qx

- negative for normal goods

- negative sign is ignored while making

comparisons among normal goods






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Elasticity

• Income Elasticity

∆Qx/∆I * I/Qx

• Could be negative or positive:

Negative for Inferior goods

Positive for Superior goods




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Elasticity

• Cross Price Elasticity:

∆Qx/∆Py * Py/Qx

• Could be negative or positive

- Negative for complements

- Positive for substitutes




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Chapter 4

Demand Estimation and

Forecasting




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Demand Estimation Techniques

Qualitative Quantitative

- consumer Surveys - Statistical estimation

- Market Experiments Techniques- Consumer Clinics - Regression




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Steps in Demand Estimation

Exercise• Identification of variables

• Collection of Data

• Mathematical specification of the relationship• Estimation of the parameters

• Using these estimates to arrive at estimates of

variables




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A Simple Linear Regression Model

• Y = a + BX + u

Where Y is the dependent variable

X is the independent variable„a‟ is the intercept ; „b‟ is the slope ; „u‟ is the

error term.




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Method of Estimation

• Method of Ordinary Least Square( OLS)

- minimizes the sum of the squared deviations of

each of the points from the mean.




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Coefficient of Determination

• Regression Sum of Squares (RSS) /

Total Sum of Squares (TSS) is R2

– Coefficient of Determination

• If R2 = 1, the best fit.

• If R2 = 0.4, 40% of the total deviationsis explained by the regression




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Graphical Representation

R2 = 1 R2 = 0




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Problems in using Regression

• Multicollinearity – where there is dependency

amongst independent variables

• Identification problem• Auto correlation




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Forecasting Techniques

• Opinion polls and market research

• Expert opinion

• Surveys• Economic indicators

• Projection Techniques

• Econometric Models




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Time Series Projection using

Least Square method

• How the dependent variable moveswith time

Yt = f (Tt , St , Ct , Rt ) whereYt is the actual value of the data in time series

Tt is the trend component at time „t‟

St is the seasonal component at time „t‟

Ct is the cyclical component at time „t‟

Rt is the random component at time „t‟




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Chapter 5

Firm as a Producer




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Creation of a firm

• To minimize Transaction costs

• One entity takes the responsibility to bring all

the factors together required for production




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Motive behind existence of a Firm

• Profits

- economic Profits

- total revenue minus total „economic‟ costs

• Economic costs are „relevant‟ costs usingthe principle of opportunity costs




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Marginal Analysis

• Used to arrive at the profit-maximizing output

level

• Uses the concepts of Marginal revenue andMarginal Cost

• Marginal revenue is the change in total

revenue due to an additional unit of output

• Marginal cost is the change in total cost due to

an additional unit of output




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Profit-maximizing Rules

• Rule- The level of output at which MR = MC

• Should this level of output be produced at all?

- Shut Down Rule:If at the optimal level of output, Average

Revenue is less than Average (economic) Cost,

then, SHUT DOWN.




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Do Firms really maximize Profits?

• Satisficing Theory

• Other Objectives:

- provide good products/services tocustomers

- a good work place for employees

- responsibility to society




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Control Mechanisms

• Principal – Agency Cost

Therefore CONTROL MECHANISMS

Internal External

-board of Directors - Takeovers

- ESOPs




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Non- Profit Firms

• No right to accumulate Profits

• Operate with funds from external sources

• Exempt from Corporate Tax




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Public Sector Firms

• Operate in areas where Private sector will not

operate

• Involved in the provision of Public goods




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Chapter 6

Analysis of Production






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Production Function with twovariable inputs

• Q = f (K , L) where K is capital and L is labour




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Isoquants

• Graphical representation of production

function• A curve drawn through the technically feasible

combinations of inputs to produce a target

level of output




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Map of Isoquants

Output 160

Output 200Output 260

K

L




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Properties of Isoquants

• They are downward sloping

• They are convex to the origin

• They do not intersect




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Production function with onevariable input

• Total Product: Q = 30L+20L2-L3

• Average Product : Q /L

• Marginal Product : MP = dQ/dL = 30+40L-L2




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Production Elasticity

• ∆Q / ∆X * X / Q = MPx * 1 / APx




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Three Stages of Production

• Stage 1: AP is increasing, MP is increasing and

Production Elasticity is > 1.

• Stage 2: AP and MP are decreasing andProduction Elasticity is 0 < Prod.Elas < 1

• Stage 3: MP and AP continue to decrease and

Production Elasticity < 0.




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Returns to Scale

• Increasing Returns to Scale When output

increases by a proportion greater than the

proportionate increase in all inputs.

• Decreasing returns to scale

• Constant returns to scale




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Cobb – Douglas ProductionFunction

• Q = A Lα Kβ

Where, α + β indicates Returns to Scale

If > 1, it exhibits Increasing Returns to Scale

If < 1, it exhibits Decreasing Returns to Scale

If = 1, it exhibits Constant Returns to Scale




Optimal Input Levels

• With one variable input:

Marginal Revenue Product (MRP) = Marginal

Variable Cost.MRP = MP * MR

• With many variable inputs:

MPL

/ PL

= MPK

/ PK

= ……….




Chapter 7

Analysis and Estimation of

Costs




Concepts of costs

• Economic costs – Relevant costs definedin terms opportunity costs

• Sunk costs – Expenditures that are

irrelevant for decision making during theconcerned period

• Normal Profit – this is as much acomponent of costs as wages, interest, etc.It is a payment for „entrepreneurship‟




Long-run total Cost (LRTC)

• Steps to derive:

- select level of output

- find the point of tangency between therelevant isoquant and the isocost line

- repeat the first two steps for differentlevels of output

- the line joining all these points of tangencyis the LRTC




Short run Total Cost (SRTC)

• The relevant cost is the Short-Run Variable

cost

• Fixed costs are irrelevant in the short run

• The slope of the SRTC varies with the

returns from the variable input




Average and Marginal Cost Curves

• The LRAC is derived from LRTC ; is U-

shaped reflecting Returns to Scale

• SRAC is derived from SRTC; is U-shapedreflecting variable returns from the variable

input in the short run

• Marginal Cost is derived from LRTC or

SRTC; is U- shaped




Relationship between Marginaland Average Cost

• When MC is below the AC, the AC falls

• When MC is above the AC, the AC rises

• When AC is at the minimum, MC is rising• MC cuts AC at the minimum of the AC




Relationship between LRAC andSRAC

• Points on the LRAC gives the lowest cost of

producing a target level of output

• The lowest point on the SRAC gives the level of output at which the AC is lowest in the short

run




Cost Functions

• Polynomial Function:

- Cubic Fn: TC = a + bQ - cQ2 +dQ3

- Quadratic Fn: TC = a + bQ + cQ2

- Linear Fn: TC = a + bQ

• Logarithmic Function:

- ln TC = a + b ln Q




Breakeven Analysis

• Qb = TFC / ( P – AVC)

P – AVC is “ Contribution”

• Quantity at which a target profit can beearned:

Q = TFC + Profit Target / Contribution




Chapter 8

The Competitive and Monopoly

Models




Optimizing rules in CompetitiveModel

• Marginal Output Rule:

MR = MC

• Shut-down Rule:If P (price) is less than Min AC , then SHUT

DOWN

M i l t t R l d S l C




Marginal output Rule and Supply CurveGraphical Representation

MC

AEC (Avg Eco. Cost

AR=MR=P

Q

Rs/unit

B

Every point above „B‟ on the MC curve is a pointon the Short run supply curve




Long Run (LR) Supply curve

• The relevant curves are the Long run MC curve

and the Long run Avg Cost curve.

• Derived from these two curves just as the Short

run supply curve.




Elasticity of supply

• Ess = % change in quantity supplied / %

change in price

• Flatter the supply curve , larger the elasticity




Characteristics of a Perfectly

competitive Market

• Large number of sellers. Each seller is

therefore a price taker

•Large number of buyers

• Homogeneous product- hence uniform price

• Perfect information

• Free entry and exit- so no supernormal profits



N i l i f P f




Normative analysis of PerfectCompetition

• Total Surplus is maximum

SS

DD

A

B




Monopoly

• A single firm faces the entire demand - Price

Maker

• No role for strategy

• No substitutes

• No entry

P i i d O d i i f




Pricing and Output decisions of aMonopolist

• Downward sloping demand curve or AR

curve

• Hence a falling MR curve• MC=MR at E

ARMR

MC

Q

E




Monopoly Vs Competitive Solution

• Output lower and price higher in a monopoly than

in competition.

• This is because :

MR = P in Competition and MR < P in Monopoly

In competition, MC =MR =P.

In monopoly, MC=MR and MR < P




Regulation of Monopoly

• Regulation of prices

• Antitrust Policies – to prevent the

monopolist from exercising Monopoly

Power.

• In India , we had the MRTP Act of 1969

• We now have the competition Act 2002

• Patent Policy

R ti l b hi d P i




Rationale behind PriceDiscrimination

• To transfer as much as possible of the

consumers surplus over to the seller




Price Discrimination

• Practice of charging different prices in

different markets for the same product

• The seller should be a price maker

• Price elasticity of demand has to be different

for different market segments

• The different market segments should be

insulated




Chapter 9

Monopolistic Competition and

Oligopoly

F t f li ti




Features of monopolisticCompetition

• Large number of sellers but each seller is a

Price Maker

• Large number of imperfect substitutes due to

product differentiation

• Large number of uninfluencing buyers – both

informed and uninformed

• Free entry

Eq ilibri m Short r n and Long




Equilibrium- Short run and Longrun

• In the Short run at MR =MC , the seller

makes Super normal Profits

• In the Long run, „ Free entry‟ squeezesout the Profit

• So at the Long run equilibrium, MR =

MC= AC




Features of Oligopoly

• Few sellers

• Interdependence

• Intense rivalry• „Strategy‟ plays a dominant role.

• Barriers to entry; Natural and Strategic




Equilibrium in Oligopoly

• Cournot Equilibrium

• Bertrand Equilibrium

• Stackelberg Equilibrium• The kinked demand model

• Cartel

• Collusion

• Price Leadership




Game Theory and Oligopoly

• A Pay off Matrix: WIPRO

without remote with

remotewithout areas areas

H remote areas 40,70

35,55

C

L With remote

areas 30,60 45,45




A Game Tree

Hero

Atlas

Atlas

low

high

Rs 4000,4000

Rs 6000,1000

Rs 1000,6000

Rs 3000,3000

highlow

lowhigh




Strategies

• Maximin Strategy

• Dominant Strategy

• Dominated Strategy• Pure and mixed Strategy




Different Games

• Entry Game• Games of imperfect and incomplete

information – Prisoners‟ Dilemma

Games• Sequential Games

• Repeated Games

• Finitely repeated Games




Chapter 10

Alternative Pricing Practices




Pricing of Multiple Products

• Products with interdependent

demands but independent production

Optimizing rule:

MCx = MRx

MRx

= dTRx /dQ

x+ dTR

y /dQ

x




Pricing of Multiple Products

• Products related in production but

independent in demand:

Optimizing rule:

1. MC of Production = MR1 + MR2+….

Eg. Petroleum Products

2. MC = MRt (Total MR)

Eg. Hide and Meat- A Product Package




Other Pricing Principles

• Fully distributed Cost – based pricing

• Incremental Cost Pricing

• Ramsey Pricing




Other Pricing Principles (contd…)

• Transfer Pricing:

- a firm with multiple divisions where eachis

treated as an autonomous profit centre.- where Market exists, the rule is:

• Transfer the product at Market Price

- where external market exists, transfer at

P=MC- where external market is imperfect,behave

like a discriminating monopolist




Other Pricing Principles (contd..)

• Two Part Tariff:

- a lump sum fixed Charge and a Variable component

• Peak Load Pricing:

- where the product is not storable.

- Where demand varies with time.

- Differing price elasticities

- The same facility is being used to meet all the different

demands




Chapter 11

Market for Factor Inputs




Competitive Factor Markets

• Demand for a single variable factor:

MRPl = MFCl

( MPl * MR = MRPl )• Demand for several variable factors:

MC = w/MPl = r/MPk

Or MC/MR = w/MRPl

= r/MRPk




Economic rent

• In the context of factor markets, the excess of

payment over the minimum required to buy

the use of the factor is economic rent.

• Economic Rent earned varies with supply

elasticity




Monopsony in the factor market

• A single buyer of a factor

• Minimum Wage Law to protect labour from

exploitation by monopsonist




Factor market with Monopoly Power

• A single seller of a factor

• A classic example is the Labour Union




Bilateral Monopoly

• A monopolist seller meets a monopsonist buyer

• Each would bargain and the price gets fixed

Ch t 12




Chapter 12

Long Term Investment and

Risk Analysis




Evaluation of Capital Expenditure

• Large investments in assets which, once

undertaken, are irreversible

• Revenue occurs in the future




The Capital Budgeting Process

• Generation of capital investment projects

• Estimation of the cash flows

• Evaluation of the projects

• Ex-post evaluation of projects

Methods of evaluating investment




Methods of evaluating investmentprojects

• Payback period

• Average return on investment or Accounting

rate of return

• Net Present Value

• Internal rate of Return




Discounting

• The process of bringing the future stream of

revenues to the present

• Choice of the discount rate is important

• The discount rate should reflect the

opportunity cost of capital to the firm

E i C B fi A l i




Economic Cost – Benefit Analysis

• Used to evaluate projects where „ profits „ are

not very relevant

• Used in situations:

- with externality

- where distributional impact is important

- of merit goods

Ri k




Risk

• A decision making situation in which the

possible outcomes can vary and the probability

of occurrence of each outcome is known

I ti f Ri k




Incorporation of Risk

• Subjective approach

• Utility function approach

• Decision tree approach• Risk adjusted discount rate approach

M i Ri k d U t i t




Managing Risk and Uncertainty

• Seek more information

• Diversification

• Hedging• Insurance

• Controlling the operating environment

• Restricting use of firm-specific assets

Th C f D l t bl R




The Case of Depletable Resources

• Cost of Production

• Cost of Depletion

I t t R t




Interest Rates

• Interest rate is the price of funds

- Prime lending rate

- Commercial paper rate- Discount rate or Bank rate

- T- Bill rate




Chapter 13

Economics of Information

I f t I f ti




Imperfect Information

• Incomplete Information

- where both sides to a transaction do not

possess complete information

• Asymmetric Information

- where one of the parties to a transaction has

more information than the other

As mmetric Information ( td )




Asymmetric Information (contd…)

• Two sources:

- the characteristic (e.g. – quality of a

used car)- a hidden action (e.g. – actions of an

employee such as „shirking‟ work)

Signalling




Signalling

• Ways of conveying and getting information on

hidden characteristics (e.g. airlines offering

various „Packages‟)

Adverse Selection




Adverse Selection

• an outcome of asymmetric information

wherein you select precisely the ones you

should not (e.g. – the unhealthy and weak

taking up health insurance)

• this is due to asymmetric information on

some hidden characteristics

Responses to Adverse Selection




Responses to Adverse Selection

• Market response:

- “the insurance industry makes medical

examination compulsory, higherpremiums”

Government Response:

- “making information mandatory”

Hidden Action




Hidden Action

Characterized by:

- one side of the transaction not being able to

observe the action taken by the other.

- The unobservable action affects the other side.

- no agreement on whether the action should be

taken or not.

* The result of hidden Action is Moral Hazard



Moral Hazards in Product Markets




Moral Hazards in Product Markets

• Brand Name Reputation as Hostages

• Guarantees and Warrantees



Externalities




Externalities

• The effect of an economic activity that is not

incorporated into or reflected in the market

price is called an Externality

• Externality if negative, imposes a „cost‟

unaccounted for

• Externality if positive, gives rise to a „benefit‟

not accounted for

Externalities (contd )




Externalities (contd..)

• Pollution is a negative externality;

development of an area due to industrial

units being set up is a positive externality

• The result is that costs and benefits are

either overestimated or underestimated

Internalizing Externalities





• Government‟s response:

- Taxes

- Regulation

- Effluent Fee

- Transferable Emission Permits

- Recycling






• Market‟s Response

- Mergers

- Social Conventions

- Property Rights

Public Goods




Public Goods

• Public goods are Non Rival

• Public Goods are Non Excludable

• The result: no reason for the consumerto reveal his/her valuation of the good or

service

• HENCE MARKETS FAIL

Provision of Public Goods




Provision of Public Goods

• Government alone being responsible.

• Public Private Partnerships (P3s)

Public Private Partnerships (PPP)




Public Private Partnerships (PPP)

• PPPs are contractual arrangements between agovernment and a private party for the provisionof Assets and the delivery of services that havebeen traditionally provided by the public sector

• The central point is the sharing of decisionmaking authority

• The not-so central point is the sharing of rewards and risks




Chapter 15

Macroeconomic Aggregates

Macro Aggregates




Macro Aggregates

• Aggregate output levels

• Aggregate Price levels

• Aggregate Investment levels

• Aggregate Consumption levels

• Balance of Payments

Fundamental Identity




Fundamental Identity

Agg output ≡ Factor Income ≡Expenditure

Measures of Aggregate Output




Measures of Aggregate Output

At Market Price At Factor Cost

* Gross Domestic Product

* Gross National Product

* Net Domestic Product

* Net National Product

* PPP Gross Domestic ProductNational Income ≡ NNP at Factor Cost

Price Indices




Price Indices

• CPI (Also called Cost of living Index)

• WPI (Wholesale Price Index)

• GDP Deflator

Price Indices




Price Indices

• CPI : Weighted Average Retail Price of aspecific basket of goods.

• WPI : Based on wholesale prices of a

specific basket of goods ( different from CPI’sbasket both in composition and in weights).

• GDP Deflator: Ration of Nominal GDP to

Real GDP.

Aggregate Consumption




Aggregate Consumption

• Keynesian Consumption function

- Concept of Marginal Propensity to

consume

• Irving Fisher‟s Hypothesis

• Life-Cycle Hypothesis

• Duesenberry‟s Hypothesis

• Random walk Hypothesis

Investment




Investment

• Investment as a function of changes in

income(Y)

- The Accelerator• A relationship between Investment and

the stock market is Tobin‟s Q

• Investment as a function of Real InterestRate

Inflation and Unemployment




Inflation and Unemployment

Cost-Push

• InflationDemand- Pull

Remedy in the Short Run: SqueezingAggregate Demand

Phillip’s Curve




Phillip s Curve

• Inflation (Wage rate) and Unemployment are

inversely related

• NAIRU: Non Accelerating Inflation Rate of

Unemployment

w

Unemp rate

W is wage rate

Balance of Payment




Balance of Payment

• Captures all transactions between any

economy and the rest of the world.

• Current Account

• Capital Account

Balance of Payment




Balance of Payment

• Items keenly watched:

- ratio of current account Deficit/surplus

to GDP- ratio of Capital Account surplus/deficit

to GDP

- extent of intervention through reserves.




Chapter 16

Fiscal, Monetary and Exchange

Rate Policies

Business Cycles




Business Cycles

• Fluctuations in economic activity.

- low level of economic activity: Recession

- Peaking levels of economic activity: Boom

• Economic activity is measured by rate of

change in GDP

• Policy interventions are called for to reduce

the severity of fluctuations and to stabilize theeconomy

Stabilization Policies




Stab at o o c es

• Reliance on Demand management Policies in

the Short Run.

Fiscal Policies Monetary Policies

Fiscal Policy




y

• Instruments: Taxes and Government Spending

• These two instruments don‟t work through the

market.

• Both these are reflected in the Budget.

Monetary Policy




y y

• The central bank of a country is the sole authority.

• Interest Rate is the instrument which is

manipulated by changes in Money supply.

• Interest rate is the price of funds.

Money Supply




y pp y

• Is primarily determined by the central bank.

• The banking sector plays a key role through the

„fractional reserve system‟ and the „multiple

expansion of deposits‟.

Money Multiplier




y p

• Given by :

Cu /D + 1

-----------------------------

Cu/D + RR/D + ER/D

Where Cu is the currency, RR is Required reserves

and ER is Excess Reserves.

Exchange Rate Policies




g

• Fixed Exchange rate Policy

• Market determined Exchange rate Policy

• Between these two, there is a system of “Managed

Floats”

Stability of Exchange Rates




y g

• Depends on elasticities of imports and exports.

• An elastic import basket and an elastic export

basket results in stable rates.

• An inelastic import basket and a relatively highly

elastic export basket also results in stable rates.

• An inelastic import basket and a not so elastic

export basket results in instability in exchangerates.

Devaluation




• A reduction in the value of a currency.

• Devaluation is done when:

- a country cannot maintain the Fixed Exchange

rate due to scarcity of Reserves.

- a country chooses to consciously improve trade.



Relationship between Monetary policies

and Exchange rate Policies




and Exchange rate Policies

• Fixed Exchange Rate Policy:

monetary Policy‟s role is exclusively to maintain

the fixed rate for which it requires reserves of

foreign and domestic currencies.

Flexible Exchange rate policy gives freedom to use

monetary policies for other purposes.

Chapter 17




The New Economy

Definition




• Outcome of the Information Revolution.

• It has 3 distinguishing characteristics:

- it is leaning on intangibles

- it is global

- it is intensely interlinked

The New Economy is thus a „Network‟ Economy.

Information Goods




• These are digitized information.

Eg. Encyclopedias, Directories

• Characteristics:

- High fixed costs but very low variable costs of

reproduction.

- The above results in non excludability and

market failure.- Pricing is Value based (since MC is near zero)

Network and Network Industries




• Industries which provide Information goods are

called Network industries.

• A network is a set of connections between nodes.

• Networks could be real or virtual.

• Larger the network size, more viable the

production and usage.

Networks




• Network Externality: The value to each user

being in the network rises at a rate much higher

than the rate of increase in the size of the network.

Old Economy Industries (OEI) Vs

Network Industries




Network Industries

• In old eco.Industries (OEI), economies of scaleoccur on the supply side, whereas in the Network industries, they occur on the Demand side.

• In OEIs, demand is downward sloping and this„shifts‟ when factors change. For network industries, demand increase as accumulateddemand increases- a positive feedback chain.

• In OEI, scarcity gives rise to value. In Network industries, abundance gives rise to value.

Rise and Fall of Dot-Coms




• Dot-Coms emerged to deal with products

and services that used the Internet.

• Focused on „mind share‟(market share) torealize Network externalities.

Ignored the result of the outcome of theabove- a “winner takes all” situation.

Fundamental Laws and Concepts of

Old Economy




Old Economy

• Profit Maximization

• Economies of scale results in one or few

winners.

• Demand estimation and elasticities are

important.

• Cost estimation is essential.

Ignoring the above led to the demise of Dot-

Coms

Internet Pricing Models




• Flat – rate Pricing

• Usage sensitive Pricing

• Transaction- based Pricing

• Priority Pricing

• Precedence model

• Smart Market Mechanism Model

Role of Government



•Public policy to facilitate adoption and adaptation.

•Policy to actively promote innovation.

•Policy to provide education.

•Policy to promote digitization.

Power Points Managerial Economics

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