Managerial Economics

MANAGERIAL ECONOMICS

PROF. B. S. PATIL

ECONOMICS z z

z

z

A social science, not a natural science… “…the study of how a given society allocates scarce resources to meet the unlimited wants and needs of its members” “…concerned with the efficient use of scarce resources to achieve the maximum satisfaction of wants” “…seeks to understand how individuals interact with the social structure… to address production and exchange of goods and services”

Why study it? z z z z

Study of economics deals with production, allocation and distribution of resources Economics is a great field and entry to lots of interesting and important jobs Allows us to think abstractly and ask… “what if…” Useful for policy-making in business, government or non-profit pursuits

What I hope you get out of this course z z z

Develop basic understanding of decision-making from an economic perspective Understand economic interactions, economic organizations & functions of the Indian economy Enhance your critical thinking, communication and problem solving skills

What this course is about z z z z z z

An analysis of firms and markets An analysis of things that influence economic behavior and decision-making Individual (micro) and aggregate (macro) effects How is economic information used? How do societies use and allocate scarce resources? How should societies be allocated?

MANAGERIAL ECONOMICS Economics contributes to a great deal towards the performance of managerial duties and responsibilities. Like : Biology - Medical profession Physics - Engineering Economics contributes to managerial profession. Managers with working knowledge of economics can perform their functions more efficiently than those without it. The emphasis here is on the maximization of the objective and limitedness of the resources. The task of management is to optimize the use of resources.

INTRODUCTION Economics though variously defined “is essentially the study of logic, tools and techniques of making optimum use of the available resources to achieve the given ends” Economics thus provides analytical tools and techniques that managers need to achieve the goals of the organisation they manage. Therefore, working knowledge of economics is essential for the managers. Managers are essentially practicing economists.

MANAGERIAL ECONOMICS - DEFINITIONS

Managerial economics in general defined as the study of economic theories, logic and methodology which are generally applied to seek solutions to the practical problems of business. McNair & Marian: “Business economics consists of the use of economic models of thought to analyze business situations”

MANAGERIAL ECONOMICS - DEFINITIONS

We may therefore, define managerial economics as “the discipline which deals with the application of economic theory to business management” Managerial economics thus lies on the broad line between economics and business management and serves as a bridge between the two disciplines

MANAGERIAL ECONOMICS DEFINITIONS Mansfield: “M.E. is concerned with application of economic concepts and economic analysis to the problems of formulating rational managerial decision” Spencer & Siegelman: “M.E. is the integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management”

MANAGERIAL ECONOMICS MANAGEMENT DECISION PROBLEM ECONOMIC THEORY -MICRO

BUSINESS MANAGEMENT - DECISION PROBLEMS

-MACRO MANAGERIAL ECONOMICS -Application of economic theory & Decision

Science tools to solve managerial decision problem OPTIMAL SOLUTION TO MANAGERIAL DECISION PROBLEMS M. E refers to the application of economic theory and decision science tools to find the optimal solution to business decision problems

SCOPE OF MANAGERIAL ECONOMICS The subject matter of business economics has been divided into two parts 1. Micro - Economics 2. Macro - Economics Micro Economics: In micro economics we make a microscopic study of the economy. It should be remembered that micro economics does not study the economy in its totality. Micro economics consists of looking at the economy through a microscope, as it were, to see how the millions of the consumers and the individuals or firms as producers play their part in the working of the whole economic organisation. For instance, Demand : we study the demand of an individual consumer for a good and from there go on to derive the market demand for the good.

SCOPE OF MANAGERIAL ECONOMICS The whole content of micro economic theory may be presented as follows Micro Economic Theory

Product Pricing

Theory Of Demand

Theory Of Production & Costs

Factor Pricing (Theory of Distribution)

Wages

Rent

Theory of Welfare Economics

Interest

Profits

SCOPE OF MANAGERIAL ECONOMICS

Macro Economics: Macro economics analyses the behaviour of the whole economic system in totality. It studies the bahaviour of the large aggregates such as total employment, the national product or income, the general price level in the economy. Therefore, macro economics is also known as aggregative economics.

SCOPE OF MANAGERIAL ECONOMICS It should be noted that micro economics also deal with some “aggregates” but not of the type with which macro economics is concerned. Ex: Industry behaviour. Macro economics concerned with aggregates which relates to the whole economy. Ex: total production of consumer goods (total consumption) and the total production of capital goods (total investment) are two important subaggregates dealt within macro economics.

SCOPE OF MANAGERIAL ECONOMICS

The contents of the macro economic theory MACRO ECONOMIC THEORY

Theory of Income and Employment

Theory of General Price level & Inflation

The Theory of Economic Growth

Entrepreneurship and Profits „

„

„

„

Unlike other factors of production, profit is not determined by the supply of and demand for entrepreneurship Profits are considered a residual from Total Revenue after the payment of rent, interest, and wages One could argue that since all other factors are determined by supply and demand, profits are indirectly determined by these forces Your author estimates profit to be about 18.5% of the Nation’s National Income

Theories of Profit

„

„

„

Economic profit is the reward for recognizing a profit opportunity and taking advantage of it Theories overlap, but see the entrepreneur as one who sees an advantage and grabs it Theories • • • •

The The The The

entrepreneur entrepreneur entrepreneur entrepreneur

as as as as

a risk taker an innovator a monopolist an exploiter of labor

The Entrepreneur as a Risk Taker

„

„

„

„

The only way to get someone to risk money is to offer a high reward (economic profit) as an incentive Economic profit is associated with uncertainty; nothing ventured, nothing gained Entrepreneurs are willing to take the risk in return for the opportunity of a large reward Profit is the reward for risk bearing

The Entrepreneur as an Innovator

„ „

„

„

An invention is not the same as an innovation Innovation includes invention but also carries the business process from production to marketing to profit generation; that is, it is the commercialization of the invention It is the effort to carry an invention through to its logical conclusion – the generation of a profit Joseph Schumpeter, noted Harvard economist, even stated that innovation and financial risk are two separate components – Financial risk is interest

The Entrepreneur as a Monopolist

„

„

„

The entrepreneur takes advantage of the idea of exclusivity to monopolize a product or service Natural scarcity – to do it first and thereby lock out potential competitors Contrived scarcity – to corner a market on a vital resource or gain economic power to limit competition and generate profit by reducing production and raising prices • • •

DeBeers (diamonds) Early Railroads National Football League

The Entrepreneur as an Exploiter of Labor

„ „

„

„

Karl Marx – The Capitalist exploits the value of Labor If the worker could produce enough value to sustain life by working six hours/day, but is forced by the capitalist to work 12 hours a day for six hours of value, the capitalist expropriates 6 hours of labor’s value for himself The capitalist uses the value of those six hours to purchase even more capital to exploit even more labor The surplus value of labor is the capitalist’s profit

Supply and Demand

DEMAND ANALYSIS

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Demand „

Demand means the Desire backed up by ability pay and willingness buy. Demand = Desire + Ability to pay + Willingness to buy

„

Prices are the tools by which the market coordinates individual desires.

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The Law of Demand „

Law of demand – there is an inverse relationship between price and quantity demanded. Quantity demanded rises as price falls, other things constant. z Quantity demanded falls as prices rise, other things constant. z

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The Law of Demand „

What accounts for the law of demand? z

People tend to substitute for goods whose price has gone up.

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The Demand Curve The demand curve is the graphic representation of the law of demand. „ The demand curve slopes downward and to the right. „ As the price goes up, the quantity demanded goes down. „

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Price (per unit)

A Sample Demand Curve

PA

A

D 0

QA Quantity demanded (per unit of time)

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Other Things Constant „

Other things constant places a limitation on the application of the law of demand. z

All other factors that affect quantity demanded are assumed to remain constant, whether they actually remain constant or not.

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Other Things Constant „

Other things constant places a limitation on the application of the law of demand. z

These factors may include changing tastes, prices of other goods, income, even the weather.

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Shifts in Demand Versus Movements Along a Demand Curve Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant. „ Graphically, it refers to the entire demand curve. „

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Shifts in Demand Versus Movements Along a Demand Curve Quantity demanded refers to a specific amount that will be demand per unit of time at a specific price. „ Graphically, it refers to a specific point on the demand curve.

„

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Shifts in Demand Versus Movements Along a Demand Curve „

A movement along a demand curve is the graphical representation of the effect of a change in price on the quantity demanded.

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Shifts in Demand Versus Movements Along a Demand Curve „

A shift in demand is the graphical representation of the effect of anything other than price on demand.

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Price (per unit)

Change in Quantity Demanded 2

B Change (Contraction) in quantity demanded (a movement along the curve)

1

A

D1 0

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100 200 Quantity demanded (per unit of time)

Price (per unit)

Shift in Demand Change (decrease) in demand (a shift of the curve)

2

1

B

A D0 D1

250 100 200 Quantity demanded (per unit of time) Micro232 2004 JAFGAC

Shift Factors of Demand „

Shift factors of demand are factors that cause shifts in the demand curve: Income. (individual and society) z The prices of other goods. z Tastes and preferences. z Expectations. z Taxes and subsidies to consumers. z

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Income „

An increase in income will increase demand for normal goods.

„

An increase in income will decrease demand for inferior goods.

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Price of Other Goods When the price of a substitute good falls, demand falls for the good whose price has not changed. „ When the price of a complement good falls, demand rises for the good whose price has not changed. „

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Tastes and preferences „

A change in taste will change demand with no change in price causing shift in demand curve.

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Expectations „

If you expect your income to rise, you may consume more now.

„

If you expect prices to fall in the future, you may put off (postpone) purchases today.

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Taxes and Subsidies „

Taxes levied on consumers increase the cost of goods to consumers, thereby reducing demand.

„

Subsidies have an opposite effect.

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The Demand Table „

The demand table assumes all the following: As price rises, quantity demanded declines. z Quantity demanded has a specific time dimension to it. z All the products involved are identical in shape, size, quality, etc. z

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The Demand Table „

The demand table assumes all the following: z

The schedule assumes that everything else is held constant.

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From a Demand Table to a Demand Curve „

You plot each point in the demand table on a graph and connect the points to derive the demand curve.

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From a Demand Table to a Demand Curve „

The demand curve graphically conveys the same information that is on the demand table.

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From a Demand Table to a Demand Curve „

The curve represents the maximum price that you will pay for various quantities of a good – you will happily pay less.

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From a Demand Table to a Demand Curve A Demand Table

A B C D E

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0.50 1.00 2.00 3.00 4.00

9 8 6 4 2

Price per DVDs (in dollars)

Price per DVD rentals cassette demanded per week (Rs)

A Demand Curve

(Rs) 6.00 5.00 4.00 3.50 3.00

E D

G

2.00

C

1.00 .50 0

F

Demand for DVDs B A

1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of DVDs demanded (per week)

Individual and Market Demand Curves „

A market demand curve is the horizontal sum of all individual demand curves. z

This is determined by adding the individual demand curves of all the demanders.

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Individual and Market Demand Curves „

Sellers estimate total market demand for their product which becomes smooth and downward sloping curve.

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From Individual Demands to a Market Demand Curve

A Rs.0.50 B 1.00 C 1.50 D 2.00 E 2.50 F 3.00 G 3.50 H 4.00

9 8 7 6 5 4 3 2

6 5 4 3 2 1 0 0

(2) Cathy’s demand

1 1 0 0 0 0 0 0

4.00

(3) Market demand

16 14 11 9 7 5 3 2

G

3.50

F

3.00 Price per cassette (Rs)

(1) (2) (3) Price per Alice’s Bruce’s cassette demand demand

E

2.50

D

2.00

C

1.50

B

1.00 0.50 0

A Cathy

2

4

Bruce Alice Market demand

6

8 10 12 14 16

Quantity of cassettes demanded per week

McGraw-Hill/Irwin

© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Law of Demand „

The demand curve is downward sloping for the following reasons: At lower prices, existing demanders buy more. z At lower prices, new demanders enter the market. z

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Supply Individuals control the factors of production – inputs, or resources, necessary to produce goods. „ Individuals supply factors of production to intermediaries or firms. „

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Supply „

The analysis of the supply of produced goods has two parts: An analysis of the supply of the factors of production to households and firms. z An analysis of why firms transform those factors of production into usable goods and services. z

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The Law of Supply „

There is a direct relationship between price and quantity supplied. Quantity supplied rises as price rises, other things constant. z Quantity supplied falls as price falls, other things constant. z

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The Law of Supply „

The law of supply is accounted for by two factors: When prices rise, firms substitute production of one good for another. z Assuming firms’ costs are constant, a higher price means higher profits. z

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The Supply Curve The supply curve is the graphic representation of the law of supply. „ The supply curve slopes upward to the right. „ The slope tells us that the quantity supplied varies directly – in the same direction – with the price. „

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Price (per unit)

A Sample Supply Curve S

PA

0

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A

QA Quantity supplied (per unit of time)

Shifts in Supply Versus Movements Along a Supply Curve „

Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant.

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Shifts in Supply Versus Movements Along a Supply Curve „

Quantity supplied refers to a specific quantity that will be supplied at a specific price.

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Shifts in Supply Versus Movements Along a Supply Curve „

Changes in price causes changes in quantity supplied represented by a movement along a supply curve.

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Shifts in Supply Versus Movements Along a Supply Curve „

A movement along a supply curve – the graphic representation of the effect of a change in price on the quantity supplied.

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Shifts in Supply Versus Movements Along a Supply Curve „

If the amount supplied is affected by anything other than a change in price, there will be a shift in supply.

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Shifts in Supply Versus Movements Along a Supply Curve „

Shift in supply – the graphic representation of the effect of a change in a factor other than price on supply.

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Shift in Supply S0 Price (per unit)

S1

15

A

B A to B Shift (Increase) in Supply (a shift of the curve)

1,250 1,500 Quantity supplied (per unit of time) Micro232 2004 JAFGAC

Change in Quantity Supplied Price (per unit)

S0 B

15

A

A to B Change (expansion) in quantity supplied (a movement along the curve)

1,250 1,500 Quantity supplied (per unit of time) Micro232 2004 JAFGAC

Shift Factors of Supply „

Other factors besides price affect how much will be supplied: Prices of inputs used in the production of a good. z Technology. z Suppliers’ expectations. z Taxes and subsidies. z

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Price of Inputs „

When costs go up, profits go down, so that the incentive to supply also goes down.

„

If costs go up substantially, the firm may even shut down.

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Technology „

Advances in technology reduce the number of inputs needed to produce a given supply of goods.

„

Costs go down, profits go up, leading to increased supply.

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Expectations „

If suppliers expect prices to rise in the future, they may store today's supply to reap higher profits later.

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Taxes and Subsidies „

When taxes go up, costs go up, and profits go down, leading suppliers to reduce output.

„

When government subsidies go up, costs go down, and profits go up, leading suppliers to increase output.

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The Supply Table Each supplier follows the law of supply. „ When price rises, each supplies more, or at least as much as each did at a lower price. „

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From a Supply Table to a Supply Curve „

To derive a supply curve from a supply table, you plot each point in the supply table on a graph and connect the points.

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From a Supply Table to a Supply Curve „

The supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good.

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From a Supply Table to a Supply Curve „

Competing suppliers’ entry into the market places a limit on the price any supplier can charge.

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Individual and Market Supply Curves „

The market supply curve is derived by horizontally adding the individual supply curves of each supplier.

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From Individual Supplies to a Market Supply (Price in Rs) (1) (2) (4) (5) (3) Quantities Price Ann's Barry's Charlie's Market Supplied (per DVD) Supply Supply Supply Supply A B C D E F G H I

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0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00

0 1 2 3 4 5 6 7 8

0 0 1 2 3 4 5 5 5

0 0 0 0 0 0 0 2 2

0 1 3 5 7 9 11 14 15

From Individual Supplies to a Market Supply 4.00

Charlie

Barry

Ann

Market Supply

Price per DVD

3.50

H

3.00

G

2.50

F

2.00

E

1.50

D

1.00 0.50 0 A

C B

CA

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quantity of DVDs supplied (per week)

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I

The Interaction of Supply and Demand Equilibrium: „ Equilibrium is a concept in which opposing dynamic forces cancel each other out. „

In a free market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price.

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Equilibrium „

Equilibrium price – the price toward which the invisible hand drives the market.

„

Equilibrium quantity – the amount bought and sold at the equilibrium price.

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What Equilibrium Isn’t „

Equilibrium isn’t a state of the world, it is a characteristic of a model.

„

Equilibrium isn’t inherently good or bad, it is simply a state in which dynamic pressures offset each other.

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What Equilibrium Isn’t „

When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change.

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Excess Supply „

Excess supply – a surplus, the quantity supplied is greater than quantity demanded

„

Prices tend to fall.

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Excess Demand „

Excess demand – a shortage, the quantity demanded is greater than quantity supplied

„

Prices tend to rise.

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Price Adjusts „

The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall.

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Price Adjusts „

When quantity demanded equals quantity supplied, prices have no tendency to change.

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The Graphical Interaction of Supply and Demand Price (per DVD) (Rs)

Quantity Supplied

1.50

7

3

+4

2.50

5

5

0

3.50

3

7

-4

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Quantity Surplus (+) Demanded Shortage (-)

The Graphical Interaction of Supply and Demand 5.00

S Excess supply

Price per DVD

4.00 3.50

A

3.00 E

2.50

C

2.00 1.50

Excess demand

1.00 1

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D

2 3 4 5 6 7 8 9 10 11 12 Quantity of DVDs supplied and demanded

The Graphical Interaction of Supply and Demand When price is Rs 3.50 each, quantity supplied equals 7 and quantity demanded equals 3. „ The excess supply of 4 pushes price down.

„

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The Graphical Interaction of Supply and Demand When price is Rs1.50 each, quantity supplied equals 3 and quantity demanded equals 7. „ The excess demand of 4 pushes price up.

„

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The Graphical Interaction of Supply and Demand „

When price is Rs 2.50 each (at point ‘E’) quantity supplied equals 5 and quantity demanded equals 5.

„

There is no excess supply or excess demand, so price will not rise or fall.

„

Therefore point ‘E’ is equilibrium situation

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Political and Social Forces and Equilibrium „

Political and social forces can push price away from a supply/demand equilibrium.

„

These forces create an equilibrium where quantity supplied won’t equal quantity demanded.

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Shifts in Supply and Demand „

Shifts in either supply or demand change equilibrium price and quantity.

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Increase in Demand An increase in demand creates excess demand at the original equilibrium price. „ The excess demand pushes price upward until a new higher price and quantity are reached. „

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Price (per DVDs)

Increase in Demand S0 B 2.50

Excess demand

A

B1

2.25 D0 0

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S1

D1

8 9 10 Quantity of DVDs (per week)

Decrease in Supply A decrease in supply creates excess demand at the original equilibrium price. „ The excess demand pushes price upward until a new higher price and lower quantity are reached. „

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Price (per DVDs)

Decrease in Supply S1 S0

C 2.50 2.25

Excess demand A D0

0

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B

8 9 10 Quantity of DVDs (per week)

The Limitations Of Supply And Demand Analysis Sometimes supply and demand are interconnected. „ Other things don't remain constant. „

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The Limitations Of Supply And Demand Analysis All actions have a multitude of ripple and possible feedback effects. „ The ripple effect is smaller when the goods are a small percentage of the entire economy.

„

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The Limitations Of Supply And Demand Analysis „

The other-things-constant assumption is likely not to hold when the goods represent a large percentage of the entire economy.

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The Fallacy of Composition „

The fallacy of composition is the false assumption that what is true for a part will also be true for the whole.

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The Fallacy of Composition „

The fallacy of composition is of central relevance to macroeconomics. z

In macroeconomics, the other-thingsconstant assumption, central to microeconomic supply/demand analysis, cannot hold.

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End of Supply and Demand

Micro232 2004 - jafgac

This is a PowerPoint presentation on the fundamentals of the concept of “elasticity” as used in principles of economics. A left mouse click or the enter key will add an element to a slide or move you to the next slide. The backspace key will take you back one element or slide. The escape key will get you out of the presentation.

Principles of Microeconomics

© R. Larry Reynolds

Elasticity · Elasticity is a concept borrowed from physics · Elasticity is a measure of how responsive a dependent variable is to a small change in an independent variable(s) · Elasticity is defined as a ratio of the percentage change in the dependent variable to the percentage change in the independent variable · Elasticity can be computed for any two related variables

Fall '97

Economics 205Principles of Microeconomics

Slide 2

Elasticity [cont. . . ] · Elasticity can be computed to show the effects of: · a change in price on the quantity demanded [ “a change in quantity demanded” is a movement on a demand function]

· a change in income on the demand function for a good · a change in the price of a related good on the demand function for a good · a change in the price on the quantity supplied · a change of any independent variable on a dependent variable

Fall '97

Economics 205Principles of Microeconomics

Slide 3

“Own” Price Elasticity · Sometimes called “price elasticity” · can be computed at a point on a demand function or as an average [arc] between two points on a demand function

· ep, η, ε are common symbols used to represent

price elasticity · Price elasticity [ep] is related to revenue · “How will a change in price effect the total revenue?” is an important question. Fall '97

Economics 205Principles of Microeconomics

Slide 4

Elasticity as a measure of responsiveness · The “law of demand” tells us that as the price of a good increases the quantity that will be bought decreases but does not tell us by how much. · ep [“own”price elasticity] is a measure of that information] · “If you change price by 5%, by what percent will the quantity purchased change? Fall '97

Economics 205Principles of Microeconomics

Slide 5

e

p

or,

% change in quantity demanded ≡ % change in price ep

≡

%∆Q %∆P

At a point on a demand function this can be calculated by:

ep =

Fall '97

Q Q22 -Q Q11 = ∆ Q Q1

=

P2 P-2 P -1 P=1 ∆ P P1

Economics 205Principles of Microeconomics

∆Q Q1 ∆P P1

Slide 6

+2 ∆ Q

ep =

[2/3 = .66667]

31 Q

=

∆ -2P P71

% ∆Q = 67% % ∆P = -28.5%

[-2/7=-.28571]

Price decreases from Rs.7 to Rs.5

Px Rs

P1 = 7 P2 = 5

A ∆ P = -2

.

[rounded]

The “own” price elasticity of demand at a price of Rs.7 is -2.3

P2- P1 = 5 - 7 = ∆ P = -2

∆ Q = +2

Fall '97

-2.3

This is “point” price elasticity. It is calculated at a point on a demand function. It is not influenced by the direction or magnitude of the price change.

B

Q1 = 3

=

Q2 = 5

Q2 - Q1 = 5 - 3 = ∆ Q = +2

D

There is a problem! If the price changes from Rs.5 to Rs.7 the coefficient of elasticity is different!

Qx/ut

Economics 205Principles of Microeconomics

Slide 7

ep =

∆-2 Q

[-2/5 = -.4]

5Q1

=

∆+2P P51

% ∆Q = -40%

% ∆P = 40%

= -1

[this is called “unitary elasticity]

[+2/5 = .4]

When the price increases from Rs.5 to Rs.7, the ep = -1 [“unitary”] In the previous slide, when the price decreased from Rs 7 to Rs 5, ep

The point price elasticity is different at every point!

There is an easier way!

Px P2 = 7 P1 = 5

ep = -2.3

A ∆ P = +2

B

∆ Q = -2

Q 2= 3 Fall '97

= -2.3

Q1= 5

Economics 205Principles of Microeconomics

ep = -1

D Qx/ut Slide 8

By rearranging terms

An easier way! ∆Q Q1 ∆Q P1

ep =

∆Q

=

Q1

*

P1 ∆ P

P1

ep

Q 2= 5

P2- P1 = 5 - 7 = ∆ P = -2

Q2 - Q1 = 5 - 3 = ∆ Q = +2

Then,

∆Q

∆P

=

+2 -2

∆P

*

P1 Q1

this is the slope of the demand function

Given that when: Q1 = 3 P1 = 7, P2 = 5,

=

∆Q

this is a point on the demand function

= -1

∆Q

= -1

∆P

P71

* Q 31

P1 = 7,

= -2.33

Q1 = 3

On linear demand functions the slope remains constant so you just put in P and Q

This is the slope of the demand Q = f(P) Fall '97

Economics 205Principles of Microeconomics

Slide 9

The following information was given

P1 = 7, P2 = 5,

Q1 = 3 Q 2= 5

7

The slope of the demand function ∆Q

∆P

=

+2 -2

= -1

The equation for the demand function we have been using is Q = 10 - 1P. A table can be constructed.

Fall '97

A B

5

Q2 - Q1 = 5 - 3 = ∆ Q = +2 P2- P1 = 5 - 7 = ∆ P = -2

[Q = f(P)] is

Q = f (P)

Px

Px must decrease by 5.

What is the Q intercept?

Q increases by 5

3

5

D

/

Q Q=x 10ut

The slope [-1] indicates that for every 1 unit increase in Q, Px will decrease by 1. Since Px must decrease by 5, Q must increase by 5

Q = 10 when Px = 0

The slope-intercept form Q = a10+ -m1 P

Economics 205Principles of Microeconomics

Slide 10

The slope is -1

The intercept is 10

For a simple demand function: Q = 10 - 1P Price (Rs)

quantity

0

10

1

9

2

8

3

7

4

6

5

5

6

4

7

3

8

2

9

1

10

0

Fall '97

ep

0 -.11 -.25 -.43 -.67 -1. -1.5 -2.3 -4. -9 undefined

Total Revenue

using our formula,

ep =

∆Q

P1

∆ P * Q1 the slope is -1, price is 7 P71 ∆Q ep = (-1) * Q1 = -2.3 3 ∆P at a price of 7, Q = 3 Calculate ep at P = 9 Q=1 ep = (-1) 9

1

= -9

Calculate ep for all other price and quantity combinations.

Economics 205Principles of Microeconomics

Slide 11

For a simple demand function: Q = 10 - 1P price

quantity

$0

10

$1

9

$2

8

$3

7

$4

6

$5

5

$6

4

$7

3

$8

2

$9

1

$10

0

Fall '97

ep

0 -.11 -.25 -.43 -.67 -1. -1.5 -2.3 -4. -9 undefined

Total Revenue

0

Notice that at higher prices the absolute value of the price elasticity of demand, ⏐ep⏐, is greater. Total revenue is price times quantity; TR = PQ. Where the total revenue [TR] is a maximum, ⏐ep ⏐ is equal to 1

9 16 21 24 25 24

In the range where ⏐ep ⏐< 1, [less than 1 or “inelastic”], TR increases as price increases, TR decreases as P decreases.

21 16 9 0

In the range where ⏐ep ⏐> 1, [greater than 1 or “elastic”], TR decreases as price increases, TR increases as P decreases.

Economics 205Principles of Microeconomics

Slide 12

To solve the problem of a point elasticity that is different for every price quantity combination on a demand function, an arc price elasticity can be used. This arc price elasticity is an average or midpoint elasticity between any two prices. Typically, the two points selected would be representative of the usual range of prices in the time frame under consideration.

The formula to calculate the average or arc price elasticity is: ∆Q P1 + P2 ep = *

P1 + P2 = 12

P1 = $7, P2 = $5,

Q1 = 3 Q2= 5

Q1 + Q2 = 8

Q2 - Q1 = 5 - 3 = ∆ Q = +2 P2- P1 = 5 - 7 = ∆ P = -2

ep =

∆Q

-1 ∆P

The average Fall '97

*

P1 12 + P2

Px

$7

Q1 + Q2

∆P

The average or arc ep between $5 and $7 is calculated,

A

Slope of demand

B

$5

ep between $5 and $7 is -1.5

∆P

= - 1

D

= - 1.5

Q1 8+ Q2

∆Q

3

Economics 205Principles of Microeconomics

5

Qx/ut Slide 13

Given: Q = 120 - 4 P

Price $ 10 $ 20 $ 25 $ 28

Quantity

e

p

TR

Calculate the point ep at each price on the table. Calculate the TR at each price on the table. Calculate arc ep at between $10 and $20. Calculate arc ep at between $25 and $28.

Calculate arc ep at between $20 and $28. Graph the demand function [labeling all axis and functions], identify which ranges on the demand function are price elastic and which are price inelastic. Fall '97

Economics 205Principles of Microeconomics

Slide 14

Given: Q = 120 - 4 P

Price

Quantity

ep

TR

$ 10

80

-.5

$800

$ 20

40

-2

$800

$ 25

20

-5

$500

$ 28

8

-14

$224

Calculate the point ep at each price on the table. Calculate the TR at each price on the table. TR = PQ Calculate arc ep at between $10 and $20. ep = -1 Calculate arc ep at between $25 and $28. ep = -7.6

ep = -4 Calculate arc ep at between $20 and $28. Graph the demand function [labeling all axis and functions], identify which ranges on the demand function are price elastic and which are price inelastic. At what price will TR by maximized? P = $15 Fall '97

Economics 205Principles of Microeconomics

Slide 15

Graphing Q = 120 - 4 P,

TR is a maximum where ep is -1 or TR’s slope = 0

Price

When ep is -1 TR is a maximum. When | ep | > 1 [elastic], TR and P move in opposite directions. (P has a negative slope, TR a positive slope.) 30

The top “half” of the demand function is elastic.

| ep | > 1 [elastic]

ep = -1 | ep | < 1

When | ep | < 1 [inelastic], TR and P move in the same direction. (P and TR 15 both have a negative slope.) Arc or average ep is the average elasticity between two point [or prices] point

ep is the elasticity at a point or price.

TR

inelastic

60

120 Q/ut

The bottom “half” of the demand function is inelastic.

Price elasticity of demand describes how responsive buyers are to change in the price of the good. The more “elastic,” the more responsive to ∆P.

Fall '97

Economics 205Principles of Microeconomics

Slide 16

Use of Price Elasticity · Ruffin and Gregory [Principles of Economics, AddisonWesley, 1997, p 101] report that:

|ep| of gasoline is = .15 (inelastic) long run |ep| of gasoline is = .78 (inelastic) short run |ep| of electricity is = . 13 (inelastic) long run |ep| of electricity is = 1.89 (elastic)

· short run · · ·

· Why is the long run elasticity greater than short run? · What are the determinants of elasticity? Fall '97

Economics 205Principles of Microeconomics

Slide 17

Determinants of Price Elasticity · Availability of substitutes [greater availability of substitutes makes a good relatively more elastic] · Portion of the expenditures on the good to the total budget [lower portion tends to increase relative elasticity] · Time to adjust to the price changes [longer time period means there are more adjustment possible and increases relative elasticity · Price elasticity for “brands” is tends to be more elastic than for the category of goods Fall '97

Economics 205Principles of Microeconomics

Slide 18

An application of price elasticity.

The price elasticity of demand for milk is estimated between -.35 and -.5. Using -.5 as a reasonable figure, there are several important observations that can be made.

What effect does a 10% increase in the Pmilk have on the quantity that individuals are willing to buy?

To solve for % ∆ Q Multiply both sides by +10%

Since

e

%∆Q

-5%(-.5 = p≡ (+10%)x ) =% ∆ Q

A 10% increase in the price of milk would reduce the quantity demanded by about 5%.

If price were decreased by 5%, what would be the effect on quantity A 10% increase demanded? Fall '97

ep

ep = -.5

in P reduces Q by 5%

% +10% ∆P

≡

%∆Q %∆P

x (+10%)

Pmilk P2 P1

+10%

Economics 205Principles of Microeconomics

-5% Q2 Q1

Dmilk Q

Slide 19 milk

ep ≡

%∆Q %∆P

The price elasticity of demand is a measure of the % ∆ Q that will be “caused” by a % ∆ P.

If the price elasticity of demand for air travel was estimated at -2.5, what effect would a 5% decrease in price have on quantity demanded ?

-2.5 =

%∆Q

% ∆P - 5%

= +12.5% change in quantity demanded

If the price elasticity of demand for wine was estimated at -.8, what effect would a 6% increase in price have on quantity demanded ?

-.8 =

Fall '97

%∆Q

%+6% ∆P

= -4.8% decrease in quantity demanded

Economics 205Principles of Microeconomics

Slide 20

If the price elasticity of demand for milk were -.5, the effects of a price change on total revenue [TR] can also be estimated. Since , %∆Q

ep ≡ When

%∆P

When |ep| < 1, demand is “inelastic. “ This means that the ⎢% ∆ Q⎢ < ⎢% ∆ P⎢. Since the % price decrease is greater than the % increase in Q, TR [TR = PQ] will decrease.

|ep| < 1, a price decrease will decrease TR;

a price increase will increase TR, Price and TR “move in the same direction.” [inelastic demand with respect to price]

When |ep| > 1, demand is “elastic.” This means that the ⎢% ∆ Q⎢ > ⎢% ∆ P⎢.

When the % price decrease is less than the % increase in Q, TR [TR = PQ] will increase. When

|ep| > 1, a price decrease will increase TR;

a price increase will decrease TR, price and TR “move in opposite directions.” [elastic demand wrt price] Fall '97

Economics 205Principles of Microeconomics

Slide 21

Graphically this can be shown

TR

TR = PQ, so the maximum TR is the rectangle 0Q1 EP1

Price and TR move in opposite directions

As price rises into the elastic range the TR will decrease. Notice that in this range the slope of demand P is negative, the slope of TR is positive

TR elastic

price rises

P1

0

at the midpoint, ep = -1

+TR (P2 Q2) is less

P2

Fall '97

TR is a maximum

E than Loss in

(P 1 Q 1) TR when ∆P

Q2

D

Q1

Economics 205Principles of Microeconomics

Q/ut Slide 22

When price elasticity of demand is inelastic

TR TR is a maximum

A price decrease will result in a decrease in TR [PQ]. notice that both TR and Demand have a negative slope in the inelastic range of the demand function. Price and TR “move in the same P direction.”

A price decrease will reduce TR; a price increase will increase TR. Note that this information is useful but does not provide information about profits! Fall '97

TR

at the midpoint,

P1 P0 0

E

inelastic

TR = P1 Q1

[Maximum] results in a smaller PQ [TR]

Q1

Economics 205Principles of Microeconomics

ep = -1

D Q0

Q/ut Slide 23

“Own” Price Elasticity of Demand · ep

is a measure of the responsiveness of buyers to changes in the price of the good.

· ep will be negative because the demand function is · ·

negatively sloped. A linear demand function will have unitary elasticity at its “midpoint.” AT THIS POINT TR IS A MAXIMUM! A linear demand function will be more “elastic” at higher prices and tends to be more “inelastic” in the lower price ranges

Fall '97

Economics 205Principles of Microeconomics

Slide 24

Elastic ep ·

When |ep| > 1 [greater than 1], the demand is “elastic”

·

• |%∆Q| > |%∆P|, this shows buyers are responsive to changes in price An increase in the price of the good results in a decrease in total revenue [TR], a decrease in the price increases TR. Price and TR move in opposite directions.

·

The demand for a good tends to become more elastic · · · ·

Fall '97

as the number of substitutes increases “luxury” good more elastic than “necessities” % of price [or expenditure on the good] of the budget as the amount of time for adjustments increases elasticity

Economics 205Principles of Microeconomics

Slide 25

Inelastic ep · When |ep| < 1 [less than 1] the demand is “inelastic” · The |%∆Q| < |%∆P|, buyers are not very responsive to changes in price. · An increase in the price of the good results in an increase in total revenue [TR], a decrease in the price decreases TR. Price and TR move in the same direction Fall '97

Economics 205Principles of Microeconomics

Slide 26

D1 is a “perfectly elastic”

D2

P

perfectly inelastic

demand function.

For an infinitesimally small change in price, Q changes by infinity. Buyers are very responsive to price changes. An infinitely small change in price changes Q by infinity.

ep ≡

%∞ ∆0Q %∆P

P

0

==undefined 0∞

ep = 0 perfectly elastic |ep| = undefined

D1

As the dem and functio n becomes horizontal, more [buyers are m o r e responsiv to price ch e anges],|ep| approaches infinity.

Q/ut

D2 is a “perfectly inelastic” demand function, no matter how

much the price changes the same amount is bought. Buyers are not responsive to price changes! |ep| = 0, perfectly inelastic. .

.

Fall '97

Economics 205Principles of Microeconomics

De

Slide 27

Examples · Goods that are relatively price elastic · lamb, restaurant meals, china/glassware, jewelry, air travel [LR], new cars, Fords · in the long run, |ep| tends to be greater

· Goods that are relatively price inelastic · electricity, gasoline, eggs, medical care, shoes, milk · in the short run, |ep| tends to be less

Fall '97

Economics 205Principles of Microeconomics

Slide 28

Income Elasticity [normal goods]

ey ≡

% ∆ Qx % ∆Y

Income elasticity is a measure of the change in demand [a “shift” of the demand function] that is “caused” by a change in income.

[Where Y = income]

The increase in income, ∆Y, increases demand to D2. The increase in demand results in a larger quantity being purchased at the same Price [P1]..

At a price of P1 , the quantity demanded P given the demand D is Q1 . D is the demand function when the income is Y1 .

For a “normal good” an increase in income to Y2 will “shift” the demand to the right. This is an increase in demand to D2.

Due to increase in income, demand increases

P1

D2 D

% ∆ Y > 0; % ∆ Q> 0; therefore,

ey >0

[it is positive]

Q1 .

Fall '97

Economics 205Principles of Microeconomics

Q2 Q/ut Slide 29

Income Elasticity [continued. . .] [normal goods]

% ∆ Qx ey ≡ %∆Y

A decrease in income is associated with a decrease in the demand for a normal good.

At income Y1, the demand D1 represents the relationship between P and Q. At a price [P1] the quantity [Q1] is demanded. % ∆Y < 0 [negative];

so, ep > 0 [ positive]

P

For a decrease in income [-∆ Y], the demand decreases; i.e. shifts to the left, at the price [P1 ], a smaller Q2 will be purchased.

A decrease in income,

% ∆Q < 0 [negative];

P1

decreases demand

For either an increase or decrease in income the ep is positive. A positive relationship [positive correlation] between ∆ Y and ∆ Q is evidence of a normal good. Fall '97

D2 Q2

Economics 205Principles of Microeconomics

Q1

D1 Q/ut

Slide 30

When income elasticity is positive, the good is considered a “normal good.” An increase in income is correlated with an increase in the demand function. A decrease in income is associated with a decrease in the demand function. For both increases

e

The greater the value of y, the more responsive buyers + are to a change in their incomes. When the value of

eeyyy ≡

and decreases in income, ey is positive

∆xxQx %%∆% +∆Q Q %∆Y +- %%∆ Y∆ Y

ey is greater than 1, it is called a “superior good.”

The |% ∆ Qx| is greater than the |% ∆ Y|. Buyers are very responsive to changes in income. Sometimes “superior goods” are called “luxury goods.”

.

Fall '97

.

Economics 205Principles of Microeconomics

% ∆ Qx ey ≡ %∆Y

Slide 31

Income Elasticity [inferior goods]

There is another classification of goods where changes in income shift the demand function in the “opposite” direction. An increase in income [+∆Y] reduces demand. An increase in income reduces the amount that individuals are willing to buy at each price of the good. Income elasticity is negative:

- ey

The greater the absolute value of - ey, the more responsive buyers are to changes in income

eyy ≡= -e

P

P1

.

Fall '97

x x

%+∆Y ∆Y

decreases demand

- %∆Q

x

Q2 .

-%%∆Q ∆Q

Economics 205Principles of Microeconomics

Q1

D2

D1 Q/ut

Slide 32

Income Elasticity [inferior goods]

Decreases in income increase the demand for inferior goods. A decrease in income [-∆Y] increases demand. A decrease in income [-∆ Y] results in an increase in demand, the income elasticity of demand is negative For both increases and decreases in income the income elasticity is negative for inferior goods. The greater the

P

P1

absolute value of ey, the more responsive buyers are to changes in income . .

Fall '97

+%∆Q % ∆ Q xx - eey y ≡ %∆Y -∆Y

Economics 205Principles of Microeconomics

D2

+%∆Q Q1

D1 x

Q2 Q/ut Slide 33

Income Elasticity · Income elasticity [ey] is a measure of the effect of an income change on demand. [Can be calculated as point or arc.]

· ey > 0,

[positive] is a normal or superior good an increase in income increases demand, a decrease in income decreases demand.

ey < 1 is a normal good 1 < ey is a superior good

· 0< ·

· ey < 0, [negative] is an inferior good Fall '97

Economics 205Principles of Microeconomics

Slide 34

Examples of · normal goods, [0 <

ey

ey < 1 ], (between 0 and 1)

· coffee, beef, Coca-Cola, food, Physicians’ services, hamburgers, . . .

· Superior goods, [

ey > 1], (greater than 1)

· movie tickets, foreign travel, wine, new cars, . . .

· Inferior goods, [ey < 0],

(negative)

· flour, lard, beans, rolled oats, . . .

Fall '97

Economics 205Principles of Microeconomics

Slide 35

Cross-Price Elasticity · Cross-price elasticity [exy] is a measure of how responsive the demand for a good is to changes in the prices of related goods. · Given a change in the price of good Y [Py ], what is the effect on the demand for good X [Qy ]? ·

exy is defined as:

e Fall '97

xy

≡

% ∆

Q % ∆ P

Economics 205Principles of Microeconomics

x y

Slide 36

Cross-price elasticity of demand , [exy] [substitutes]

Pp 2

When beef is $2, Qb beef Pb is purchased. at Pb = $2 more increase beef will be bought demand to substitute for the smaller 2 quantity of for an increase pork. in Ppork, demand for Db Db Dp beef increases

When pork is $1.50, Qp pork is purchased. price of pork increases The quantity demanded of pork decreases.

1.50

’

-∆Qp

Q p’ Q p .

Fall '97

[price of beef]

[price of pork]

When the price of pork increases, it will tend to increase the demand for beef. People will substitute beef, which is relatively cheaper, for pork, which is relatively more expensive.

pork/ut

Qb

Economics 205Principles of Microeconomics

Qb’

beef/ut Slide 37

Cross-price elasticity · In the case of beef and pork · the ebp is not the same as epb · ebp is the % change in the demand for beef with respect to a % change in the price of pork

· epb is the % change in the demand for pork with

respect to a % change in the price of beef · beef may not be a good substitute for pork · pork may not be a good substitute for beef Fall '97

Economics 205Principles of Microeconomics

Slide 38

Cross-price elasticity of demand , [exy] [substitutes]

The cross elasticity of the demand for beef with respect to the price of pork,

+ebp ebp = positive

ebeef-pork or ebp can be calculated:

+Q ∆Q %∆ ofb beef %∆P+of ∆Ppork p

cross elasticity is positive

+eebpbp = positive

Qbeef b %∆ -Q ∆of %∆P of pork - ∆Pp

An increase in the price of pork, “causes” an increase in the demand for beef. A decrease in the price of pork, “causes” a decrease in the demand for beef.

If goods are substitutes, exy will be positive. The greater the coefficient, the more likely they are good substitutes. Fall '97

Economics 205Principles of Microeconomics

Slide 39

Cross-price elasticity of demand , [exy] [compliments]

Pc P1 Po

Pc

a decrease in the price of crayons,

-∆Pc

Dp

Q2

Q1

- ebc ebc =

negative

Fall '97

∆Q %∆+ Q ofbb

-

$3

crayons

increases the quantity demanded of crayons

%∆P of c

∆Pc

increase demand

as more crayons are purchased, the demand for colour books increases. At the same price a larger quantity will be bought

Dc Dc’ 2000

2500

+ ∆Qb

colour books

for compliments, the cross elasticity is negative for price increase or decrease.

Economics 205Principles of Microeconomics

Slide 40

Cross-Price Elasticity · exy > 0

[positive],

· exy < 0

[negative],

suggests substitutes, the higher the coefficient the better the substitute suggests the goods are compliments, the greater the absolute value the more complimentary the goods are

· exy = 0, suggests the goods are not related · exy can be used to define markets in legal proceedings

Fall '97

Economics 205Principles of Microeconomics

Slide 41

Elasticity of Supply · Elasticity of supply is a measure of how responsive sellers are to changes in the price of the good. · Elasticity of supply [ep] is defined:

e

s

Fall '97

% ∆ Quantity Supplied = % ∆ price Economics 205Principles of Microeconomics

Slide 42

Elasticity of supply

es = P

%∆Qsupplied %∆P

Given a supply function, at a price [P1], Q1 is produced and offered for sale. At a higher price [P2], a larger y pl quantity, Q2, will be produced p u s and offered for sale.

P2 P1

The increase in price [ ∆P ], induces a larger quantity goods [ ∆Q]for sale.

+∆P

The more responsive sellers are to

+∆Q Q1 Fall '97

Q2

∆P, the greater the absolute value of

Q /ut

es.

[The supply function is “flatter”or more elastic]

Economics 205Principles of Microeconomics

Slide 43

The supply function is a model of sellers behavior.

P

Sellers behavior is influenced by: 1. technology 2. prices of inputs 3. time for adjustment

Si a perfectly inelastic supply, es = 0 l es a t n o z i r o h s

proache p a ly p p u s as infinity s e h c a o r p p a

market period short run long run very long run

4. expectations 5. anything that influences costs of production

Se a perfectly elastic supply [es is undefined.]

Q /ut

taxes regulations, . . .

Fall '97

Economics 205Principles of Microeconomics

Slide 44

Elasticity · Price elasticity of demand [measures a move on a demand function caused by change in price/arc or point] ·

elastic, inelastic or unitary elasticity

· income elasticity [measures a shift of a demand function associated with a change in income] ·

superior, normal, and inferior

· cross elasticity ·

measure the shift of a demand function for a good associated with the change in the price of a related good

·

[compliment/substitute]

· price elasticity of supply [measures move on a supply curve] Fall '97

Economics 205Principles of Microeconomics

Slide 45

Forecasting Forecasting is the art and science of predicting future events -Institute of business forecasting

(www.ibforecast.com)

Why Forecast? ‹ Lead

times require that decisions be made in advance of uncertain events. ‹ Forecasting is an important for all strategic and planning decisions in a supply chain. ‹ Forecasts of product demand, materials, labor, financing are an important inputs to scheduling, acquiring resources, and determining resource requirements.

Demand Management ‹ Demand

management is the interface between production planning & control and the marketplace. Activities include: ‹ Forecasting. ‹ Order Processing. ‹ Making delivery promises.

Demand Management Resource Planning Marketplace

Production Planning

Demand Mgt. Master Production Planning

Forecasting Horizons. ‹ Short

Term (0 to 3 months): for inventory management and scheduling. ‹ Medium Term (3 months to 2 years): for production planning, purchasing, and distribution. ‹ Long Term (2 years and more): for capacity planning, facility location, and strategic planning.

Principles of Forecasting ‹ Forecasts

are almost always wrong. ‹ Every forecast should include an estimate of the forecast error. ‹ The greater the degree of aggregation, the more accurate the forecast. ‹ Long-term forecasts are usually less accurate than short-term forecasts.

Forecasting Methods ‹ Qualitative

methods are subjective in nature since they rely on human judgment and opinion. ‹ Quantitative methods use mathematical or simulation models based on historical demand or relationships between variables.

Some Qualitative Methods ¾

Jury of Executive Opinion (opinions of a small group of high-level managers is pooled).

¾

Sales Force Composite (aggregation of salespersons estimate of sales in their territory).

¾

Market Research Method (solicit input from customers or potential customers regarding future purchasing plans).

¾ Delphi Method (a forecasting group uses a staff to prepare, distribute, collect, and summarize a series of questionnaires and survey results from geographically dispersed respondents, whose judgements are valued).

Quantitative Forecast Methods ‹

‹

‹

Time Series Methods use historical data extrapolated into the future. They are best suited for stable environments. Moving averages, exponential smoothing methods, time series decomposition, and Box-Jenkins Methods. Causal Methods assume demand is highly correlated with certain environmental factors (indicators). Correlation methods, regression models, and econometric models. Simulation Methods imitate the consumer choices that give rise to demand to arrive at a forecast.

Time Series Demand Model ‹

Observed Demand = Systematic Component + Random Component.

‹

Systematic Component measures the expected value of demand and consists of: ‹Level: the current deseasonalized demand. ‹Trend: the rate of growth or decline in demand. ‹Seasonality: the regular periodic oscillation in demand.

‹

Random Component is that part of demand that follows no discernable or predictable pattern.The random component is estimated by the forecast error (forecast – actual demand).

Basic Forecasting Approach ‹

‹

‹

Understand the forecasting objective. What decisions will be made from the forecasts? What parties in the supply chain will be affected by the decision. Integrate demand planning and forecasting. All planning activities within the supply chain that will use the forecast or influence demand should be linked. Identify factors that influence the demand forecast. Is demand growing or declining? Is there are relationship (complementary or substitution) between products?

Forecasting Approach (cont.) ‹

‹

‹

Understand and Identify customer segments. Customer demand can be separately forecast for different segments based on service requirements, volume, order frequency, volatility, etc. Determine the appropriate forecasting technique. Typically, using a combination of the different techniques is of the the most effective approach. Establish performance and error measures. Forecasts need to be monitored for their accuracy and timeliness.

Time Series Forecasting ¾

Static ¾ Assume

estimates of level, trend, and seasonality do not vary as new data is observed.

¾

Adaptive ¾ Update

forecast as new data becomes available

Time Series Forecasting ‹ Static ‹ Adaptive ‹ Moving

average ‹ Single exponential smoothing ‹ Trend-adjusted exponential smoothing (Holt’s) ‹ Trend & Seasonal adjusted exponential smoothing (Winter’s)

Static Forecasting (steps) 1. 2. 3.

Determine periodicity (even or odd?) Deseasonalize data Find the equation of the trend line a. b. c.

4.

Estimate seasonalized factors a. b.

5.

Simple linear regression Independent variable (period) Dependent variable (deseasonalized data) Per period Index (Averages)

Forecast

Find the equation of the line ‹ Use

simple regression

‹ Excel:

(Tools/Data Analysis/Regression) ‹ Dependent variable (y) is deseasonalized demand ‹ Independent variable (x) is period t ‹ y= intercept + slope * x = demand Other Excel Analysis Functions

Costs and Production

www.stmartin.edu

Expectations • Long run vs. Short run in Economic terms • Production: Total product & marginal product graphs • Law of diminishing marginal returns • Effects of a productivity enhancement • What is the difference between average and marginal cost www.stmartin.edu

The Long Run Versus the Short Run • In the short run, costs are fixed and variable • In the long run, all costs are variable

PRODUCTION TABLE

Labor input (workers per day) 0 1 2 3 4 5

Total product (output per day) 0 1,000 2,200 3,500 4,700 5,800

Marginal product (output per day) 1,000 1,200 1,300 1,200 1,100

NOTE: ON THIS TABLE WE HAVE INFORMATION ON INPUTS AND OUTPUT ONLY—NOT COST OF PRODUCTION

Marginal product curve

TP

Marginal product

Total product

Total product curve

Increasing marginal returns

Diminishing marginal returns

5800 4700

1300 1200

3500

MP

1100 1000 2200

1000

0

1

2

3

Labor input

4

5

0

1

2

3

Labor input

4

5

Law of diminishing marginal returns • At some point, the marginal product falls as additional units are added • More inputs yield additional output at a smaller rate than before • “Too many cooks in the kitchen”

Effects of a Productivity Enhancement Increase in marginal product curve TP1 TP0

Marginal product

Total product

Increase in total product curve

MP1

MP0

Labor input

Labor input

Now, let’s talk about costs of production „Total

cost „Average total cost „Marginal cost

COST-OUTPUT RELATIONSHIP Units of TFC Output 1 2

0 1 2 3 4 5 6 7 8 www.stmartin.edu

50 50 50 50 50 50 50 50 50

TVC

TC

3

4

0 20 35 60 100 145 190 237 284

50 70 85 110 150 195 240 287 334

AFC AVC (2/1) (3/1) 5 6

0 50.0 25.0 16.7 12.5 10.0 8.3 7.1 6.3

0.0 20.0 17.5 20.0 25.0 29.0 31.7 33.9 35.5

ATC (4/1 or 5+6) 7

0 70 42.5 36.7 37.5 39.0 40.0 41.0 41.8

Average variable cost plus average fixed cost gives us the average total cost Average total cost

Costs

Total cost

Total variable cost and total fixed cost gives us total cost

Total Cost

Total variable cost

50

Total fixed cost

Output per day

Average variable cost

Marginal cost

The change in total cost when one more unit is produced is the marginal cost

What is the difference between average total cost and marginal cost?

• Average total cost is the total cost per unit of output

• Marginal cost is the change in total cost when one more additional unit of output is produced

Profit = Total revenue – costs •Accountants count explicit costs (Rs) (all paid-out costs as wages, rent, interests, material costs etc) •Economists count explicit and implicit costs (Implicit cost is opportunity cost)

Is bigger production better? Pros Mass production and standardization can meet large demand (e.g. Ford) Economies of scale Capture gains quickly

Cons Can’t meet specialized tastes of consumers (e.g. microbrews)

Economies of Scale

Economies of Scale z The

advantages of large scale production that result in lower unit (average) costs (cost per unit) z AC = TC / Q z Economies of scale – spreads total costs over a greater range of output

Economies of Scale z Internal

– advantages that arise as a result of the growth of the firm Technical z Commercial z Financial z Managerial z Risk Bearing z

Economies of Scale z

z z z z z

External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities

Economies of Scale Capital

Land

Labour

Output

Scale A

5

3

4

100

Scale B

10

6

8

300

•Assume each unit of capital = Rs.50, Land = Rs.80 and Labour = Rs.20 •Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility •What happens and why?

Economies of Scale Capital

Land

Labour

Output

TC

AC

Scale A

5

3

4

100

570

5.7

Scale B

10

6

8

300

1140

3.8

•Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production •PER UNIT has fallen •Don’t get confused between Total Cost and Average Cost •Overall ‘costs’ will rise but unit costs can fall •Why?

Economies of Scale z Internal:

Technical

Specialisation – large organisations can employ specialised labour z Indivisibility of plant – machines can’t be broken down to do smaller jobs! z Increased dimensions – bigger containers can reduce average cost z

Economies of Scale Indivisibility of Plant/Machines: z Some machineries available in large and lumpy size-cannot be broken and used in small production

Economies of Scale z Commercial z Large

firms can negotiate favourable prices as a result of buying in bulk

z Large

firms may have advantages in keeping prices higher because of their market power

Economies of Scale z Financial z Large

firms able to negotiate cheaper finance deals z Large firms able to be more flexible about finance – share options, etc. z Large firms able to utilise skills of merchant banks to arrange finance

Economies of Scale z Managerial z Use

of specialists – accountants, marketing, lawyers, production, human resources, etc.

Economies of Scale z Risk Bearing z Diversification z Markets across regions/countries z Product ranges z R&D

ECONOMIES OF SCALE Y AC

E>D AC

O

E
X Large Scale Production

Diseconomies of Scale z

The disadvantages of large scale production that can lead to increasing average costs z z z

z z

Problems of management Maintaining effective communication Co-ordinating activities – often across the globe! De-motivation and alienation of staff Divorce of ownership and control

Break-Even Analysis

Defined: Break-even analysis examines the cost tradeoffs associated with demand volume.

Overview:

Break-Even Analysis • • • •

Benefits Defining Page Getting Started Break-even Analysis – Break-even point – Comparing variables • Algebraic Approach • Graphical Approach

Benefits and Uses: • The evaluation to determine necessary levels of service or production to avoid loss. • Comparing different variables to determine best case scenario.

Defining Page: • USP

= Unit Selling Price

• UVC

= Unit Variable costs

• FC

= Fixed Costs

• Q

= Quantity of output units sold (and manufactured)

Defining Page:

Cont. • OI

= Operating Income

• TR

= Total Revenue

• TC

= Total Cost

• USP

= Unit Selling Price

Getting Started: • Determination of which equation method to use: – Basic equation – Contribution margin equation – Graphical display

Break-even analysis:

Break-even point

• Mr. Raj sells a product for Rs.10 and it cost Rs.5 to produce (UVC) and has fixed cost (FC) of Rs.25,000 per year • How much will he need to sell to break-even? • How much will he need to sell to make Rs.1000?

Algebraic approach:

Basic equation

Revenues – Variable cost – Fixed cost = OI (USP x Q) – (UVC x Q) – FC = OI Rs10Q – Rs5Q – Rs25,000 =Rs 0.00 Rs.5Q = Rs.25,000 Q = 5,000 What quantity demand will earn Rs.1,000? Rs.10Q – Rs.5Q – Rs.25,000 = Rs.1,000 Rs.5Q = Rs.26,000 Q = 5,200 (Because: Revenue = Rs10x200 = Rs.2000 minus Rs 5 x200=1000 UVC)

Algebraic approach:

Contribution Margin equation (USP – UVC) x Q = FC + OI Q = FC + OI UMC Q = 25,000 + 0 5 Q = 5,000

What quantity needs sold to make 1,000?

Q = 25,000 + 1,000 5 Q = 5,200

Graphical analysis: Rs 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue Break-even point 10,000 Line 0 1000 2000 3000 4000 5000 6000 Quantity

Graphical analysis:

Cont.

Dollars 70,000 Profit zone Total Cost 60,000 B Line 50,000 40,000 30,000 Loss zone 20,000 Total Revenue Break-even point 10,000 Line 0 1000 2000 3000 4000 5000 6000 Quantity

Scenario 1:

Break-even Analysis Simplified • When total revenue is equal to total cost the process is at the break-even point. TC = TR

Summary: • Break-even analysis can be an effective tool in determining the cost effectiveness of a product. • Required quantities to avoid loss. • Use as a comparison tool for making a decision.

END OF BREAK-EVEN ANALYSIS (FOR SCDL-PCP)

Break-even Analysis:

Comparing different variables

• Company XYZ has to choose between two machines to purchase. The selling price is Rs10 per unit. • Machine A: annual cost of Rs 3000 with per unit cost (VC) of Rs 5. • Machine B: annual cost of Rs 8000 with per unit cost (VC) of Rs 2.

Break-even analysis:

Comparative analysis Part 1 • Determine break-even point for Machine A and Machine B. • Where: V =

FC SP - VC

Break-even analysis:

Part 1, Cont. Machine A:

Machine B:

v = $3,000 $10 - $5 = 600 units v = $8,000 $10 - $2 = 1000 units

Part 1: Comparison • Compare the two results to determine minimum quantity sold. • Part 1 shows: – 600 units are the minimum. – Demand of 600 you would choose Machine A.

Part 2: Comparison Finding point of indifference between Machine A and Machine B will give the quantity demand required to select Machine B over Machine A. Machine A FC + VC $3,000 + $5 Q $3Q Q

= = = = =

Machine B FC + VC $8,000 + $2Q $5,000 1667

Part 2: Comparison

Cont.

• Knowing the point of indifference we will choose: • Machine A when quantity demanded is between 600 and 1667. • Machine B when quantity demanded exceeds 1667.

Part 2: Comparison

Graphically displayed

Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 0 500 1000 1500 2000 2500 3000 Quantity

Part 2: Comparison

Graphically displayed Cont. Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 Point of indifference 3,000 0 500 1000 1500 2000 2500 3000 Quantity

Exercise 1: • Company ABC sell widgets for $30 a unit. • Their fixed cost is$100,000 • Their variable cost is $10 per unit. • What is the break-even point using the basic algebraic approach?

Exercise 1:

Answer

Revenues – Variable cost - Fixed cost = OI

(USP x Q) – (UVC x Q) – FC $30Q - $10Q – $100,00 $20Q Q

= OI = $ 0.00 = $100,000 = 5,000

Exercise 2: • Company DEF has a choice of two machines to purchase. They both make the same product which sells for $10. • Machine A has FC of $5,000 and a per unit cost of $5. • Machine B has FC of $15,000 and a per unit cost of $1. • Under what conditions would you select Machine A?

Exercise 2:

Answer

Step 1: Break-even analysis on both options. Machine A: v = $5,000 $10 - $5 = 1000 units Machine B: v = $15,000 $10 - $1 = 1667 units

Exercise 2:

Answer Cont. Machine A FC + VC $5,000 + $5 Q $4Q Q

= = = = =

Machine B FC + VC $15,000 + $1Q $10,000 2500

• Machine A should be purchased if expected demand is between 1000 and 2500 units per year.

Lecture 5 Perfect competition ECN101 Professor Grob

www.stmartin.edu

Expectations for Chapter 5 15 1415 1314 1213 1112 1011 910 89 78 67 56 45 34 23 12 01 00

• Describe how a perfectly competitive firm maximizes profits or minimizes losses. • Explain how a perfectly competitive firm achieves economic efficiency in the long run. • Identify factors that contribute to monopoly. • Develop a model that illustrates profit maximization and loss minimzation for a monopoly. • Assess the advantages and disadvantages of a 1,400,000 perfectly firm and a2,800,000 monopoly. 0 competitive 1,400,000 2,800,000 Quantity of fish (lbs.) Quantity of fish (lbs.)

Continuum of market structures #producers or sellers

1 2

30+

5

Duopoly

Many

Perfect Competition

Monopoly Oligopoly

Monopolistic competition

Chapter 5 deals with the extremes #producers or sellers

1

Monopoly

Many

Perfect Competition

Price

Market equilibrium facing a competitive firm 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Market supply

Market demand

0

1,400,000 Quantity of fish (lbs.)

2,800,000 Quantity

Some characteristics of market structures Perfect Competition • No barriers to entry • Many sellers • Many buyers • Standardized product • Perfect information about the market (buying, producing, selling)

Monopoly • High barriers to entry • One seller • Many buyers • Brand loyalty • Control of production and distribution processes

Demand and revenue for a competitive firm Demand and Marginal Revenue for one company

$ 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Total revenue $ 70 63

Total revenue

56 49

Demand = P = MR 42 35 28 21

7

14

1

7 0 0

2

4

6

8

Quantity of fish (lbs.)

10

12

0

1

2

3

4

5

6

7

8

9 10 11 12

Quantity of fish (lbs.)

Profit Maximization and Loss Minimization • Marginal revenue (MR)= marginal Cost (MC) • In the case of the perfectly competitive firm, marginal revenue = price • Price=MR=MC is the point where profits are maximized • If price falls below average total cost, then what? Operate as long as total revenue exceeds total cost.

Short-run economic profit/loss for a competitive firm Profit maximization Rs 9.00

MC

8.00

A

7.00 6.00 5.00

Loss minimization Rs 8.00

Demand = P = MR ATC

Total profit = Rs.2,500

4.00

Total loss = Rs.2,128

7.00

MC ATC

6.00 5.33 5.00

AVC Demand = P = MR

4.00 3.00

3.00 2.00

2.00

1.00

1.00

0.00

0.00 0

500 1000 1500 2000 2500 3000 3500 Quantity of fish (lbs.)

0

700

1600 Quantity of fish (lbs.)

3000

Price

Market S0 7

S1 6

Price and cost

Long-run adjustments for a competitive firm: effects of market entry Individual firm 7

Demand0 = Price0

6

LRATC A 5

5

Demand1 = Price1

D0 4

4 0

0 Quantity of fish (lbs.)

500 Quantity of fish (lbs.)

Perfect Competition

Price

Market S1 6

S2

Price and cost

Long-run adjustments for a competitive firm: effects of market exit Individual firm 6 LRATC A

5

5

4

4

Demand1 = Price1

Demand2 = Price2

D0 3

3 0

0 Quantity of fish (lbs.)

500 Quantity of fish (lbs.)

Monopoly

Monopoly While a competitive firm is a price taker, a monopoly firm is a price maker.

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Monopoly ‹A

firm is considered a monopoly if . . . …it is the sole seller of its product. …its product does not have close substitutes.

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Why Monopolies Arise The fundamental cause of monopoly is barriers to entry.

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Why Monopolies Arise Barriers to entry have three sources: ‹

Ownership of a key resource. Ê This tends to be rare. De Beers is an example

‹

The government gives a single firm the exclusive right to produce some good. Ê Patents, Copyrights and Government Licensing.

‹

Costs of production make a single producer more efficient than a large number of producers. Ê Natural Monopolies

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Economies of Scale as a Cause of Monopoly... Cost

Average total cost 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity of Output

Monopoly versus Competition Monopoly ‹ Is the sole producer ‹ Has a downwardsloping demand curve ‹ Is a price maker ‹ Reduces price to increase sales

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Competitive Firm ‹Is one of many producers ‹Has a horizontal demand curve ‹Is a price taker ‹Sells as much or as little at same price

Demand Curves for Competitive and Monopoly Firms...

Price

(a) A Competitive Firm’s Demand Curve

(b) A Monopolist’s Demand Curve Price

Demand

Demand 0

Quantity of Output

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0

Quantity of Output

A Monopoly’s Revenue ‹ Total

Revenue

P x Q = TR ‹ Average

Revenue

TR/Q = AR = P ‹ Marginal

Revenue

∆TR/∆Q = MR Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less than the price of its good. ‹The

demand curve is downward sloping. ‹When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.

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A Monopoly’s Total, Average, and Marginal Revenue (Rs) Quantity (Q) 0 1 2 3 4 5 6 7 8

Price (P) 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00

Total Revenue (TR=P x Q) 0.00 10.00 18.00 24.00 28.00 30.00 30.00 28.00 24.00

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Average Revenue (AR=TR/Q)

Marginal Revenue (MR= ∆TR / ∆Q )

10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00

10.00 8.00 6.00 4.00 2.00 0.00 -2.00 -4.00

A Monopoly’s Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q). ‹The

output effect—more output is sold, so Q is higher. ‹The price effect—price falls, so P is lower. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

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Demand and Marginal Revenue Curves for a Monopoly... Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4

Demand (average revenue)

Marginal revenue 1

2

3

4

5

6

7

8

Quantity of Water

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Profit-Maximization for a Monopoly... 2. ...and then the demand curve shows the price consistent with this quantity.

Costs and Revenue

B

Monopoly price

1. The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity... Average total cost

A Demand

Marginal cost

Marginal revenue 0

QMAX

Quantity

Comparing Monopoly and Competition ‹ For

a competitive firm, price equals marginal cost.

P = MR = MC ‹ For

a monopoly firm, price exceeds marginal cost.

P > MR = MC

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A Monopoly’s Profit Profit equals total revenue minus total costs.

Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q

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The Monopolist’s Profit... Costs and Revenue Marginal cost

Average total cost D

B

y ol op it on f M pro

Monopoly E price

Average total cost

C Demand

Marginal revenue 0

QMAX

Quantity

The Monopolist’s Profit The monopolist will receive economic profits as long as price is greater than average total cost.

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Public Policy Toward Monopolies Government responds to the problem of monopoly in one of four ways. Making monopolized industries more competitive. ‹ Regulating the behavior of monopolies. ‹ Turning some private monopolies into public enterprises. ‹

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Price Discrimination Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. In order to do this, the firm must have market power.

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Price Discrimination

‹ Two

important effects of price discrimination:

It can increase the monopolist’s profits. ‹ It can reduce deadweight loss. ‹

‹

But in order to price discriminate, the firm must ‹ ‹

Be able to separate the customers on the basis of willingness to pay. Prevent the customers from reselling the product.

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Monopolistic Competition

The Four Types of Market Structure Number of Firms? Many firms One firm

Few firms

Monopoly

Oligopoly

• Tap water • Cable TV

Type of Products? Differentiated products

Identical products

Monopolistic Competition

Perfect Competition

• Tennis balls

• Novels

• Wheat

• Crude oil

• Movies

• Milk

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Types of Imperfectly Competitive Markets ‹ Monopolistic

Competition

‹ Many

firms selling products that are similar but not identical.

‹ Oligopoly ‹ Only

a few sellers, each offering a similar or identical product to the others.

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Monopolistic Competition Markets that have some features of competition and some features of monopoly.

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Attributes of Monopolistic Competition Large number of firms ‹ Product differentiation ‹ Free entry and exit ‹ Downward-sloping demand curve ‹

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Many Sellers There are many firms competing for the same group of customers. ‹Product

examples include books, CDs, movies, computer games, restaurants, piano lessons, furniture, bath soaps etc.

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Product Differentiation ‹ Each

firm produces a product that is at least slightly different from those of other firms. ‹ Rather than being a price taker, each firm faces a downward-sloping demand curve.

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Free Entry or Exit ‹ Firms

can enter or exit the market without restriction. ‹ The number of firms in the market adjusts until economic profits are zero.

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Monopolistic Competitors in the Short Run... (a) Firm Makes a Profit Price

MC

Price Average total cost

ATC

Demand

Profit

MR 0

Profitmaximizing quantity

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Quantity

Monopolistic Competitors in the Short Run... (b) Firm Makes Losses Price

MC

ATC

Losses Average total cost Price Demand

MR 0

Lossminimizing quantity

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Quantity

Monopolistic Competition in the Short Run Short-run economic profits encourage new firms to enter the market. This: ‹ Increases

the number of products offered. ‹ Reduces demand faced by firms already in the market. ‹ Incumbent firms’ demand curves shift to the left. ‹ Demand for the incumbent firms’ products fall, and their profits decline. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Monopolistic Competition in the Short Run Short-run economic losses encourage firms to exit the market. This: ‹ Decreases

the number of products offered. ‹ Increases demand faced by the remaining firms. ‹ Shifts the remaining firms’ demand curves to the right. ‹ Increases the remaining firms’ profits. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Long-Run Equilibrium Firms will enter and exit until the firms are making exactly zero economic profits.

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A Monopolistic Competitor in the Long Run... Price

MC ATC

P=ATC

MR 0

Profit-maximizing quantity

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Demand Quantity

Two Characteristics of LongRun Equilibrium œAs in a monopoly, price exceeds marginal cost. ‹ Profit

maximization requires marginal revenue to equal marginal cost. ‹ The downward-sloping demand curve makes marginal revenue less than price.

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Two Characteristics of LongRun Equilibrium As in a competitive market, price equals average total cost. ‹ Free

entry and exit drive economic profit to zero.

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Monopolistic versus Perfect Competition There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.

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Excess Capacity ‹ There

is no excess capacity in perfect competition in the long run. ‹ Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm.

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Excess Capacity ‹ There

is excess capacity in monopolistic competition in the long run. ‹ In monopolistic competition, output is less than the efficient scale of perfect competition.

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Excess Capacity... (a) Monopolistically Competitive Firm

(b) Perfectly Competitive Firm

Price

Price MC

MC

ATC

P

P = MC

ATC

P = MR (demand curve)

Excess capacity Demand Quantity Quantity Efficient produced scale Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity Quantity= Efficient produced scale

Markup Over Marginal Cost ‹ For

a competitive firm, price equals marginal cost. ‹ For a monopolistically competitive firm, price exceeds marginal cost.

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Markup Over Marginal Cost Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm.

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Markup Over Marginal Cost... (a) Monopolistically Competitive Firm Price

(b) Perfectly Competitive Firm

Price Markup

MC

P Marginal cost

MC

ATC

P = MC

ATC

P = MR

(demand curve)

MR

Demand Quantity

Quantity produced Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity Quantity produced

Monopolistic versus Perfect Competition... (a) Monopolistically Competitive Firm Price

(b) Perfectly Competitive Firm

Price

MC

Markup

ATC

P

P = MC

MC ATC P = MR

(demand curve)

Marginal cost

Demand

MR Quantity produced

Efficient scale

Quantity

Excess capacity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity produced = Quantity Efficient scale

Monopolistic Competition and the Welfare of Society Monopolistic competition does not have all the desirable properties of perfect competition.

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Monopolistic Competition and the Welfare of Society ‹ There

is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. ‹ However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Monopolistic Competition and the Welfare of Society Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry.

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Monopolistic Competition and the Welfare of Society The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers.

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Monopolistic Competition and the Welfare of Society The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms.

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Advertising When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product.

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Advertising ‹ Firms

that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. ‹ Overall, about 2 percent of total revenue, or over $100 billion a year, is spent on advertising.

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Advertising ‹ Critics

of advertising argue that firms advertise in order to manipulate people’s tastes. ‹ They also argue that it impedes competition by implying that products are more different than they truly are.

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Advertising ‹ Defenders

argue that advertising provides information to consumers ‹ They also argue that advertising increases competition by offering a greater variety of products and prices. ‹ The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Brand Names

‹ Critics

argue that brand names cause consumers to perceive differences that do not really exist.

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Brand Names ‹ Economists

have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality. ‹ providing

information about quality. ‹ giving firms incentive to maintain high quality.

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Summary ‹A

monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. ‹ The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary ‹ Monopolistic

competition does not have all of the desirable properties of perfect competition. ‹ There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. ‹ The number of firms can be too large or too small. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Summary ‹ The

product differentiation inherent in monopolistic competition leads to the use of advertising and brand names.

‹ Critics

of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition.

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Summary ‹ Defenders

argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality.

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Graphical Review

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Monopolistic Competitors in the Short Run... (a) Firm Makes a Profit Price

MC

Price Average total cost

ATC

Demand

Profit

MR 0

Profitmaximizing quantity

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Quantity

Monopolistic Competitors in the Short Run... (b) Firm Makes Losses Price

MC

ATC

Losses Average total cost Price Demand

MR 0

Lossminimizing quantity

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Quantity

A Monopolistic Competitor in the Long Run... Price

MC ATC

P=ATC

MR 0

Profit-maximizing quantity

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Demand Quantity

Excess Capacity... (a) Monopolistically Competitive Firm

(b) Perfectly Competitive Firm

Price

Price MC

MC

ATC

P

P = MC

ATC

P = MR (demand curve)

Excess capacity Demand Quantity Quantity Efficient produced scale Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity Quantity= Efficient produced scale

Markup Over Marginal Cost... (a) Monopolistically Competitive Firm Price

(b) Perfectly Competitive Firm

Price Markup

MC

P Marginal cost

MC

ATC

P = MC

ATC

P = MR

(demand curve)

MR

Demand Quantity

Quantity produced Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity Quantity produced

Monopolistic versus Perfect Competition... (a) Monopolistically Competitive Firm Price

(b) Perfectly Competitive Firm

Price

MC

Markup

ATC

P

MC ATC

P = MC

P = MR

(demand curve)

Marginal cost

Demand

MR Quantity produced

Efficient scale

Quantity

Excess capacity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Quantity produced = Efficient scale

Quantity

Oligopoly

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Imperfect Competition Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

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Types of Imperfectly Competitive Markets ‹Oligopoly ‹ Only a few sellers, each offering a similar or identical product to the others. ‹Monopolistic Competition ‹ Many firms selling products that are similar but not identical. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Four Types of Market Structure Number of Firms? Many firms One firm

Few firms

Monopoly

Oligopoly

• Tap water • Cable TV

Type of Products? Differentiated products

Identical products

Monopolistic Competition

Perfect Competition

• Cell Phone

• Novels

• Wheat

• Crude oil

• Movies

• Milk

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Characteristics of an Oligopoly Market Few sellers offering similar or identical products ‹ Interdependent firms ‹ Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost ‹ There is a tension between cooperation and self-interest. ‹

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Competition, Monopolies, and Cartels ‹The Oligopolists may agree on a

monopoly outcome. ‹Collusion ‹The

two firms may agree on the quantity to produce and the price to charge.

‹Cartel ‹The

two firms may join together and act in unison.

‹

However, both outcomes are illegal in India due to MRTP Act.

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£

Profit-maximising Profit-maximising cartel cartel Industry MC

P1

Industry MR O

Q1

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Industry D ≡ AR Q

Oligopoly „

Tacit collusion Ê price leadership: dominant firm Ê price leadership: Low Cost firm

„

Collusion and the law

„

The breakdown of collusion

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Oligopoly „

Non-collusive oligopoly: the kinked demand curve theory Êassumptions of the model

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Rs

Kinked Kinked demand demand for for aa firm firm under under oligopoly oligopoly

P1

D

O

Q1

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Q

Oligopoly „

Non-collusive oligopoly: the kinked demand curve theory Êassumptions of the model Êthe shape of the demand curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

£

The The MR MR curve curve P1 MR

a

O

Q1

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

D = AR

Q

Stable Stable price price under under conditions conditions of of aa £ kinked demand kinked demand curve curve MC2 MC1

P1

a

D = AR

b O

Q1

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Q MR

Oligopoly „

Non-collusive oligopoly: the kinked demand curve theory Êassumptions of the model Êthe shape of the demand curve Êstable prices

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Oligopoly „

Oligopoly and the consumer Ê disadvantages • worse if there is extensive collusion

Ê advantages • countervailing power • supernormal profits may allow higher R&D • greater choice for consumers

Ê difficulties in drawing general conclusions

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Summary of Equilibrium for an Oligopoly ‹ Possible

outcome if oligopoly firms pursue their own self-interests: ‹ Joint

output is greater than the monopoly quantity but less than the competitive industry quantity. ‹ Market prices are lower than monopoly price but greater than competitive price. ‹ Total profits are less than the monopoly profit. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

How the Size of an Oligopoly Affects the Market Outcome ‹ How

increasing the number of sellers affects the price and quantity: ‹ The

output effect: Because price is above marginal cost, selling more at the going price raises profits. ‹ The price effect: Raising production lowers the price and the profit per unit on all units sold.

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Pricing Methods and Policies Context and concepts • Learning outcomes • Explore the meaning of price to marketers • understand the nature of the internal and external factors that influence pricing decisions • explain pricing methods and their uses • Understand the two generic pricing strategies and their application

Importance of price to marketers Price is a key element in the marketing mix because: • Directly -Price relates directly to the generation of total revenue -Price is also the only marketing mix element that generates revenue, others are costs • Indirectly -Price can be a major determinant of the quantity of goods sold -Price also influences total costs through its impact on quantity sold • Symbolically -Price has a psychological impact on customers -By raising price the quality of the product can be emphasised -By lowering price marketers can emphasis a bargain

Price and Competition • Price competition • Is a policy whereby marketers emphasises price as an issue and matches or beats the prices of competitors

• Non-price competition • Is a policy in which a seller elects not to focus on price but to emphasis other factors instead.

Non-Price Competition Non price competition is done in the following ways: - Reinforcing the quality image of the product (Sony) - Reinforcing the desirability of the product benefits - Using extended warranty to help customers think they are getting more for their money - Emphasise the longer term cost saving derived from using this product with the cheaper competition - Customer loyalty cards - Incentives for purchasing off-peak, or out of season - Internet shopping - Home delivery systems

Some pricing context • In service markets the influences on prices are related to service characteristics - perishability (service cannot be stored) - intangibility (difficult to measure quality) • In non-profit markets the pricing of the product/service is for different objectives • in organisational markets prices are affected by the relationship between price & cost, value management

Internal influences on pricing • Organisational objectives - the role pricing can play in achieving long and short-term corporate objectives • Marketing objectives - long & short term marketing objectives; price & product positioning • Costs - the relationship between price and cost; balancing the need to cover costs against the price the market will bear

External influences on pricing • Customers and consumers: demand & elasticity; price sensitivity • Channels of distribution: need to cover costs, value added to products; desired margins • Competitors: pricing under different market structures • Legal and regulatory: freedom to set prices, unfair pricing practices: sales taxes, VAT and their impact on prices

Internal & External Influences on Pricing • Internal factors - Marketing strategies .Targeting .positioning and .marketing mix strategy -Financial strategies .the cost base of fixed & variable costs .the financial objectives of the organisation

• External factors -Types of customers .customer perception of value of the product .elasticity of demand -the competitiveness of the market place .perfect competition .monopolistic .oligopolistic .pure monopoly

Pricing Methods Break-even analysis Cost-based pricing

Competition-based pricing

Target Rate of return Return on investment Payback period Going rate Seal bid Competitive reaction

Market-based pricing

Identifying customer value Matching sellers/buyers Perceived values Demand differentiation

Pricing Methods • Cost-based pricing - prices set mainly on the basis of cost (fixed & variable overheads) • Competition-based pricing - pricing a product or service at a price comparable with that charged by the competition (this could be slightly higher or lower than the competition) • Customer-based pricing - relies on the perceived value and how much customers are prepared to pay for the product or service

Two generic pricing strategies for new products Skimming Policy • Price skimming involves charging a relatively high price for a short time where a new, innovative, or much-improved product is launched onto a market • A major disadvantage is that it encourages new entrants

• Penetration Policy •

Penetration pricing involves the setting of lower, rather than higher prices in order to achieve a large, if not dominant market share.

•

This strategy is most often used in businesses wishing to enter a new market or build on a relatively small market share.

•

A successful penetration pricing strategy may lead to large sales volumes/market shares and therefore lower costs per unit.

New product launch strategy High

High

Promotion

Low

Rapid skimming

Slow skimming

Rapid penetration

Slow penetration

Price

Low

New product launch pricing strategies •

Rapid Skimming strategy - tends to combine high price and high promotion expenditure. High prices is used to create high revenue, while high promotion used for product awareness & knowledge

•

Slow skimming strategy - tends to combine high prices with low level of promotion expenditure - High prices means high revenue but promotion is left to mainly word-ofmouth

•

Rapid penetration strategy - tends to combine low prices with high promotional expenditure - aims to gain market share rapidly

•

Slow penetration strategy - tends to combine low prices with low promotional expenditure - mainly used by Own-label brands

Conditions for charging high & low prices •

Conditions for charging high prices -product provides high value -customers have high ability to pay -lack of competition -high pressure to buy

•

Conditions for charging low prices -lack of differential advantage -market presence or dominance -economies of scale -objective to make money later -make money by using loss leader to attract customers -using low price as a barrier to entry

Trial prices for new product • Pricing a new product low for a limited period of time in order to lower the risk to customers - the idea is to win customers acceptance first and make profits later • Trial pricing also works for services. Health clubs & other service providers may offer trial membership or special introductory prices. The hope is that the customer tries the service at a low price and is converted to a regular price customer

Characteristics of high price market segments

• • • • •

Products provide high value Customers have high ability to pay Customer and bill payer are different lack of competition High pressure to buy

Steps in Price Planning • The process involves: -Developing a pricing objective (s) - Estimating demand -Determining costs -Evaluating the pricing environment -Choosing a pricing strategy -Selecting the final price

Conclusion • Pricing decisions should be made on the basis of cost, competition, demand but in the context of the overall marketing objectives and strategy. • Pricing decision must also take account of the other elements of the marketing mix and must be consistent with them

Chapter 12 Cost/Benefit Analysis: Four Four Different Approaches

Copyright: Vail Training Associates

56

1

Cost/Benefit Analysis A systematic comparison of the expected costs and benefits of a course of action.

Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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2

Cost/Benefit Analysis When benefits and costs are measured on the same scale, such as dollars, the benefits should exceed the costs for a given course of action. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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3

Cost/Benefit Analysis When benefits can not be measured readily in dollars, cost-benefit analysis generally requires the comparison of two or more alternatives. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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Cost/Benefit Analysis When the alternatives are estimated to provide the same benefit (such as the same level of national defense), the alternative with the lowest cost should be selected. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods (PMBOK® Third Edition)

Cost/Benefit Analysis

Two Broad Categories • Benefit Measurement Methods • Mathematical Models Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Mathematical Models Also known as Algorithms (Constrained Optimization Methods, PMBOK® 2000 Edition)

Linear Programming Non Linear Programming Dynamic Programming Integer Programming Multi-objective Programming

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Mathematical Models Also known as Algorithms (Constrained Optimization Methods, PMBOK® 2000 Edition)

Linear Programming Non Linear Programming Dynamic Programming Integer Programming Multi-objective Programming

Copyright: Vail Training Associates

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8

4.1.2.1 Project Selection Methods PMBOK® Third Edition

Mathematical Models Linear Programming

A mathematical approach to obtaining the best or optimal solution to a complex problem with: (a) A specified objective (such as maximization of profits) (b) Quantifiable constraints or limitations. Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods

Mathematical Models Also known as Algorithms (Constrained Optimization Methods, PMBOK® 2000 Edition)

Linear Programming Non Linear Programming Dynamic Programming Integer Programming Multi-objective Programming

Copyright: Vail Training Associates

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10

4.1.2.1 Project Selection Methods PMBOK® Third Edition

Benefit Measurement Methods Comparative Approaches Scoring Models Benefit Contribution Economic Models Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Benefit Measurement Methods Comparative Approaches Scoring Models Benefit Contribution Economic Models Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Benefit Measurement Methods Comparative Approaches Scoring Models Benefit Contribution Economic Models Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Benefit Measurement Methods Comparative Approaches Scoring Models Benefit Contribution Economic Models Copyright: Vail Training Associates

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4.1.2.1 Project Selection Methods PMBOK® Third Edition

Benefit Measurement Methods Comparative Approaches Scoring Models Benefit Contribution Economic Models Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models The process of identifying the financial (economic) benefits is called Capital Budgeting. It is the decision-making process by which some organizations evaluate and select projects. Kerzner, Seventh Edition

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models Sophisticated capital budgeting techniques take into consideration depreciation schedules, tax information, inflation and other economic considerations. Fortunately: These are beyond the scope of this presentation. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models Since we are discussing only the principles of capital budgeting we will restrict our discussion to:

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow – Net Present Value

• Internal Rate of Return (IRR) Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• • • • •

Benefit/Cost Ratio Payback Period Discounted Cash Flow Net Present Value Internal Rate of Return (IRR)

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio Simply put it is the financial value of the benefit divided by the financial cost. $Benefit $Cost

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio Project Benefit =

Rs. 7,000

Project Cost =

Rs. 5,000

Benefit/Cost Ratio = 1.4

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio (Criteria) An organization could establish any “criteria” that they wanted for the purposes of evaluating a project. Company A might have a Benefit/Cost Ratio requirement of 1.5 or greater. Company B might simply make the decision to do the project if it had a Benefit/Cost Ratio of 1.0.

Copyright: Vail Training Associates

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23

Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow – Net Present Value

• Internal Rate of Return (IRR) Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Payback Period Payback period is the length of time, usually expressed in years or fractions there of, needed for a firm to recover its initial investment on a project. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Payback Period Initial Project Expense = Rs.5,000 Payback Year 1 Year 2 Year 3 Year 4

Rs 1,000 2,000 2,000 2,000

Copyright: Vail Training Associates

Rs (4,000) (2,000) 0 2,000 56

26

Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Payback Period (Criteria) An organization that uses Payback Period would also have to define what the payback period criteria would be. Some organizations would be very happy with a payback period of three years. Others would no doubt use a much shorter payback period criteria. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio & Payback Period These two approaches have a common problem. They do not take into consideration the “TIME VALUE OF MONEY”. As a result they are typically used on only relatively short term projects. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

Future Value And Present Value Concepts Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Future Value

FV = PV (1+interest rate) raised to the (number of years) power. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Future Value Lets say we have Rs.1,000 invested at 6% for three years. FV = Rs.1,000 (1+.06) to the third power. FV = Rs.1,000 * (1.1910) FV = Rs.1,191 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Future Value Table Years

2%

3%

6%

10%

1

1.0200

1.0300

1.0600

1.1000

2

1.0404

1.0609

1.1236

1.2100

3

1.0612

1.0927

1.1910

1.3310

4

1.0824

1.1255

1.2624

1.4641

5

1.1040

1.1592

1.3382

1.6105

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value

PV = FV * 1 / ((1+interest rate) to the (number of years) power).

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value

The result of discounting one or more amounts to be received or paid in the future by a discount rate.

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value

For example: Rs.100 invested at 6% will amount to Rs.106 at the end of one year (this is a future value). Therefore: Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value The present value of Rs.106 due at the end of one year at 6% is Rs.100.

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value Lets say we have Rs.1,000 being sent to us 3years from now and the inflation rate is at 3%. PV = Rs.1,000 * 1/((1+.03) to the third power). PV = Rs.1,000 * (.9151) FV = Rs.915.10 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value Table Years

2%

3%

6%

1

.9803

.9708

.9433

.9090

2

.9611

.9425

.8899

.8264

3

.9422

.9151

.8396

.7513

4

.9238

.8884

.7921

.6830

5

.9057

.8626

.7472

.6209

Copyright: Vail Training Associates

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10%

38

Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Present Value Analysis Any method of evaluating alternatives with the time value of money incorporated to more effectively determine the long term financial effects on investment dollars. (It is the recognition that any amount due in the future is worth less than that same amount if it were due today.) Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow – Net Present Value

• Internal Rate of Return (IRR) Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Discounted Cash Flow 1. A method of evaluating a long term project that explicitly takes into account the time value of money. 2. The present value of all expected net cash receipts from a project, discounted by an appropriate discount rate. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Discounted Cash Flow Initial Project Expense = Rs.5,000

(Payback) Discounted

Year 1 Year 2 Year 3 Year 4

Cash Flow at 6%.

Future

Present

Value

Value

Rs.1,000 Rs.2,000 Rs.2,000 Rs.2,000

Rs.943 Rs.1,780 Rs.1,697 Rs.1,584

Copyright: Vail Training Associates

56

(Rs.4,057) (Rs.2,277) (Rs. 580) Rs.1,004 42

Cost/Benefit Analysis Benefit Measurement Methods Economic Models

Initial Project Expense = Rs.5,000 Payback Year 1 Year 2 Year 3 Year 4

Rs.1,000 Rs.2,000 Rs.2,000 Rs.2,000

Copyright: Vail Training Associates

(Rs.4,000) (Rs.2,000) Rs 0 Rs.2,000

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow – Net Present Value

• Internal Rate of Return (IRR)

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Net Present Value The algebraic sum of the present values of all outlays and inflows associated with a given project or investment. Calculation of net present value usually involves subtracting the initial outlay cost of an investment from the present value of all future cash flows. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Net Present Value Discounted Cash Flow at 6%. Year 1 Rs.1,000 Rs. 943 Year 2 Rs.2,000 Rs.1,780 Year 3 Rs.2,000 Rs.1,697 Year 4 Rs.2,000 Rs.1,584 Total Rs.6,004 accrued benefit Less Investment - 5,000 Net Present Value Rs.1,004 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow – Net Present Value

• Internal Rate of Return (IRR)

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Internal Rate of Return (IRR)

The effective annual Return on Investment (ROI) over the life of a project. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Internal Rate of Return (IRR)

IF we invested Rs.5,000 in a project, and we got a Rs.6,004 discounted return on the investment, WHAT interest rate would we have had to have received on an investment of Rs.5,000 to get that Rs.6,004? Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Internal Rate of Return (IRR)

Rs.6,004 / Rs.5000 = 1.2008 (a factor) Years

2%

3%

6%

10%

1

1.0200

1.0300

1.0600

1.1000

2

1.0404

1.0609

1.1236

1.2100

3

1.0612

1.0927

1.1910

1.3310

4

1.0824

1.1255

1.2624

1.4641

5

1.1040

1.1592

1.3382

1.6105

Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

We are looking for a factor of 1.2008 Is it 5% ? No, 5% for 4 years = 1.2155 Is it 4.5% ? No, 4.5% for 4 years = 1.1925 Is it 4.7% ? Very close, 4.7% = 1.2016 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Internal Rate of Return (Criteria)

Hurdle Rate The minimum acceptable

return on investment. Dictionary of Accounting, Ralph Estes Second Edition, MIT Press, 1995 Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Internal Rate of Return (Criteria)

Hurdle Rates High Tech Companies tend to very high “hurdle rates”. Less competitive organizations tend to have much lower “hurdle rates”. Copyright: Vail Training Associates

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Cost/Benefit Analysis Benefit Measurement Methods Economic Models

• Benefit/Cost Ratio • Payback Period • Discounted Cash Flow –Net Present Value

• Internal Rate of Return (IRR) Copyright: Vail Training Associates

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End of Cost-Benefit Analysis

Copyright: Vail Training Associates

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CHAPTER 12a. COST BENEFIT ANALYSIS

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Cost-Benefit Analysis - 1 In cost-benefit analysis, we compare the costs and benefits of one or more projects to determine which are worthwhile, and which should be prioritized when there are multiple projects. The computations are similar to those in cost effectiveness analysis; we simply are applying economic evaluation techniques to two entities: costs and benefits. The minimum requirement for a project to be judged worthwhile is that its benefit-cost ratio be at least 1.0. This means that the benefits equal or exceed the costs of the project. When comparing multiple worthwhile projects, priority would be given to the project with the highest benefit-cost ratio. Cost-benefit analysis can be much more complex that we will present here. Real work problems frequently have benefits to multiple groups, i.e. the recipients of the service and society at large. For example, a person cured of substance abuse could show his or her wages as a personal benefit. Society would also gain because this individual now pays taxes, does not steal to pay for the drug habit, etc. Principles of Macroeconomics: Cost Benefit Analysis, Slide 2 Ch. 20

Second Canadian Edition

Cost-Benefit Analysis - 2 In many cases, benefits to one group may be costs to another group. For example, welfare reform may save the government money, but reduce the income of merchants who own the stores where welfare recipients shop. Another complexity which we will not pursue is the probability or likelihood of the occurrence of different events or outcomes. Future events and costs are based on the assumption of their likelihood of occurrence. We can calculate scenarios with different probabilities for future events to see what impact that would make for choosing among the available alternatives.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 3 Ch. 20

Second Canadian Edition

Example 1: East Stockton Urban Renewal Project - 1 This problem is similar to the problem in Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 157-159. The objective and social benefits of urban renewal are (1) superior pattern of resource allocation, (2) social benefits of the removal of blight, and (3) improved local financial position. Although there may be a number of alternative uses for land being redeveloped, we are here considering the more aggregate alternatives, either urban renewal or no urban renewal in a particular section of the city. This is the level of evaluation appropriate for cost-benefit analysis. The alternatives would then be the particular urban renewal projects that should or should not be undertaken. Among the constraints active on urban renewal is the legal requirement that a redevelopment agency must provide former residents of an urban renewal area with decent, safe, and sanitary housing that is conveniently located and within the means of the residents. Note that it is not implicitly assumed that relocation results in housing facility improvement for the residents,

Principles of Macroeconomics: Cost Benefit Analysis, Slide 4 Ch. 20

Second Canadian Edition

Example 1: East Stockton Urban Renewal Project - 2 The costs include those for relocation, survey and planning, administration, public improvements, demolition, and the value of improvements demolished. Benefits include those specifically associated with the stated objectives as well as non-economic negative effects of relocation and possible land value writedown. In urban renewal there are, of course, tangible and intangible benefits; in this exercise, our goal is to determine what level of intangible benefits would decision makers have to substantiate in order to justify the project from a costbenefit perspective. The East Stockton, California, Urban Renewal Project was officially approved by the federal government in July 1959. The workbook, “Urban Renewal.xls”, which can be downloaded from the course download web page, displays the various costs associated with the renewal project and the time at which they occurred. Most of the costs were actually incurred over an interval of time; in such cases the center of the interval is used as the date of the cost.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 5 Ch. 20

Second Canadian Edition

Example 1: East Stockton Urban Renewal Project - 3 The cost of the land is not included in the list of costs since land purchases were later resold. In the East Stockton renewal project, the land was purchased for $669,129 over a period roughly centered at June 30, 1960. After clearing and renewal, the land was subsequently sold for $1,200,000 over a period roughly centered at June 30, 1965. Employing a discount rate of 6 percent, the selling price was discounted to June 30, 1960, yielding a present value of $896,760; hence, the redevelopment agency had a “profit” of $227,631 on the project area land. This amount is included in the list of tangible benefits in the “UrbanRenewal” workbook. Other tangible benefits were not quite so easily estimated. The increase in the property value in the project area was the result of three factors: inflation, growth in real income and population, and urban renewal. To isolate the increase due to urban renewal, a comparison was made between increases in the project area and increases near the project area. The comparison led to an estimate of $415,500 as the increase in the value of the neighborhood properties. Public improvements such as schools and parts were estimated at a value equal to their cost. Principles of Macroeconomics: Cost Benefit Analysis, Slide 6 Ch. 20

Second Canadian Edition

Example 1: East Stockton Urban Renewal Project - 4 Urban renewal is generally expected to reduce the cost of municipal services. The savings in the cost of fire protection was estimated by noting that prior to urban renewal the per person expenditure for East Stockton as was 2½ times what it was for the rest of the city. Assuming that after renewal the residents of East Stockton would require only average protection, the reduced cost of fire protection was estimated to be $42,000 annually. Capitalizing the annual amount of $42,000 at 6 percent yields $700,000 as the present value of future fire protection cost savings. The savings in health protection and police protection costs were estimated similarly. The questions we will answer in this exercise are: what level of intangible benefits need to be identified in order for this project to satisfy the minimum cost benefit ratio of 1.0? Does a higher or lower discount rate substantially change our answer?

Principles of Macroeconomics: Cost Benefit Analysis, Slide 7 Ch. 20

Second Canadian Edition

Tangible costs/benefits of urban renewal project

The Thetangible tangiblecosts costsand andbenefits benefitsfor forthe theproject projecthave have been entered in a workbook called UrbanRenewal.xls been entered in a workbook called UrbanRenewal.xls which whichcan canbe bedownloaded downloadedfrom fromaacourse courseweb webpage. page. All All ofofthis information is given in the chapter by McKenna. this information is given in the chapter by McKenna. Note Notethat thatthe theworksheet worksheetincludes includesthe theDate Dateofofthe the expense expensebecause becausenot notall allexpenses expensesoccurred occurredatatregular regular annual intervals. Excel has another worksheet function annual intervals. Excel has another worksheet function to tosupport supportcalculations calculationsofofnet netpresent presentvalue valuewhen whenthe the stream of payments occur in different time periods, stream of payments occur in different time periods,the the XNPV function. XNPV function.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 8 Ch. 20

Second Canadian Edition

The discount rate

First, First,we weenter enterthe thediscount discount rate stated in the problem rate stated in the problem 6% 6%ininthe thecell cellD2 D2ofofthe the Cost-benefit analysis Cost-benefit analysis worksheet. worksheet.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 9 Ch. 20

Second Canadian Edition

Use XNPV function to calculate value of tangible costs First, First,select selectthe thecell cellininwhich whichwe we Excel Excelto toreturn returnthe thepresent presentvalue valueofof the thetangible tangiblecosts, costs,cell cellB14 B14on onthe the Cost-benefit analysis worksheet. Cost-benefit analysis worksheet.

Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Unlike Unlikethe the‘NPV’ ‘NPV’function, function, the the‘XNPV’ ‘XNPV’function functiondoes does not make the assumption not make the assumption that thatthe theseries seriesofofcosts costs occurs at regular, annual occurs at regular, annual intervals. intervals. XPNV XPNVpermits permits us usto toassociated associateddates dates with each cost item. with each cost item.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 10 Ch. 20

Second Canadian Edition

Locate the XNPV function We Wewill willsearch searchfor forthe theXNPV XNPV function. function.First, First,type typeXNPV XNPVininthe the Search for text box, and click Search for text box, and clickon on the Go button. the Go button.

The TheXNPV XNPVfunction functionname namewill willappear appearinin the theSelect Selectaafunction functionlist listbox. box.Click Clickon onthe the OK button access the dialog box where OK button access the dialog box where the thefunction functionarguments argumentsare areentered. entered.

Note: Note:the theXNPV XNPVfunction functionisispart partofofthe the Analysis Toolpak that we used for Analysis Toolpak that we used for Data DataAnalysis. Analysis.IfIfExcel Exceldoes doesnot notfind find it, it,check checkto tomake makesure surethe theAnalysis Analysis Toolpak ToolpakAdd-in Add-inhas hasbeen beeninstalled. installed.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 11 Ch. 20

Second Canadian Edition

The arguments to the XNPV function The Thefirst firstargument argumentto to the theXNPV XNPVfunction functionisisthe the discount rate, which we discount rate, which we put putinincell cellD2. D2.

The Thethird thirdargument argumentto to the XNPV function is the the XNPV function is the cells cellscontaining containingthe the dates datesthe thetangible tangiblecosts costs occurred, C2:C12. occurred, C2:C12.

The Thesecond secondargument argument to the XNPV function to the XNPV functionisis the thecells cellscontaining containingthe the tangible costs, B2:B12. tangible costs, B2:B12.

With Withthe thearguments arguments entered, click entered, clickon on the theOK OKbutton. button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 12 Ch. 20

Second Canadian Edition

Net present value of tangible costs

Excel Excelcomputes computesthe the net netpresent presentvalue valuefor for the series of costs for the series of costs for this thisproject. project.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 13 Ch. 20

Second Canadian Edition

The table of tangible benefits - 1 The TheXPNV XPNVfunction functiondiscounts discountsthe thestream streamofofcosts costsor orbenefits benefits back to the first date in the series. For costs, the entry back to the first date in the series. For costs, the entryfor for ‘Survey ‘Surveyand andplanning’ planning’was wasdated datedto tooccur occuratatthe thestart startofofthe the project. Since this item was listed first, it could be used for project. Since this item was listed first, it could be used for the thedate date(12-31-58) (12-31-58)to towhich whichall allother othercosts costswere werediscounted. discounted.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 14 Ch. 20

Second Canadian Edition

The table of tangible benefits - 2 The Thetable tableofoftangible tangiblebenefits benefitswas wascopied copied from the McKenna text, except for the from the McKenna text, except for the entry entryon onrow row18 18which whichwas wasadded addedas asaa requirement requirementofofthe theXNPV XNPVfunction. function.

In Inthe thecase caseofofbenefits, benefits,there therewas, was,quite quitenaturally, naturally,no nobenefit benefit to tobe berealized realizedatatthe thestart startofofthe theproject. project. To Tosatisfy satisfythe theExcel Excel XPNV function, I added a dummy entry to the table, XPNV function, I added a dummy entry to the table, ‘Immediate ‘Immediatebenefits’ benefits’with withaavalue valueofof$0 $0to tobe berealized realizedatatthe the start of the project on 12-31-58. Since this entry was for start of the project on 12-31-58. Since this entry was forzero zero dollars, it will not affect our benefit calculations. The date dollars, it will not affect our benefit calculations. The date entry entryinincell cellC18 C18meets meetsthe therequirement requirementofofthe theXNPV XNPVfunction function for an initial date to which all other benefits are discounted. for an initial date to which all other benefits are discounted.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 15 Ch. 20

Second Canadian Edition

Use XNPV to calculate value of tangible benefits First, First,select selectthe thecell cellininwhich whichwe we Excel Excelto toreturn returnthe thepresent presentvalue valueofof the thetangible tangiblebenefits benefitscell cellB26 B26on onthe the Cost-benefit analysis worksheet. Cost-benefit analysis worksheet.

Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 16 Ch. 20

Second Canadian Edition

Locate the XNPV function

We Wewill willsearch searchfor forthe theXNPV XNPV function. function.First, First,type typeXNPV XNPVinin the theSearch Searchfor fortext textbox, box,and and click on the Go button. click on the Go button.

The TheXNPV XNPVfunction functionname namewill willappear appearinin the Select a function list box. Click the Select a function list box. Clickon onthe the OK OKbutton buttonaccess accessthe thedialog dialogbox boxwhere where the thefunction functionarguments argumentsare areentered. entered.

Note: Note:the theXNPV XNPVfunction functionisispart part ofofthe theAnalysis AnalysisToolpak Toolpakthat thatwe we used for Data Analysis. If Excel used for Data Analysis. If Excel does doesnot notfind findit, it,check checkto tomake make sure surethe theAnalysis AnalysisToolpak ToolpakAdd-in Add-in has been installed. has been installed.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 17 Ch. 20

Second Canadian Edition

The arguments to the XNPV function The Thefirst firstargument argumentto to the theXNPV XNPVfunction functionisisthe the discount rate, which we discount rate, which we put putinincell cellD2. D2.

The Thesecond secondargument argumentto to the theXNPV XNPVfunction functionisisthe the cells cellscontaining containingthe thetangible tangible benefits, B18:B24. benefits, B18:B24.

The Thethird thirdargument argumentto tothe theXNPV XNPV function is the cells containing function is the cells containing the thedates datesthe thetangible tangiblebenefits benefits occurred, C18:C24. occurred, C18:C24.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 18 Ch. 20

Second Canadian Edition

Net present value of tangible benefits

Excel Excelcomputes computesthe thenet net present value for the present value for theseries series ofofbenefits benefitsfor forthis thisproject. project.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 19 Ch. 20

Second Canadian Edition

Compute the required intangible benefits

The Theproblem problemstatement statementwanted wanted us usto tofind findthe theminimum minimumlevel levelofof intangible benefits that would intangible benefits that wouldbe be necessary necessaryto tomeet meetthe theminimum minimum benefit-cost benefit-costratio ratioofof1.0. 1.0. The The‘Required ‘Requiredintangible intangiblebenefits’ benefits’ are equal to the difference are equal to the difference between betweentangible tangiblecosts costsand and tangible benefits. tangible benefits.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 20 Ch. 20

In Incell cellB28, B28,enter enterthe theformula formula for computing the difference for computing the difference between betweentangible tangiblecosts costsinincell cell B14 B14and andtangible tangiblebenefits benefitsinin cell cellB26: B26:=B14-B26. =B14-B26. In Inorder orderto tosatisfy satisfybenefit-cost benefit-cost criteria, the project criteria, the projectplanners planners would wouldhave haveto toidentify identifyand and document $1,062,932 in document $1,062,932 in intangible intangiblebenefits. benefits.

Second Canadian Edition

What if the discount rate were different

The Theproblem problemstatement statementalso also wanted us to determine whether wanted us to determine whether or ornot notaahigher higheror orlower lowerdiscount discount rate substantially changes rate substantially changesour our answer. answer. In Inorder orderto tosee seethe theresults resultsofofthe the testing testingdifferent differentdiscount discountrates, rates, we wesplit splitthe thescreen screenatatrow row24 24and and arrange the panes as shown. arrange the panes as shown.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 21 Ch. 20

Second Canadian Edition

Test a higher discount rate

Enter Enter7% 7%inincell cellD2 D2 to test the effect of to test the effect ofaa higher higherdiscount discountrate. rate.

Excel Excelhas hasrecalculated recalculatedthe the required requiredintangible intangiblebenefits benefits needed neededto tobe behigher higherby by about $15,000 about $15,000 ($1,077,691-$1,062,932). ($1,077,691-$1,062,932). For Forthis thissize sizeofofthe theurban urban renewal project, I would renewal project, I would not notconsider considerthis thisaa substantial substantialdifference difference

Principles of Macroeconomics: Cost Benefit Analysis, Slide 22 Ch. 20

Second Canadian Edition

Test a lower discount rate

To Totest testaalower lowerdiscount discountrate, rate, enter 5% in cell D2 to test enter 5% in cell D2 to testthe the effect of a higher discount rate. effect of a higher discount rate.

Excel Excelhas hasrecalculated recalculatedthe the required intangible benefits required intangible benefits needed neededto tobe belower lowerby byabout about $16,000 ($1,046,037$16,000 ($1,046,037$1,062,932). $1,062,932). For Forthis thissize sizeofofthe theurban urban renewal renewalproject, project,I Iwould wouldnot not consider this a substantial consider this a substantial difference difference We Wehave haveanswered answeredall all ofofthe questions stated the questions stated ininthe theproblem. problem.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 23 Ch. 20

Second Canadian Edition

Example 2: A Highway Expansion Project This example was adapted from a problem presented in Public Policy Analysis: Applied Research Methods by Theodore H. Poister, pages 397-400. This case pertains to a hypothetical highway project in which two alternative expansion levels (expansion to a 4-lane highway and expansion to a 6-lane highway) are considered in comparison with the alternative of retaining the existing roadway. In this application, the alternatives are compared incrementally, so that the benefits and costs of expanding to a 4-lane highway are derived by comparing it with the existing roadway, and the costs and benefits corresponding to the 6-lane expansion are based on the incremental costs and benefits beyond the 4-lane highway expansion. Sequentially, then, the analysis addresses the issue of whether it is justifiable to expand to a 4-lane highway, as if so, whether it is further justified to expand to the 6-lane highway. For this problem, we will present in detail how the benefits and costs are derived. The sheet, column, and row labels have been entered into the workbook, HighwayProject.xls.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 24 Ch. 20

Second Canadian Edition

The benefit of travel time saved by the proposed highways

The Theaverage averagetime timespent spentper pertrip tripdeclines declinesdramatically dramatically with the expansion to the 4-lane highway, with the expansion to the 4-lane highway,and andthen then modestly modestlyas aswe wemove moveto tothe the6-lane 6-lanehighway highway expansion. expansion. Average Averagedriving drivingtime timeper pertrip tripon onthe the existing existinghighway highwayisisestimated estimatedto tobe be30 30minutes. minutes. IfIf the thehighway highwayisisexpanded expandedto to4-lanes, 4-lanes,the theaverage averagetrip trip time drops to 18 minutes. If the highway is time drops to 18 minutes. If the highway is expanded expandedto to6-lanes, 6-lanes,the theaverage averagetrip triptime timedrops dropsan an additional two minutes to 16 minutes. additional two minutes to 16 minutes.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 25 Ch. 20

Second Canadian Edition

Computing the time cost per trip Setting Settingthe thevalue valueofofthe thedriver’s driver’stime time atat$2.00 $2.00 per perhour, hour,the thetime timecost costper pertrip tripisiscomputed computedby by dividing the number of minutes in the average dividing the number of minutes in the average trip tripby by60 60and andthen thenmultiplying multiplyingby by$2.00. $2.00.

In Incell cellB3, B3,enter enterthe theformula formula =B2/60*2. In cell C3, =B2/60*2. In cell C3,enter enterthe the formula formula=C2/60*2. =C2/60*2.In Incell cellD3, D3, enter enterthe theformula formula=D2/60*2. =D2/60*2.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 26 Ch. 20

Second Canadian Edition

Total cost per trip Other Othertrip tripcosts costsincrease increaseslightly slightlyatatthe thefirst firstexpansion expansionlevel level (from $1.75 to $1.90), because of higher and less efficient (from $1.75 to $1.90), because of higher and less efficient operating operatingspeeds, speeds,and andthen thendecrease decreaseslightly slightlyatatthe thesecond second expansion level (from $1.90 to $1.85) because of improved expansion level (from $1.90 to $1.85) because of improved maneuverability maneuverabilityinindispersed dispersedtraffic. traffic.Enter Enter$1.75 $1.75inincell cellB4, B4, $1.90 $1.90inincell cellC4, C4,and and$1.85 $1.85inincell cellD4. D4.

Total Totalvariable variablecost costper pertrip tripisis computed by adding ‘Time computed by adding ‘Timecost cost per pertrip’ trip’and and‘Other ‘Othercosts costsper per trip’. trip’.Enter Enter=B3+B4 =B3+B4inincell cellB5, B5, =C3+C4 in cell C5, and =C3+C4 in cell C5, and =D3+D4 =D3+D4inincell cellD5. D5.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 27 Ch. 20

Second Canadian Edition

Cost savings per trip The Thecost costsavings savingsper pertrip tripwhen when expanding expandingto tothe the4-lane 4-lanehighway highway isisthe thedifference differencebetween betweenthe the total variable costs for the total variable costs for the existing existinghighway highway($2.75) ($2.75)and and the 4-lane highway ($2.50) the 4-lane highway ($2.50) which whichequals equals$.25. $.25.Enter Enterthe the formula =B5-C5 in cell C6. formula =B5-C5 in cell C6.

The Thecost costsavings savingsper pertrip tripwhen when expanding to the 6-lane highway expanding to the 6-lane highway isisthe thedifference differencebetween betweenthe the total variable costs for the total variable costs for the44lane highway ($2.50) and the lane highway ($2.50) and the66lane lanehighway highway($2.38) ($2.38)which which equals equals$.12. $.12.Enter Enterthe theformula formula =C5-D5 =C5-D5inincell cellD6. D6.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 28 Ch. 20

Second Canadian Edition

Computing cost savings on current trips

First, First,we weenter enterthe thesame samenumber numberofoftrips tripsper peryear year for each highway condition, 1 million trips per year for each highway condition, 1 million trips per year inincells cellsB8, B8,C8, C8,and andD8. D8. ItItisislikely likelythat thatthe the number numberofoftrips tripswould wouldincrease increasebecause becauseofof improved improvedtravel. travel. Estimating Estimatingsavings savingsbased basedon onthe the existing number of trips is, therefore, a existing number of trips is, therefore, a conservative conservativeestimate estimateofofthe theprobable probablesavings. savings.

Second, Second,to tocompute computethe thecost cost savings for all trips, we multiply savings for all trips, we multiply the thecost costsavings savingsper pertrip tripon onrow row 66by the number of trips per by the number of trips per year yearon onrow row8.8.Enter Enter=C6*C8 =C6*C8inin cell cellC9 C9and and=D6*D8 =D6*D8inincell cellD9. D9.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 29 Ch. 20

Second Canadian Edition

Projected savings worksheet First, First,copy copythe thecost costsavings savingsfor foreach eachofofthe the expansion projects from cells C9 through expansion projects from cells C9 throughD9 D9 on the ‘Cost-benefit Analysis’ worksheet and on the ‘Cost-benefit Analysis’ worksheet and Paste PasteSpecial Specialthe theValues Valuesinto intocells cellsB2 B2through through C2 on the ‘Projected Savings’ worksheet. C2 on the ‘Projected Savings’ worksheet.

Second, Second,fill fillthe theannual annualsavings savings down downfor foraatwenty-five twenty-fiveyear yeartime time period. For this problem, the period. For this problem, the present presentvalue valueofofthe thebenefits benefits stream is computed by stream is computed by assuming assumingthat thatthe thesame sameamount amount ofofbenefit benefitwill willaccrue accruefor foreach eachofof 25 25years yearsinto intothe thefuture. future. Highlight Highlightcells cellsB2 B2through throughC26 C26 and select the Fill > Down and select the Fill > Down command commandfrom fromthe theEdit Editmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 30 Ch. 20

Second Canadian Edition

Compute NPV of savings for 4 lane expansion

First, First,select selectthe thecell cellininwhich whichwe we Excel to return the present value Excel to return the present value ofofthe thesavings, savings,cell cellC10 C10on onthe the Cost-benefit Analysis worksheet. Cost-benefit Analysis worksheet. Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 31 Ch. 20

Second Canadian Edition

Locate the NPV function We Wewill willsearch searchfor forthe theNPV NPV function. function.First, First,type typeNPV NPVinin the theSearch Searchfor fortext textbox, box,and and click on the Go button. click on the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 32 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV function is the NPV function is the discount discountrate, rate,which whichwe we will willenter enterdirectly directlyas as8%. 8%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing the projected savings for 4 lane expansion, containing the projected savings for 4 lane expansion, 'Projected 'ProjectedSavings'!B2:B26. Savings'!B2:B26. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet worksheetProjected ProjectedSavings Savingsbecause becauseititcontains containsaaspace. space.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 33 Ch. 20

Second Canadian Edition

NPV for projected savings for 4 lane expansion

The TheNPV NPVfunction functionreturns returnsthe the present presentvalue valueofofthe theprojected projected savings savingsfor for44lane laneexpansion, expansion, $2,668,694.05. $2,668,694.05.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 34 Ch. 20

Second Canadian Edition

Compute NPV of projected savings for 6 lane expansion

First, First,select selectthe thecell cellininwhich whichwe we Excel Excelto toreturn returnthe thepresent presentvalue value ofofthe thesavings, savings,cell cellD10 D10on onthe the Cost-benefit Analysis worksheet. Cost-benefit Analysis worksheet. Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 35 Ch. 20

Second Canadian Edition

Locate the NPV function

We Wewill willsearch searchfor forthe theNPV NPV function. First, type NPV function. First, type NPVinin the theSearch Searchfor fortext textbox, box, and click on the Go button. and click on the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 36 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV function is the NPV function is the discount discountrate, rate,which whichwe we will enter directly as 8%. will enter directly as 8%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing containingthe theprojected projectedsavings savingsfor for66lane laneexpansion, expansion, 'Projected 'ProjectedSavings'!C2:C26. Savings'!C2:C26. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet Projected Savings because it contains a space. worksheet Projected Savings because it contains a space.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 37 Ch. 20

Second Canadian Edition

NPV for projected savings for 6 lane expansion

The TheNPV NPVfunction functionreturns returnsthe the present presentvalue valueofofthe theprojected projected savings savingsfor for66lane laneexpansion, expansion, $1,245,394.11. $1,245,394.11.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 38 Ch. 20

Second Canadian Edition

The costs of the highway projects - 1

The Theexpansion expansionto toaa4-lane 4-lanehighway highway will cost $2,000,000 in construction will cost $2,000,000 in construction costs. costs.Enter Enter$2,000,000 $2,000,000inincell cellC13. C13. Similarly, Similarly,the theexpansion expansionto to66lanes lanes will cost an additional $2,000,000. will cost an additional $2,000,000. Enter Enter$2,000,000 $2,000,000inincell cellD13. D13.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 39 Ch. 20

Second Canadian Edition

The costs of the highway projects - 2

The Theannual annualmaintenance maintenancecosts costsfor forboth both the theexisting existinghighway highwayand andeach eachofofthe the alternatives alternativesisisentered enteredininthe theworksheet. worksheet. Enter Enter$20,000 $20,000inincell cellB14, B14,$30,000 $30,000inin cell C14, and $50,000 in cell cell C14, and $50,000 in cellD14. D14.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 40 Ch. 20

Second Canadian Edition

The costs of the highway projects - 3 The Theincrease increaseininmaintenance maintenancecosts costsare are computed by subtracting the existing computed by subtracting the existingroadway roadway maintenance maintenancecosts costsfrom fromthe the4-lane 4-laneexpansion expansion maintenance maintenancecosts costsand andsubtracting subtractingthe the4-lane 4-lane expansion maintenance costs from the 6-lane expansion maintenance costs from the 6-lane maintenance maintenancecosts. costs.

First, First,enter enterthe theformula formula =C14-B14 =C14-B14inincell cellC15 C15to to compute the increase in compute the increase in maintenance maintenancecosts costs associated associatedwith withthe the expansion to 4 lanes. expansion to 4 lanes.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 41 Ch. 20

Second, Second,enter enterthe the formula =D14-C14 formula =D14-C14inin cell cellD15 D15to tocompute compute the increase the increaseinin maintenance maintenancecosts costs associated associatedwith withadding adding two additional lanes two additional lanesto to the the44lane lanehighway. highway.

Second Canadian Edition

Annual Maintenance worksheet First, First,copy copythe theincrease increaseininmaintenance maintenance costs for each of the expansion costs for each of the expansionprojects projects from fromcells cellsC15 C15through throughD15 D15on onthe the‘Cost‘Costbenefit Analysis’ worksheet and Paste benefit Analysis’ worksheet and Paste Special Specialthe theValues Valuesinto intocells cellsB2 B2through throughC2 C2 on onthe the‘Annual ‘AnnualMaintenance’ Maintenance’worksheet. worksheet.

Second, Second,fill fillthe theannual annualmaintenance maintenance cost costincreases increasesdown downfor foraatwenty-five twenty-five year time period. For this problem, year time period. For this problem, the thepresent presentvalue valueofofthe thecost coststream stream isiscomputed by assuming that computed by assuming thatthe the same amount of maintenance costs same amount of maintenance costs will willbe beincurred incurredfor foreach eachofof25 25years years into the future. into the future. Highlight Highlightcells cellsB2 B2through throughC26 C26and and select the Fill > Down command select the Fill > Down commandfrom from the theEdit Editmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 42 Ch. 20

Second Canadian Edition

Compute NPV of increased maintenance for 4 lane expansion

First, First,select selectthe thecell cellininwhich whichwe we Excel to return the present value Excel to return the present value ofofthe theincreased increasedmaintenance, maintenance, cell C16 on the Cost-benefit cell C16 on the Cost-benefit Analysis Analysisworksheet. worksheet. Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 43 Ch. 20

Second Canadian Edition

Locate the NPV function We Wewill willsearch searchfor forthe theNPV NPV function. function.First, First,type typeNPV NPVininthe the Search for text box, and click Search for text box, and clickon on the Go button. the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 44 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV NPVfunction functionisisthe the discount discountrate, rate,which whichwe we will enter directly as 8%. will enter directly as 8%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing the increased maintenance for 4 lane expansion, containing the increased maintenance for 4 lane expansion, 'Projected 'ProjectedSavings'!B2:B26. Savings'!B2:B26. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet worksheetAnnual AnnualMaintenance Maintenancebecause becauseititcontains containsaaspace. space.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 45 Ch. 20

Second Canadian Edition

NPV for increased maintenance for 4 lane expansion

The TheNPV NPVfunction functionreturns returnsthe the present value of the increased present value of the increased maintenance maintenancefor for44lane lane expansion, $106,747.76. expansion, $106,747.76.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 46 Ch. 20

Second Canadian Edition

Compute NPV of maintenance for 6 lane expansion

First, First,select selectthe thecell cellininwhich whichwe we Excel to return the present value Excel to return the present value ofofthe theincreased increasedmaintenance, maintenance, cell D16 on the Cost-benefit cell D16 on the Cost-benefit Analysis Analysisworksheet. worksheet. Second, Second,select selectthe the Function command Function command from fromthe theInsert Insertmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 47 Ch. 20

Second Canadian Edition

Locate the NPV function

We Wewill willsearch searchfor forthe theNPV NPV function. First, type NPV function. First, type NPVininthe the Search Searchfor fortext textbox, box,and andclick clickon on the Go button. the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 48 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV NPVfunction functionisisthe the discount discountrate, rate,which whichwe we will enter directly as 8%. will enter directly as 8%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing containingthe theincreased increasedmaintenance maintenancefor for66lane laneexpansion, expansion, 'Projected Savings'!C2:C26. 'Projected Savings'!C2:C26. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet Annual Maintenance because it contains a space. worksheet Annual Maintenance because it contains a space.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 49 Ch. 20

Second Canadian Edition

NPV for increased maintenance for 6 lane expansion

The TheNPV NPVfunction functionreturns returnsthe the present value of the increased present value of the increased maintenance maintenancefor for66lane lane expansion, $213,495.52. expansion, $213,495.52.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 50 Ch. 20

Second Canadian Edition

Total project costs The Thetotal totalproject projectcosts costsfor forthe the two expansion projects are two expansion projects arethe the sum sumofofthe thecapital capitalcosts costsand and the theyearly yearlymaintenance maintenancecosts. costs.

Sum Sumtotal totalproject projectcosts costsfor forthe the44 lane expansion by entering the lane expansion by entering the formula formula=C13+C16 =C13+C16inincell cellC17. C17. Sum total project costs for the Sum total project costs for the66 lane laneexpansion expansionby byentering enteringthe the formula formula=D13+D16 =D13+D16inincell cellD17. D17.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 51 Ch. 20

Second Canadian Edition

Compute benefit-cost ratio for the two expansion plans

First, First,compute computethe the benefit-cost ratio benefit-cost ratiofor for the the4-lane 4-laneexpansion expansion by bydividing dividingthe thepresent present value of savings value of savings(C10) (C10) by bytotal totalproject projectcosts costs (C17), (C17),displaying displayingthe the result resultinincell cellC19. C19.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 52 Ch. 20

Second, Second,compute computethe the benefit-cost benefit-costratio ratiofor for the the6-lane 6-laneexpansion expansion by dividing the by dividing thepresent present value valueofofsavings savings(D10) (D10) by total project costs by total project costs (D17), (D17),displaying displayingthe the result in cell D18. result in cell D18.

Second Canadian Edition

Results of the benefit-cost analysis

The Thebenefit-cost benefit-costratio ratiofor forthe the4-lane 4-laneexpansion expansion isisover 1.0. Based on this analysis, the over 1.0. Based on this analysis, the4-lane 4-lane expansion is justified. expansion is justified. However, However,the thebenefit-cost benefit-costratio ratiofor forthe the additional additional22lanes lanesto tocomplete completeaa6-lane 6-lane expansion expansionisisless lessthan than1.0. 1.0.The Theadditional additional22 lanes to complete the 6-lane expansion lanes to complete the 6-lane expansionisisnot not justified, justified,based basedon onbenefit-cost benefit-costanalysis. analysis.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 53 Ch. 20

Second Canadian Edition

Example 3: Methadone Maintenance Treatment Program - 1 This problem is from Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 162-163. Cost-benefit analysis has used the past 6 years' experience of a methadone maintenance treatment program (MMTP) to see if it is worth continuing for the next six years. Here decision makers are considering two basic alternatives, to continue the program or not. Although the effects of the program are expected to last longer than the 6-year length of the program, only the benefits during these years are considered. All projections are based on the assumption that future experience will follow the patterns of the past. The actual expenditures of the program include salaries for physicians, counselors, nurses, and administrators, rent, supplies, and the cost of the methadone. The analysis includes a dropout rate; if a patient drops out there no further costs or benefits for that patient. The total costs for the six years can be found on the 'Costs of the MMTP' worksheet in the 'MMTP.xls' workbook.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 54 Ch. 20

Second Canadian Edition

Example 3: Methadone Maintenance Treatment Program - 2 In methadone treatment as in most social programs there are both tangible and intangible benefits. Here the intangibles are not included in the calculations; however, the decision maker must be aware of them when interpreting the results of the analysis. The benefits of MMTP include decreases in private protection expenditures, the costs of injury to crime victims, the negative value placed on fear of attack by an addict, criminal justice expenditures, expenditures on heroin by the addict, expenditures for narcotic-related illnesses, and increases in legal earning. The last three are tangible benefits and are summarized on the worksheet 'Benefits of the MMTP' worksheet in the 'MMTP.xls' workbook. Your assignment is to determine the net present value of the MMTP, and to compute and interpret its cost-benefit ratio. HINT: since we conducting this analysis on an on-going program, any start-up costs have either been absorbed or included in the first year of the new cycle for the program, 1978. Do not discount 1978 costs or benefit with the NPV function, but rather add the full amount of 1978 costs and benefits to the discounted costs and benefits for the years 1979 to 1983, discounted back to 1978 using a 10% discount rate. Principles of Macroeconomics: Cost Benefit Analysis, Slide 55 Ch. 20

Second Canadian Edition

Open the MMTP.xls workbook

The TheMMTP.xls MMTP.xlsworkbook workbookcontains contains three worksheets: one three worksheets: one containing containingthe theannual annualcosts costsfor for the program, one containing the program, one containingthe the annual annualbenefits benefitsfor forthe theprogram, program, and andone onefor forcomputing computingthe the benefit-cost ratio. benefit-cost ratio.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 56 Ch. 20

Second Canadian Edition

Costs in the first year The Thefirst-year first-yearcosts costs are arenot notdiscounted. discounted.

First, First,enter enteraa label label Costs, Costs, year 1 in year 1 incell cellB9. B9.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 57 Ch. 20

Second, Second,enter enterthe the first year costs, first year costs, $2,220,000, $2,220,000,inincell cellC9. C9.

Second Canadian Edition

Costs in the years two through six The Thetotal totalcosts costsfor foryears yearstwo two through six are discounted through six are discountedto to the thefirst firstyear yearusing usingaa10% 10%rate. rate.

First, First,enter enteraa label NPV, label NPV, Costs, Costs,year year2-6 2-6 inincell B10. cell B10.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 58 Ch. 20

Second, Second,select select cell C10 and cell C10 andinsert insert the theNPV NPVfunction. function.

Second Canadian Edition

Locate the NPV function

We Wewill willsearch searchfor forthe theNPV NPV function. First, type NPV function. First, type NPVininthe the Search Searchfor fortext textbox, box,and andclick clickon on the Go button. the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 59 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV NPVfunction functionisisthe thediscount discount rate, rate,which whichwe wewill willenter enter directly as 10%. directly as 10%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing the costs of the program in years 2 through containing the costs of the program in years 2 through6, 6, 'Costs 'Costsofofthe theMMTP'!D3:D7. MMTP'!D3:D7. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet worksheetCosts Costsofofthe theMMTP MMTPbecause becauseititcontains containsspaces. spaces.

With Withthe thearguments arguments entered, click entered, clickon on the theOK OKbutton. button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 60 Ch. 20

Second Canadian Edition

NPV for projected savings for MMTP

The TheNPV NPVfunction functionreturns returnsthe the present value of the costs for present value of the costs for years years22through through6, 6,$5,247,308. $5,247,308.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 61 Ch. 20

Second Canadian Edition

Total Project Cost The Thetotal totalproject projectcost costisis computed by summing computed by summingthe thefirst first year yearcosts costsand andthe thediscounted discounted costs costsfor foryears yearstwo twothrough throughsix. six.

First, First,enter enterthe the label Total Project label Total Project Cost Costinincell cellB11. B11.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 62 Ch. 20

Second, Second,sum sumthe thecosts costsby by entering enteringthe theformula formula=C9+C10 =C9+C10 inincell cellC11. C11.The Thetotal totalproject project cost is $7,467,308. cost is $7,467,308.

Second Canadian Edition

Increased earnings benefit in the first year Like Likethe thefirst-year first-yearcosts, costs, the first-year benefits the first-year benefits are arenot notdiscounted. discounted.

First, First,enter enter aalabel label Year Year 11inincell cellA9. A9.

Second, Second,enter enteraaformula formulato to point to the first year benefits point to the first year benefits =B2 =B2inincell cellB9. B9.By Byusing usingaa formula, we can drag formula, we can dragfill fillthe the other otherbenefit benefitcolumns. columns.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 63 Ch. 20

Second Canadian Edition

Increased earnings benefit in years two through six The Thetotal totalbenefits benefitsfor foryears yearstwo two through throughsix sixare arediscounted discountedto to the thefirst firstyear yearusing usingthe thesame same 10% rate we used for costs. 10% rate we used for costs.

First, First,enter enteraa label label Yr Yr2-6 2-6 inincell cellA10. A10.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 64 Ch. 20

Second, Second,select select cell B10 and cell B10 andinsert insert the theNPV NPVfunction. function.

Second Canadian Edition

Locate the NPV function

We Wewill willsearch searchfor forthe theNPV NPV function. First, type NPV function. First, type NPVininthe the Search Searchfor fortext textbox, box,and andclick clickon on the Go button. the Go button.

The TheNPV NPVfunction functionname namewill will appear in the Select a function appear in the Select a function list listbox. box.Click Clickon onthe theOK OKbutton button access accessthe thedialog dialogbox boxwhere wherethe the function arguments are entered. function arguments are entered.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 65 Ch. 20

Second Canadian Edition

The arguments to the NPV function The Thefirst firstargument argumentto tothe the NPV NPVfunction functionisisthe the discount discountrate, rate,which whichwe we will enter directly as 10%. will enter directly as 10%.

The Thesecond secondargument argumentto tothe theNPV NPVfunction functionisisthe thecells cells containing containingthe theincreased increasedearnings, earnings,'Benefits 'Benefitsofofthe the MMTP'!B3:B7. MMTP'!B3:B7. Remember Rememberto toenter enterthe thequote quotemarks marksaround aroundthe thename nameofofthe the worksheet Benefits of the MMTP because it contains a space. worksheet Benefits of the MMTP because it contains a space.

With Withthe thearguments arguments entered, click entered, clickon on the OK button. the OK button.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 66 Ch. 20

Second Canadian Edition

NPV for increased earnings for MMTP

The TheNPV NPVfunction functionreturns returnsthe the present value of the increased present value of the increased earnings earningsfor foryears years22through through6, 6, $6,727,065.65. $6,727,065.65.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 67 Ch. 20

Second Canadian Edition

Total Increased Earnings Benefit The Thetotal totalfor forthe theincreased increased earnings benefit is earnings benefit iscomputed computedby by summing the first year benefit summing the first year benefit and andthe thediscounted discountedbenefits benefitsfor for years two through six. years two through six.

First, First,enter enter the label the labelTotal Total inincell cellA11. A11.

Second, Second,sum sumthe thecosts costsby by entering the formula =B9+B10 entering the formula =B9+B10 inincell cellB11. B11.The Thetotal totalproject project cost is 7,141,065.65. cost is 7,141,065.65.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 68 Ch. 20

Second Canadian Edition

Drag fill the other benefit columns The Thebenefits benefitsattributed attributedto tocriminal criminal justice justicesavings savingsand andreduced reducedheroin heroin consumption are computed in consumption are computed inthe the same way as increased earnings. same way as increased earnings. We Wecan cancomplete completethese thesecalculations calculations by drag filling the columns. by drag filling the columns.

First, First,select selectcells cells B9 B9through throughD11. D11.

Second, Second,select selectthe the Fill > Right command Fill > Right command from fromthe theEdit Editmenu. menu.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 69 Ch. 20

Second Canadian Edition

Total Project Benefits The Thetotal totalbenefits benefitsattributed attributedto to the project are computed by the project are computed by summing summingthe thetotal totalbenefits benefitsfrom from the three tangible sources. the three tangible sources.

First, First,select selectcell cellB13 B13 and enter the label and enter the label Total Totalproject projectbenefits. benefits. Second, Second,select selectcell cellC13 C13 and enter the formula and enter the formula =B11+C11+D11. =B11+C11+D11. The Thetotal totalproject projectbenefits benefits are are$$39,352,844.66. 39,352,844.66.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 70 Ch. 20

Second Canadian Edition

The Benefit-cost Ratio To Tocompute computethe thebenefit benefitcost costratio ratio for the MMTP project, we enter for the MMTP project, we enterthe the total totalcosts costsand andtotal totalbenefits benefitson on the theBenefit-cost Benefit-costRatio Ratioworksheet. worksheet.

First, First,inincell cellB1, B1,enter enteraa reference referenceto tothe thetotal totalproject project costs ='Costs of the MMTP'!C11. costs ='Costs of the MMTP'!C11. Second, Second,inincell cellB2, B2,enter enteraareference reference to the total project benefits to the total project benefits ='Benefits ='Benefitsofofthe theMMTP'!C13. MMTP'!C13.

Third, Third,compute computethe theratio ratio by entering the formula by entering the formula =B2/B1 =B2/B1inincell cellB4. B4. The Theratio ratioofof5.27 5.27indicates indicatesthat that the benefits clearly out weigh the benefits clearly out weigh the thecosts. costs. Using Usingbenefit-cost benefit-cost criteria, criteria,the theMMTP MMTPprogram program should be continued. should be continued.

Principles of Macroeconomics: Cost Benefit Analysis, Slide 71 Ch. 20

Second Canadian Edition

Chapter 20 The Influence of Monetary and Fiscal Policy on Aggregate Demand

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Overview ‹The

theory of liquidity preference. ‹The supply and demand for money. ‹How fiscal policy affects aggregate demand. ‹The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Aggregate Demand (AD) ‹Many

factors influence AD, including desired spending by households and business firms. When desired spending changes, shifts in the AD cause short-run fluctuations in output and employment. ‹Monetary and Fiscal policy are used to stabilize the economy during these fluctuations. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

How Monetary Policy Influences Aggregate Demand ‹The

Aggregate Demand curve is downward sloping due to three effects: Pigou’s Wealth Effect – Keynes’s Interest-Rate Effect – Real Exchange-Rate Effect –

‹Of

these three effects, the Keynes’s Interest-Rate Effect is most important.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference: Keynes’s theory: The development of interest rates ‹The

Liquidity Preference Theory of interest rates states that “...market rates of interest adjust to balance the supply and demand for money.”

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference: Keynes’s theory: The development of interest rates ‹Summary:

An increase in the price level causes an increase in the demand for money, which ... ... leads to higher interest rates, which ... ... leads to reduced total spending (i.e. AD). Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Overview 9 The

theory of liquidity preference. ‹The supply and demand for money. ‹How fiscal policy affects aggregate demand. ‹The economy in the long-run and short-run.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference: The Supply and Demand for Money ‹The

Money Supply is controlled by the RBI, which alters the money supply in three ways: – – –

Open-Market Operations Changing the Bank Rate Buying and selling Canadian dollars in the market for foreign-currency exchange

‹The

quantity of money supplied in the economy is fixed at whatever level the RBI decides to set it.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference: The Supply and Demand for Money ‹Because

the money supply is fixed by the RBI it does not depend on the interest rate. ‹The fixed money supply is represented by a vertical supply curve.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Money Market Interest Rate

Money Supply

QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Theory of Liquidity Preference: The Supply and Demand for Money ‹By

using the Open-Market Operations the RBI can shift the vertical money supply curve left or right. ‹If the RBI buys government bonds: –

‹If –

Bank reserves increase and the money supply increases.

the RBI sells government bonds: Bank reserves decrease and the money supply declines.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Money Market Interest Rate

Money Supply

If the RBI buys government bonds, money supply increases.

QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

The Money Market Interest Rate

Money Supply

If the RBI sells government bonds, money supply decreases.

QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Theory of Liquidity Preference: The Supply and Demand for Money ‹The

Money Demand is determined by several factors. However, the most important is the interest rate. ‹“People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.” (i.e. a desire of liquidity) Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference: The Supply and Demand for Money ‹The

primary opportunity cost of having the convenience of holding money is the interest income that one gives up when one holds cash. ‹An increase in the interest rate raises the cost of holding money and thus reduces the quantity of money balances people wish to hold. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Money Market Interest Rate

Money Demand

I0

Q0 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

The Money Market Interest Rate

Money Demand

I1

I0

Q0 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

The Money Market Interest Rate

Money Demand

I1

I0

Q1 Principles of Macroeconomics: Ch. 20

Q0

Quantity of Money Second Canadian Edition

Equilibrium in the Money Market ‹By

the Theory of Liquidity Preference:

The interest rate adjusts to balance the supply and demand for money. – There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly equals the quantity of money supplied. –

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Equilibrium in the Money Market Interest Rate

Money Supply

Money Demand QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Equilibrium in the Money Market Interest Rate

Money Supply

IE Money Demand QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Equilibrium in the Money Market Interest Rate

Money Supply

Money Supply and Money Demand are equal at the equilibrium interest rate.

IE Money Demand QFixed Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Theory of Liquidity Preference and the Aggregate Demand Curve ‹ The

general price level of all goods and services in the economy influences the money demand and interest rates: – A higher price level raises money demand (i.e. a shift in the money demand curve.) – Higher money demand leads to a higher interest rate. – Higher interest rates reduces the quantity of goods and services demanded (AD).

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Theory of Liquidity Preference and the Aggregate Demand Curve ‹As

interest rates increase, the cost of borrowing and the return to saving is greater. Fewer households and firms borrow money, leading to a decrease in spending. ‹The end result is a negative relationship between the price level and the AD. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in the Money Supply ‹The

RBI has control over shifts in the aggregate demand when it changes monetary policy. Recall: An increase in the money supply (i.e. buying bonds) will... …shift the Money Supply to the right … without a change in the Money Demand the interest rate will fall, thus … inducing people to hold the additional money the RBI has created.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Money Supply Interest Rate

MS0

IE0 Money Demand QFixed0 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Changes in Money Supply Interest Rate

MS0 MS1

IE0 Money Demand QFixed0 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Changes in Money Supply Interest Rate

MS0 MS1

IE0 Money Demand QFixed0 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Changes in Money Supply Interest Rate

MS0 MS1

IE0 IE1 Money Demand QFixed0 QFixed1 Principles of Macroeconomics: Ch. 20

Quantity of Money Second Canadian Edition

Monetary Policy in the Closed Economy ‹A

monetary injection by the RBI causes interest rates to fall, leading to a stimulative effect on residential and firm investment, and increasing output. ‹ The increase in output requires that people hold more money. This raises the demand curve for money and causes a partial reversal in the interest rate. ‹ As a result, the increase in the quantity of goods and services is smaller that it would have otherwise been. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Small Open Economy Considerations ‹A

monetary injection by the RBI causes the Rupee to depreciate, which causes net exports to rise shifting the AD curve to the right. Output increases by more than it would in a closed economy. ‹The RBI must allow the exchange rate to vary freely if its desire is to change the money supply. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Overview The theory of liquidity preference. 4 The supply and demand for money. ‹How fiscal policy affects aggregate demand. ‹The economy in the long-run and short-run. 4

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

How Fiscal Policy Influences Aggregate Demand ‹Fiscal

policy refers to the government’s choices regarding the overall level of government purchases or taxes. ‹Fiscal policy influences saving, investment, and growth in the longrun. In the short-run, fiscal policy affects the aggregate demand. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Government Purchases ‹The

Union government can influence the economy because of the size of the central government in relation to the economy and other economic entities. – of the deliberate use of spending and taxes to manipulate the economy toward achieving a predetermined outcome. –

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Government Purchases ‹The

Union government’s control of the economy is both direct and indirect. Its expenditures have a direct effect on aggregate spending and therefore equilibrium GDP. – Taxes and tax policy indirectly affect the aggregate spending of consumers. –

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Government Purchases ‹There

are two macroeconomic effects from government purchases: The Multiplier Effect – The Crowding-Out Effect –

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Multiplier Effect of Government Purchases ‹ Each

rupee spent by the government can raise the aggregate demand for goods and services by more than a rupee — a multiplier effect. ‹ The total impact of the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Multiplier Effect Price Level

AD1

Quantity of Output Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Multiplier Effect Price Level

An increase in government purchases initially increases AD

AD1

AD2

Quantity of Output Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Multiplier Effect Price Level

The multiplier effect can amplify the shift in AD

AD3 AD1

AD2

Quantity of Output Principles of Macroeconomics: Ch. 20

Second Canadian Edition

The Multiplier Effect of Government Purchases ‹The

formula for the multiplier is:

Multiplier = 1 ÷ (1 - MPC) ™ the

MPC is the Marginal Propensity to Consume.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Taxes ‹When –

the government cuts taxes, it:

Increases households’ take-home pay, which ... … results in households saving some of the additional income, but … households will spend some on consumer goods, thus … shifting the aggregate-demand curve to the right.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Open Economy Considerations ‹

In a small, open economy, an expansionary fiscal policy causes the Rupee to appreciate. Since this causes net exports to fall, there is an additional effect that reduces the demand for Indian produced goods and services.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Changes in Taxes ‹The

size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier effect. ‹The duration of the shift in the aggregate demand is also determined by the RBI’s policy for the exchange rate (fixed or varied).

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Using Policy to Stabilize the Economy ‹ Many

policy-makers believe it necessary to use monetary and fiscal policy to achieve any level of aggregate demand and GDP that they wish. –

–

Active monetary and fiscal intervention is necessary to tame an inherently unstable private sector. The use of policy instruments stabilize aggregate demand and production and employment.

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Using Policy to Stabilize the Economy ‹The

use of government tax and spending policies to stabilize economic ups and downs in the shortrun are called discretionary fiscal policies. ‹Generally, those that accept this approach to short-run economic stabilization follow the Keynesian theory of the economy. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Using Policy to Stabilize the Economy ‹Some

economists argue that the government should avoid using monetary and fiscal policy to try to stabilize the economy. They suggest the economy should be left to deal with the short-run fluctuations on its own. ‹Discretionary Fiscal policy affects the economy with substantial lags. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Automatic Stabilizers ‹Automatic

Stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policy-makers having to take any deliberate action. ‹Automatic stabilizers include: The Tax System – Government Spending – Flexible Exchange Rate –

Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Conclusion ‹ Government

macroeconomic policy should proceed carefully and with an understanding of the consequences of its policies in the short and long-run. ‹ Fiscal policies can have long-run effects on saving, investment, the trade balance and growth. ‹ Monetary policy can ultimately determine the level of prices and affect the inflation rate. Principles of Macroeconomics: Ch. 20

Second Canadian Edition

Business Cycles and Inflation

Business cycle

Why do we study business z Capitalism is subject to booms and cycles? busts: profits to be made z When

goods are unsold and jobs become scarce, many are hurt economically z Downturns can be mild or prolonged z Macroeconomic instability can be modified by good policies

What are the four phases of the business cycle? z Peak:

GDP is at a temporary high z Recession: decline in total output, income, employment and trade lasting at least 6 months z Trough: the low point z Recovery: expansion of GDP moving toward full employment

The business cycle Real GDP Peak

Peak Real GDP Recovery Recession

Trough

0 0 Time

How do we predict a recession? z Leading

economic indicators z Theories of business cycles Demand changes z Supply changes z

z Usually

caused by some disturbance (war, oil price shocks, tight monetary policy, terrorism, natural calamities etc.)

Inflation

Why do we care about inflation? z

z z z z

Many labor agreements are tied to an inflation measure Æ automatic increases in income Many retirees live on fixed income and would be hurt by inflation If income does not increase, real purchasing power declines with inflation Inflation favors those in debt Inflation hurts taxpayers

Rates of inflation over time Percent Change in CPI (1984-1986=100) 20% 15% 10% 5%

-10% -15%

20 01

19 93

19 85

19 77

19 69

19 61

19 53

19 45

19 37

19 29

-5%

19 21

19 13

0%

Who wins & who loses from inflation? Loses z Savers (non interest bearing) z Fixed income (retirees, workers with no or small pay raise)

Wins z Debtors z Home owners z Banks,leasing companies.

Causes of inflation z Demand

pull

Demand outpaces supply z “Too much money chases too few goods” z

z Cost

push

Businesses raise prices z Workers demand higher wages to keep up with inflation z Prices of other inputs rises z

Government Policy and Market Failures

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Introduction „

Economists use the invisible hand framework to determine whether the government should intervene in the market. z

Invisible hand framework – perfectly competitive markets lead individuals to make voluntary choices that are in society’s interest.

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Market Failures „

Market failure – the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes.

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Market Failures When a market failure exists, government intervention into markets to improve the outcome is justified. „ Government failure occurs when government intervention does not improve the situation. „

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Externalities Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. „ Externalities can be either positive or negative. „

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Externalities „

Negative externalities occur when the effects of a decision not taken into account by the decision-maker are detrimental to others.

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Externalities „

Positive externalities occur when the effects of a decision not taken into account by the decision-maker is beneficial to others.

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A Negative Externality Example „

When there is a negative externality, marginal social cost is greater than marginal private cost. A steel plant benefits the owner of the plant and the buyers of steel. z The plant’s neighbors are made worse off by the pollution caused by the plant. z

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A Negative Externality Example „

Marginal social cost includes all the marginal costs borne by society. z

It is the marginal private costs of production plus the cost of the negative externalities associated with that production.

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A Negative Externality Example „

When there are negative externalities, the competitive price is too low and equilibrium quantity too high to maximize social welfare.

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A Negative Externality S1 = Marginal social cost

Cost

S = Marginal private cost Marginal cost from externality

P1 P0

D = Marginal social benefit 0 McGraw-Hill/Irwin

Q1 Q0

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A Positive Externality Example „

Private trades can benefit third parties not involved in the trade. z

A person who is working and taking night classes benefits himself directly, and his coworkers indirectly.

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A Positive Externality Example „

Marginal social benefit equals the marginal private benefit of consuming a good plus the positive externalities resulting from consuming that good.

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A Positive Externality S = Marginal private and social cost

Cost P1

D1 = Marginal social benefit Marginal benefit of an externality

P0

D0 = Marginal private benefit 0 McGraw-Hill/Irwin

Q0 Q1

Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Alternative Methods of Dealing with Externalities „

Externalities can be dealt with via: Direct regulation. z Incentive policies. z Voluntary solutions. z

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Direct Regulation „

Direct regulation –the amount of a good people are allowed to use is directly limited by the government.

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Direct Regulation „

Direct regulation is inefficient, not efficient. Inefficient – achieving a goal in a more costly manner than necessary. z Efficient achieving a goal at the lowest cost in total resources without consideration as to who pays those costs. z

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Incentive Policies Incentive policies are more efficient than direct regulatory policies. „ The two types of incentive policies are either taxes or market incentives. „

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Tax Incentive Policies A tax incentive program uses a tax to create incentives for individuals to structure their activities in a way that is consistent with the desired ends. „ The tax often yields the desired end more efficiently than straight regulation. „

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Tax Incentive Policies „

This solution embodies a measure of fairness about it – the person who conserves the most pays the least tax.

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Tax Incentive Policies A way to handle pollution is through a tax called an effluent fee. „ Effluent fees – charges imposed by government on the level of pollution created. „

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Regulation Through Taxation Marginal social cost

Cost

Marginal private cost P1

Efficient tax

P0

Marginal social benefit 0 McGraw-Hill/Irwin

Q1 Q0

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Market Incentive Policies „

Market incentive program – market participants certify they have reduced total consumption – their own and/or other’s – by a specified amount.

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Market Incentive Policies A market incentive program is similar to the regulatory solution. „ The amount of the good consumed is reduced. „

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Market Incentive Policies A market incentive program differs from a regulatory solution. „ Individuals who reduce consumption by more than the required amount receive marketable certificates that can be sold to others.

„

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Voluntary Reductions Voluntary reductions allow individuals to choose whether to follow what is socially optimal or what is privately optimal. „ Economists are dubious of voluntary solutions. „

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Voluntary Reductions „

A person’s willingness to do things for the good of society generally depends on the belief that others will also be helping.

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Voluntary Reductions „

The socially conscious will often lose their social conscience when they believe a large number of other people are not contributing. z

This is example of a free rider problem – individuals’ unwillingness to share in the cost of a public good.

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The Optimal Policy „

An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.

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The Optimal Policy „

Resources are being wasted if a policy isn’t optimal. z

What is saved by reducing the program is worth more than what is lost from the reducing the program.

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The Optimal Policy Some environmentalists want to totally eliminate pollution. „ Economists want to reduce pollution to the point where marginal costs of reducing pollution equals the marginal benefits. „

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The Optimal Policy „

Optimal level of pollution – the amount of pollution at which the marginal benefit of reducing pollution equals the marginal cost.

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Public Goods „

A public good is nonexclusive and nonrival. Nonexclusive – no one can be excluded from its benefits. z Nonrival – consumption by one does not preclude consumption by others. z

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Public Goods „

There are no pure examples of a public good. z

„

The closest example is national defense.

Technology can change the public nature of goods. z

Roads are an example.

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Public Goods Once a pure public good is supplied to one individual, it is simultaneously supplied to all. „ A private good is only supplied to the individual who bought it. „

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Public Goods With public goods, the focus is on groups. „ With private goods, the focus is on the individual. „

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Public Goods „

In the case of a public good, the social benefit of a public good is the sum of the individual benefits.

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Public Goods Adding demand curves vertically is easy to do in textbooks, but not in practice. „ This is because individuals do not buy public goods directly so that their demand is not revealed in their actions. „

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The Market Value of a Public Good Price 1.00 .80

0.50

.60 .40

0.10 0.60

1 McGraw-Hill/Irwin

0.40

0.50

.20

Market demand DB

2

DA 0.10 3 Quantity

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Informational Problems Perfectly competitive markets assume perfect information. „ Real-world markets often involve deception, cheating, and inaccurate information. „

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Informational Problems „

When there is a lack of information, buyers and sellers do not have equal information, markets may not work properly.

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Informational Problems Economists call such market failures adverse selection problems. „ Adverse selection problems – problems that occur when a buyer or a seller have different amounts of information about the good for sale. „

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Policies to Deal with Informational Problems Regulate the market and see that individuals provide the correct information. „ Government licenses individuals in the market and requires them to provide full information about the good being sold. „

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A Market in Information Information is valuable, and is an economic product in its own right. „ Left on their own, markets will develop to provide information that people need and are willing to pay for it. „

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A Market in Information „

If the government regulates information, then markets for information will not develop.

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Licensing of Doctors Currently all doctors practicing medicine are required to be licensed. „ Licensing of doctors is justified by informational problems. „

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Licensing of Doctors „

Some economists argue that licensure laws were established to restrict supply, not to help the consumer. z

Instead of licensing doctors, the government could give the public information about which treatments work and which do not.

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Licensing of Doctors „

Providing information rather than licensing would give rise to consumer sovereignty. z

Consumer sovereignty – the right of the individual to make choices about what is consumed and produced.

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An Informational Alternative to Licensure „

In this scenario, the government would require doctors to post their: Grades in college. z Grades in medical school. z Success rate for various procedures. z References. z Medical philosophy. z Charges and fees. z

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An Informational Alternative to Licensure „

This information alternative would provide much more useful information to the public than the present licensing procedure.

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Government Failures and Market Failures Market failures should not automatically call for government intervention. „ Why? Because governments fail too. „

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Government Failures and Market Failures „

Government failure occurs when the government intervention in the market to improve the market failure actually makes the situation worse.

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Reasons for Government Failures Governments do not have an incentive to correct the problem. „ Governments do not have the information to deal with the problem. „ Intervention in the markets is almost always more complicated than it initially looks. „

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Reasons for Government Failures The bureaucratic nature of government intervention does not allow fine tuning. „ Government intervention leads to more government intervention. „

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