Anda di halaman 1dari 572

MANAGERIAL ECONOMICS

PROF. B. S. PATIL
ECONOMICS

z A social science, not a natural science…


z “…the study of how a given society allocates scarce
resources to meet the unlimited wants and needs of
its members”
z “…concerned with the efficient use of scarce
resources to achieve the maximum satisfaction of
wants”
z “…seeks to understand how individuals interact with
the social structure… to address production and
exchange of goods and services”
Why study it?

z Study of economics deals with production, allocation


and distribution of resources
z Economics is a great field and entry to lots of
interesting and important jobs
z Allows us to think abstractly and ask… “what if…”
z Useful for policy-making in business, government or
non-profit pursuits
What I hope you get out of this
course

z Develop basic understanding of decision-making


from an economic perspective
z Understand economic interactions, economic
organizations & functions of the Indian economy
z Enhance your critical thinking, communication and
problem solving skills
What this course is about

z An analysis of firms and markets


z An analysis of things that influence economic
behavior and decision-making
z Individual (micro) and aggregate (macro)
effects
z How is economic information used?
z How do societies use and allocate scarce
resources?
z 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 BUSINESS MANAGEMENT


-MICRO - 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

Factor Pricing Theory of Welfare


Product Pricing
(Theory of Distribution) Economics

Theory
Theory
Of Wages Rent Interest Profits
Of
Production
Demand
&
Costs
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 sub-
aggregates dealt within macro economics.
SCOPE OF MANAGERIAL ECONOMICS
The contents of the macro economic theory
MACRO ECONOMIC THEORY

Theory of General
Theory of Income The Theory of
Price level &
and Employment Economic Growth
Inflation
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 entrepreneur as a risk taker
• The entrepreneur as an innovator
• The entrepreneur as a monopolist
• The entrepreneur as 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

Micro232 2004 - jafgac


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.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


The Law of Demand
„ What accounts for the law of demand?
z People tend to substitute for goods whose
price has gone up.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


A Sample Demand Curve
Price (per unit)

PA A

D
0
QA
Quantity demanded (per unit of time)

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Change in Quantity Demanded

2 B
Price (per unit)

Change (Contraction) in
quantity demanded
(a movement along the curve)
A
1

D1
0
100 200
Quantity demanded (per unit of time)

Micro232 2004 JAFGAC


Shift in Demand

Change (decrease) in
demand
2
Price (per unit)

(a shift of the curve)

B A
1

D0

D1
100 200 250
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:
z Income. (individual and society)
z The prices of other goods.
z Tastes and preferences.
z Expectations.
z Taxes and subsidies to consumers.

Micro232 2004 JAFGAC


Income
„ An increase in income will increase
demand for normal goods.

„ An increase in income will decrease


demand for inferior goods.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Tastes and preferences
„ A change in taste will change demand with
no change in price causing shift in demand
curve.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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

„ Subsidies have an opposite effect.

Micro232 2004 JAFGAC


The Demand Table
„ The demand table assumes all the
following:
z 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.

Micro232 2004 JAFGAC


The Demand Table
„ The demand table assumes all the
following:
z The schedule assumes that everything else is
held constant.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


From a Demand Table to a
Demand Curve
„ The demand curve graphically conveys the
same information that is on the demand
table.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


From a Demand Table to a
Demand Curve
A Demand Table (Rs) A Demand Curve
6.00
Price per DVD rentals 5.00

Price per DVDs (in dollars)


cassette demanded per
(Rs)
week 4.00 E
3.50 G
A 0.50 9 3.00 D
B 1.00 8 Demand for
2.00 C
C 2.00 6 DVDs
D 3.00 4 1.00
F B
A
E 4.00 2 .50
0
1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of DVDs demanded (per week)

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Individual and Market
Demand Curves
„ Sellers estimate total market demand for
their product which becomes smooth and
downward sloping curve.

Micro232 2004 JAFGAC


From Individual Demands
to a Market Demand Curve
(1) (2) (3) (2) (3)
4.00
Price per Alice’s Bruce’s Cathy’s Market G
cassette demand demand demand demand 3.50
3.00 F
A Rs.0.50 9 6 1 16 E

Price per cassette (Rs)


B 1.00 8 5 1 14 2.50
D
C 1.50 7 4 0 11 2.00
D 2.00 6 3 0 9 C
1.50
E 2.50 5 2 0 7 B
F 3.00 4 1 0 5 1.00
A
G 3.50 3 0 0 3 0.50
H 4.00 2 0 0 2 Cathy Bruce Alice Market demand
0
2 4 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:
z At lower prices, existing demanders buy more.
z At lower prices, new demanders enter the
market.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


Supply
„ The analysis of the supply of produced
goods has two parts:
z 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.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


A Sample Supply Curve
Price (per unit)

A
PA

0
QA
Quantity supplied (per unit of time)

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Shifts in Supply Versus
Movements Along a Supply
Curve
„ Quantity supplied refers to a specific
quantity that will be supplied at a specific
price.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Shift in Supply
S0
S1
Price (per unit)

A B
15 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
S0

B
Price (per unit)

A to B
Change (expansion) in
A quantity supplied
15
(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:
z Prices of inputs used in the production of a
good.
z Technology.
z Suppliers’ expectations.
z Taxes and subsidies.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


From a Supply Table to a
Supply Curve
„ Competing suppliers’ entry into the market
places a limit on the price any supplier can
charge.

Micro232 2004 JAFGAC


Individual and Market Supply
Curves
„ The market supply curve is derived by
horizontally adding the individual supply
curves of each supplier.

Micro232 2004 JAFGAC


From Individual Supplies to a
Market Supply (Price in Rs)
(1) (2) (3) (4) (5)
Quantities Price Ann's Barry's Charlie's Market
Supplied (per DVD) Supply Supply Supply Supply
A 0.00 0 0 0 0
B 0.50 1 0 0 1
C 1.00 2 1 0 3
D 1.50 3 2 0 5
E 2.00 4 3 0 7
F 2.50 5 4 0 9
G 3.00 6 5 0 11
H 3.50 7 5 2 14
I 4.00 8 5 2 15

Micro232 2004 JAFGAC


From Individual Supplies to a
Market Supply
Charlie Barry Ann Market Supply
4.00 I
3.50 H
3.00
Price per DVD

G
2.50 F
2.00 E
1.50 D
1.00 C
0.50 B CA
0 A
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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

„ Equilibrium quantity – the amount


bought and sold at the equilibrium price.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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

„ Prices tend to fall.

Micro232 2004 JAFGAC


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

„ Prices tend to rise.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


The Graphical Interaction of
Supply and Demand
Price (per Quantity Quantity Surplus (+)
DVD) (Rs) Supplied Demanded Shortage (-)
1.50 7 3 +4
2.50 5 5 0
3.50 3 7 -4
Micro232 2004 JAFGAC
The Graphical Interaction of
Supply and Demand
5.00
S
4.00 Excess supply
Price per DVD

3.50 A
3.00
2.50 E

2.00 C
1.50
Excess demand
1.00 D
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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


Micro232 2004 JAFGAC
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.

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Increase in Demand
S0
S1
Price (per DVDs)

B
2.50 Excess demand
A
2.25 B1

D0 D1

0 8 9 10
Quantity of DVDs (per week)

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


Decrease in Supply
S1
Price (per DVDs)

S0
C
2.50 Excess demand
B
2.25 A

D0

0 8 9 10
Quantity of DVDs (per week)

Micro232 2004 JAFGAC


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

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


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.

Micro232 2004 JAFGAC


The Fallacy of Composition
„ The fallacy of composition is of central
relevance to macroeconomics.
z In macroeconomics, the other-things-
constant assumption, central to
microeconomic supply/demand analysis,
cannot hold.

Micro232 2004 JAFGAC


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
% change in quantity demanded
ep

% change in price
%∆Q
or, ep ≡
At a point on a demand function this can be
calculated by:
%∆P
Q
Q22 -
-QQ11 = ∆ Q ∆Q
Q1 Q1
ep = =
P2 P-2 P
-1 P=1 ∆ P ∆P
P1 P1

Fall '97 Economics 205Principles of Microeconomics Slide 6


+2
∆ Q
[2/3 = .66667]
31
ep = Q
-2P
∆ =
% ∆Q = 67%
= -2.3 [rounded]
% ∆P = -28.5%
P71 [-2/7=-.28571] The “own” price elasticity of demand
at a price of Rs.7 is -2.3
Price decreases from Rs.7 to Rs.5
This is “point” price elasticity. It is calculated at a point
Px on a demand function. It is not influenced by the direction
Rs or magnitude of the price change.
A
P1 = 7 P2- P1 = 5 - 7 = ∆ P = -2
∆ P = -2
B Q2 - Q1 = 5 - 3 = ∆ Q = +2
P2 = 5 There is a problem! If the
price changes from Rs.5 to
D Rs.7 the coefficient of
∆ Q = +2 elasticity is different!

Q1 = 3 Q2 = 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 7
.
∆-2
Q [-2/5 = -.4]
% ∆Q = -40%
ep = 5Q1 =
% ∆P = 40%
= -1 [this is called “unitary elasticity]
∆+2P
P51 [+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 = -2.3

The point price elasticity is Px


different at every point! ep = -2.3
A
P2 = 7 ep = -1
∆ P = +2 B
There is an P1 = 5
easier way!
D
∆ Q = -2
Q 2= 3 Q1= 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 8
An easier way! By rearranging terms
∆Q this is a point on
∆Q P1 ∆Q P1 the demand
ep = Q1
∆Q
P1
=
Q1 * ∆ P
=
∆P
* function
Q1
P1 this is the
slope of the
Given that when: demand function
P1 = 7, Q1 = 3
∆Q P71
P2 = 5, Q 2= 5 ep = -1
∆P
* Q
31
= -2.33
P2- P1 = 5 - 7 = ∆ P = -2
P1 = 7, Q1 = 3
Q2 - Q1 = 5 - 3 = ∆ Q = +2
On linear demand functions the
Then, slope remains constant so you
∆Q +2 just put in P and Q
= = -1
∆P -2
This is the slope of the demand Q = f(P)
Fall '97 Economics 205Principles of Microeconomics Slide 9
The following information was Px Q = f (P)
given
P1 = 7, Q1 = 3 A
7
P2 = 5, Q 2= 5 What is the Q
B intercept?
5
Q2 - Q1 = 5 - 3 = ∆ Q = +2
P2- P1 = 5 - 7 = ∆ P = -2 Px must decrease
The slope of the demand function
by 5. D
Q increases by 5
[Q = f(P)] is ∆Q +2
∆P
=
-2
= -1 3 5 Q
The slope [-1] indicates that for every
/
Q=x 10ut
1 unit increase in Q, Px will decrease by 1.
Since Px must decrease by 5, Q must
The equation for the demand increase by 5
function we have been using is Q = 10 when Px = 0
Q = 10 - 1P. A table can be The slope-intercept form
constructed. Q = a10+ -m1 P

Fall '97 Economics 205Principles of Microeconomics Slide 10


using our formula,
The slope is -1 The intercept is 10
∆Q P1
ep =
∆ P * Q1
For a simple demand function: Q = 10 - 1P
Price quantity ep Total
(Rs) Revenue the slope is -1, price is 7
0 ∆Q P71
ep = (-1) * Q1 = -2.3
0 10

1 9 -.11 ∆P 3
2 8 -.25 at a price of 7, Q = 3
3 7 -.43
4 6 -.67 Calculate ep at P = 9
-1. Q=1
ep = (-1) 9
5 5
= -9
6 4 -1.5 1
7 3 -2.3 Calculate ep for all other
8 2 -4. price and quantity
9 1 -9 combinations.
10 0 undefined
Fall '97 Economics 205Principles of Microeconomics Slide 11
Notice that at higher prices
the absolute value of the price
For a simple demand function: Q = 10 - 1P elasticity of demand, ⏐ep⏐, is
greater.
price quantity ep Total
Revenue
Total revenue is price times
$0 10 0 0 quantity; TR = PQ.
$1 9 -.11 9 Where the total revenue [TR]
16 is a maximum, ⏐ep ⏐ is equal
$2 8 -.25
to 1
$3 7 -.43 21
In the range where ⏐ep ⏐< 1, [less
$4 6 -.67 24
than 1 or “inelastic”], TR increases as
$5 5 -1. 25 price increases, TR decreases as P
$6 4 -1.5 24 decreases.
$7 3 -2.3 21 In the range where ⏐ep ⏐> 1,
$8 2 -4. 16 [greater than 1 or “elastic”], TR
$9 1 -9 9 decreases as price increases, TR
$10 0 undefined 0 increases as P decreases.

Fall '97 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
P1 + P2 = elasticity is: ∆Q P1 + P2
12 ep = * Q1 + Q2
∆P
P1 = $7, Q1 = 3
Q1 + Q2
Px The average or arc ep between
P2 = $5, Q2= 5 $5 and $7 is calculated,
= 8
A
Q2 - Q1 = 5 - 3 = ∆ Q = +2 $7
Slope of demand
P2- P1 = 5 - 7 = ∆ P = -2 ∆Q
B = - 1
$5 ∆P

∆Q P1 12
+ P2 D
ep = -1
* = - 1.5
∆P Q1 8+ Q2
The average ep between $5 and $7 is -1.5 3 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 13
Calculate the point ep at each
Given: Q = 120 - 4 P
price on the table.
Price Quantity e p TR
Calculate the TR at each price
on the table.
$ 10
Calculate arc ep at between
$ 20 $10 and $20.
$ 25 Calculate arc ep at between
$ 28 $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


Calculate the point ep at each
Given: Q = 120 - 4 P
price on the table.
Price Quantity ep TR
Calculate the TR at each price
on the table. TR = PQ
$ 10 80 -.5 $800
Calculate arc ep at between
$ 20 40 -2 $800
$10 and $20. ep = -1
$ 25 20 -5 $500
Calculate arc ep at between
$ 28 8 -14 $224 $25 and $28. ep = -7.6
Calculate arc ep at between $20 and $28. ep = -4
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, Price TR is a maximum
where ep is -1 or TR’s
slope = 0
When ep is -1 TR is a maximum. The top “half” of the demand
When | ep | > 1 [elastic], TR and P function is elastic.
TR
move in opposite directions. (P has | ep | > 1 [elastic]
a negative slope, TR a positive slope.) 30

When | ep | < 1 [inelastic], TR and P ep = -1


move in the same direction. (P and TR 15 | ep | < 1
both have a negative slope.) inelastic
Arc or average ep is the average
elasticity between two point [or prices]
60 120 Q/ut
point ep is the elasticity at a point or price.
The bottom “half” of the demand
Price elasticity of demand describes function is inelastic.
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, Addison-
Wesley, 1997, p 101] report that:
· short run |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)


· 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.
%∆Q
What effect does a
Since ep = -.5 ep ≡
10% increase in the Pmilk %∆P
have on the quantity that
individuals are willing to buy?
To solve for % ∆ Q
%∆Q
Multiply both sides by +10% -5%(-.5
(+10%)x = p≡ e
) =% ∆ Q x (+10%)
A 10% increase in the price of milk would % +10%
∆P
reduce the quantity demanded by about Pmilk
5%.
P2
If price were decreased by 5%, what +10%
P1
would be the effect on quantity Dmilk
demanded? A 10% increase -5%
in P reduces Q
Fall '97
by 5%
Economics 205Principles of Microeconomics Q2 Q1 Q
Slide 19 milk
%∆Q
ep ≡ The price elasticity of demand is a measure of
%∆P 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 ?
%∆Q
-2.5 = = +12.5% change in quantity demanded
% ∆P
- 5%

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

%∆Q
-.8 = = -4.8% decrease in quantity demanded
%+6%
∆P

Fall '97 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 , When |ep| < 1, demand is “inelastic. “ This means that
the ⎢% ∆ Q⎢ < ⎢% ∆ P⎢. Since the % price
ep ≡
%∆Q
decrease is greater than the % increase in Q,
%∆P TR [TR = PQ] will decrease.
When |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


TR
Graphically this can be shown Price and
TR is a maximum
TR move in
TR = PQ, so the maximum TR is the opposite
rectangle 0Q1 EP1 directions

As price rises into the elastic range


the TR will decrease. Notice that
in this range the slope of demand TR
is negative, the slope of TR is P
elastic
positive
P2 at the midpoint, ep = -1
price rises +TR
E
(P2 Q2) is less
P1
than
Loss in
(P
TR1 Q 1)
when
∆P D
0 Q2 Q1 Q/ut

Fall '97 Economics 205Principles of Microeconomics Slide 22


TR
When price elasticity of demand is TR is a maximum
inelastic

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. TR
Price and TR “move in the same P
direction.”

A price decrease will reduce at the midpoint, ep = -1


TR; a price increase will E
P1 inelastic
increase TR. Note that
TR = P1 Q1
this information is useful P0 [Maximum]
but does not provide
results in a smaller PQ D
[TR]
information about profits! 0 Q0
Q1 Q/ut

Fall '97 Economics 205Principles of Microeconomics 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
· 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

Fall '97 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


P D2
D1 is a “perfectly elastic” perfectly
demand function. inelastic
For an infinitesimally small ep = 0
change in price, Q changes
by infinity. Buyers are very perfectly elastic
responsive to price changes. An
infinitely small change in price
|ep| = undefined D1
As the dem
changes Q by infinity. and functio
horizontal,
to price ch
[buyers are
n becomes
mo r
more
e responsiv
De
anges],|ep| e
approaches
infinity.
∆0Q
%∞
ep ≡ ==undefined
0∞
%∆P
P 0 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 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]

Income elasticity is a measure of the change in


demand [a “shift” of the demand function] that is
% ∆ Qx “caused” by a change in income.
ey ≡ The increase in income, ∆Y, increases demand
% ∆Y to D2. The increase in demand results in a
[Where Y = income] larger quantity being purchased at the
same Price [P1]..
At a price of P1 , the quantity demanded
given the demand D is Q1 . D is the P Due to increase
demand function when the income is Y1 . in income,
For a “normal good” an increase demand
increases
in income to Y2 will “shift” the
demand to the right. This is an P1 D2
increase in demand to D2.
% ∆ Y > 0; % ∆ Q> 0; therefore,
D
ey >0 [it is positive]
Q1 Q2 Q/ut

. Fall '97 Economics 205Principles of Microeconomics Slide 29


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

A decrease in income is associated with a decrease in


% ∆ Qx
ey ≡ the demand for a normal good.
%∆Y
For a decrease in income [-∆ Y],
At income Y1, the demand D1 represents the demand decreases; i.e. shifts
the relationship between P and Q. At to the left, at the price [P1 ], a
a price [P1] the quantity [Q1] is smaller Q2 will be purchased.
demanded.
P
A decrease in income,
% ∆Y < 0 [negative]; % ∆Q < 0 [negative]; decreases
so, ep > 0 [ positive] demand
P1
For either an increase or decrease in income
the ep is positive. A positive relationship D1
[positive correlation] between ∆ Y and ∆ Q D2
is evidence of a normal good.
Q2 Q1 Q/ut
Fall '97 Economics 205Principles of Microeconomics 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
and decreases in

The greater the value of y, e +-


income, ey is positive

eeyyy ≡ %%∆%
∆Q∆xxQx
Q
the more responsive buyers +
are to a change in their incomes. %∆Y
+- %%∆ Y∆ Y
When the value of ey is greater than 1, it is called a “superior good.”
The |% ∆ Qx| is greater than the |% ∆ Y|.
% ∆ Qx
Buyers are very responsive to changes in
income. Sometimes “superior goods” are
ey ≡
%∆Y
called “luxury goods.”

. Fall '97
. Economics 205Principles of Microeconomics 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.
-%%∆Q
∆Q x

eyy ≡=
x
An increase in income reduces -e %+∆Y
∆Y
the amount that individuals P
are willing to buy at each price
of the good. Income elasticity
decreases
is negative: - ey demand
P1
The greater the absolute value
of - ey, the more responsive buyers D1
- %∆Q x
D2
are to changes in income

Q2 Q1 Q/ut
.
. Fall '97 Economics 205Principles of Microeconomics Slide 32
Income Elasticity
[inferior goods]

Decreases in income increase the demand for inferior goods.

A decrease in income [-∆Y] increases demand.


+%∆Q
% ∆ Q
A decrease in income [-∆ Y]
results in an increase in demand, P - eey y ≡ xx

%∆Y
the income elasticity of demand -∆Y
is negative

For both increases and decreases in


P1 D2
income the income elasticity is negative
for inferior goods. The greater the D1
absolute value of ey, the more responsive
+%∆Q x

buyers are to changes in income


Q1 Q2 Q/ut
. . Fall '97 Economics 205Principles of Microeconomics 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.
· 0< ey < 1 is a normal good
· 1 < ey is a superior good

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


Fall '97 Economics 205Principles of Microeconomics Slide 34
Examples of ey
· normal goods, [0 < 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:
% ∆ Q
e ≡ x
xy
% ∆ P y

Fall '97 Economics 205Principles of Microeconomics Slide 36


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

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.

When beef is $2, Qb beef


[price of pork]

When pork is $1.50, Qp pork

[price of beef]
is purchased. Pb is purchased.
Pp price of pork increases at Pb = $2 more
increase beef will be bought
The quantity demanded
demand to substitute for
2 of pork decreases.
2 the smaller
for an increase quantity of
1.50
in Ppork, pork.
Dp
demand for
beef increases
Db Db ’
-∆Qp

Q p’ Q p pork/ut Qb Qb’ beef/ut

Fall '97 Economics 205Principles of Microeconomics 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, ebeef-pork or ebp can be calculated:
+Q
%∆ ∆Q
ofb beef An increase in the price of pork,
+ebp
ebp = “causes” an increase in the demand
positive %∆P+of
∆Ppork
p for beef.
cross elasticity is positive

%∆ -Q ∆of
Qbeef
b A decrease in the price of pork,
+eebpbp = “causes” a decrease in the demand
positive %∆P of pork
- ∆Pp 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]
as more crayons are
purchased, the
demand for colour
Pc a decrease in the price
Pc books increases.
increase
of crayons, demand At the same
P1 price a larger
$3 quantity will
-∆Pc Dp be bought
Po
Dc Dc’
Q1 Q2 crayons 2000 2500 colour books
increases the quantity demanded + ∆Qb
of crayons
∆Q for compliments, the cross
- ebc %∆+ Q ofbb
ebc =
negative
elasticity is negative for price
increase or decrease.
-
%∆P of c
∆Pc

Fall '97 Economics 205Principles of Microeconomics Slide 40


Cross-Price Elasticity
· exy > 0 suggests substitutes, the
[positive],
higher the coefficient the better the
substitute
· exy < 0 [negative],
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:
% ∆ Quantity Supplied
e =
s
% ∆ price
Fall '97 Economics 205Principles of Microeconomics Slide 42
Elasticity of supply
%∆Qsupplied
es =
%∆P
Given a supply function, at a price [P1], Q1 is produced and offered
for sale.
P At a higher price [P2], a larger
pl y quantity, Q2, will be produced
up
s and offered for sale.

P2 The increase in price [ ∆P ], induces


+∆P a larger quantity goods [ ∆Q]for
P1 sale.
The more responsive sellers are to

+∆Q ∆P, the greater the absolute value of es.


[The supply function is “flatter”or
Q1 Q2 Q /ut more elastic]

Fall '97 Economics 205Principles of Microeconomics Slide 43


The supply function is a P
Si a perfectly inelastic
model of sellers behavior.
supply, es = 0
ho rizo nta l es
s
proache
Sellers behavior is influenced by: as su p p ly a p
1. technology p r o a ch es infinity
a p Se
2. prices of inputs
a perfectly
3. time for adjustment elastic supply
market period
short run
[es is undefined.]
long run
very long run
Q /ut
4. expectations
5. anything that influences costs of production
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 Production
Planning Planning

Marketplace 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. Determine periodicity (even or odd?)
2. Deseasonalize data
3. Find the equation of the trend line
a. Simple linear regression
b. Independent variable (period)
c. Dependent variable (deseasonalized data)
4. Estimate seasonalized factors
a. Per period
b. Index (Averages)
5. 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 Total product Marginal product


(workers per day) (output per day) (output per day)
0 0
1 1,000 1,000
2 2,200 1,200
3 3,500 1,300
4 4,700 1,200
5 5,800 1,100

NOTE: ON THIS TABLE WE HAVE INFORMATION ON INPUTS


AND OUTPUT ONLY—NOT COST OF PRODUCTION
product Total product curve Marginal product curve

Marginal
product
Total

Increasing Diminishing
TP marginal returns marginal returns
5800

4700
1300

3500 1200 MP
1100

1000
2200

1000

0 1 2 3 4 5 0 1 2 3 4 5
Labor input Labor input
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 total product curve Increase in marginal product curve

Marginal product
Total product

TP1

TP0

MP1

MP0

Labor input Labor input


Now, let’s talk about
costs of production
„Totalcost
„Average total cost
„Marginal cost
COST-OUTPUT RELATIONSHIP

Units of AFC AVC ATC


TFC TVC TC
Output (2/1) (3/1) (4/1 or 5+6)
1 2 3 4 5 6 7
0 50 0 50 0 0.0 0
1 50 20 70 50.0 20.0 70
2 50 35 85 25.0 17.5 42.5
3 50 60 110 16.7 20.0 36.7
4 50 100 150 12.5 25.0 37.5
5 50 145 195 10.0 29.0 39.0
6 50 190 240 8.3 31.7 40.0
7 50 237 287 7.1 33.9 41.0
8 50 284 334 6.3 35.5 41.8
www.stmartin.edu
Total variable cost and total Average variable cost plus
fixed cost gives us total cost average fixed cost gives us the
average total cost

Average
total cost

Costs
Total cost

Total
Cost

Total
Average
variable
variable
cost
cost

Total Marginal
50
fixed cost cost

Output per day 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 • Marginal cost is the


cost is the total change in total
cost per unit of cost when one
output 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 Cons
Mass production and Can’t meet specialized
standardization can tastes of consumers
meet large demand (e.g. microbrews)
(e.g. Ford)
Economies of scale
Capture gains quickly
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
z Technical
z Commercial

z Financial

z Managerial

z Risk Bearing
Economies of Scale

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
z Supply of skilled labour
z Reputation
z Local knowledge and skills
z Infrastructure
z 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
z 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
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 Useof 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 E<D

AC E=D

X
O Large Scale Production
Diseconomies of Scale

z The disadvantages of large scale


production that can lead to increasing
average costs
z Problems of management
z Maintaining effective communication
z Co-ordinating activities – often across
the globe!
z De-motivation and alienation of staff
z 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
60,000 Total Cost
Line
50,000
40,000
30,000
20,000
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Quantity
Graphical analysis:
Cont.
Dollars
70,000
60,000
Profit zone
Total Cost
Line B
50,000
40,000
30,000
20,000 Loss zone
Total Revenue
10,000 Line Break-even point
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:
v = $3,000
$10 - $5
= 600 units
Machine B:
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 = Machine B
FC + VC = FC + VC
$3,000 + $5 Q = $8,000 + $2Q
$3Q = $5,000
Q = 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
3,000 Point of indifference
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 = OI
$30Q - $10Q – $100,00 = $ 0.00
$20Q = $100,000
Q = 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 = Machine B
FC + VC = FC + VC
$5,000 + $5 Q = $15,000 + $1Q
$4Q = $10,000
Q = 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
• Describe how a perfectly competitive firm
1415
1314
maximizes profits or minimizes losses.
1213
1112
• Explain how a perfectly competitive firm achieves
1011
910
economic efficiency in the long run.
89
78
• Identify factors that contribute to monopoly.
67
56
• Develop a model that illustrates profit
45
34
maximization and loss minimzation for a monopoly.
23
12
• Assess the advantages and disadvantages of a
01
perfectly
00
0 competitive firm and a2,800,000
monopoly.
1,400,000
1,400,000 2,800,000
Quantity of fish (lbs.)
Quantity of fish (lbs.)
Continuum of market structures

#producers or sellers

1 2 5 30+
Many

Duopoly Perfect
Monopoly Competition

Oligopoly Monopolistic
competition
Chapter 5 deals with the extremes

#producers or sellers

1 Many

Perfect
Monopoly Competition
Market equilibrium facing a competitive firm

Price 15
14
13
12 Market supply
11
10
9
8
7
6
5
4
3
2 Market demand
1
0
0 1,400,000 Quantity
2,800,000
Quantity of fish (lbs.)
Some characteristics of market structures

Perfect Competition Monopoly


• No barriers to entry • High barriers to entry
• Many sellers • One seller
• Many buyers • Many buyers
• Standardized product • Brand loyalty
• Perfect information • Control of production
about the market and distribution
(buying, producing, processes
selling)
Demand and revenue for a competitive firm

$ Demand and Marginal Revenue Total revenue


15 for one company $ 70
14
63
13
12 56 Total
11 revenue
49
10 Demand = P = MR
9 42
8
35
7
6 28
5
21
4 7
3 14
1
2
7
1
0 0
0 2 4 6 8 10 12 0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of fish (lbs.) 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 Loss minimization


Rs
9.00 Rs 8.00
MC Total loss
8.00 7.00 = Rs.2,128 MC
A Demand
7.00
ATC
= P = MR 6.00
6.00 ATC 5.33 AVC
5.00
5.00
Total profit 4.00 Demand
4.00 = Rs.2,500 = P = MR
3.00
3.00
2.00
2.00
1.00
1.00

0.00 0.00
0 500 1000 1500 2000 2500 3000 3500 0 700 1600 3000
Quantity of fish (lbs.) Quantity of fish (lbs.)
Long-run adjustments for a competitive firm: effects of
market entry

Market Individual firm

Price and cost


Price

S0
7 7

S1
Demand0 = Price0
6 6

LRATC
A
5 5
Demand1 = Price1

D0
4 4
0 0 500
Quantity of fish (lbs.) Quantity of fish (lbs.)
Perfect Competition

Long-run adjustments for a competitive firm: effects of market exit

Market Individual firm

Price and cost


Price

S1
6 6

LRATC
S2
A
5 5
Demand1 = Price1

4 4
Demand2 = Price2

D0
3 3
0 0 500
Quantity of fish (lbs.) Quantity of fish (lbs.)
Monopoly
Monopoly

While a competitive firm is a


price taker, a monopoly firm is
a price maker.

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

‹A firm is considered a monopoly if . . .


…it is the sole seller of its product.
…its product does not have close
substitutes.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Why Monopolies Arise

The fundamental cause of


monopoly is barriers to entry.

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Economies of Scale as a Cause of
Monopoly...
Cost

Average
total
cost

0 Quantity of Output
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopoly versus Competition

Monopoly Competitive Firm


‹ Is the sole producer ‹Is one of many
‹ Has a downward- producers
sloping demand curve ‹Has a horizontal
‹ Is a price maker demand curve
‹ Reduces price to ‹Is a price taker
increase sales ‹Sells as much or as
little at same price

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Demand Curves for Competitive and
Monopoly Firms...

(a) A Competitive Firm’s (b) A Monopolist’s


Demand Curve Demand Curve
Price Price

Demand

Demand

0 Quantity of 0 Quantity of
Output Output

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Monopoly’s Total, Average, and
Marginal Revenue
(Rs)
Average
Quantity Price Total Revenue Revenue Marginal Revenue
(Q) (P) (TR=P x Q) (AR=TR/Q) (MR= ∆TR / ∆Q )
0 11.00 0.00
1 10.00 10.00 10.00 10.00
2 9.00 18.00 9.00 8.00
3 8.00 24.00 8.00 6.00
4 7.00 28.00 7.00 4.00
5 6.00 30.00 6.00 2.00
6 5.00 30.00 5.00 0.00
7 4.00 28.00 4.00 -2.00
8 3.00 24.00 3.00 -4.00

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

Demand and Marginal Revenue Curves


for a Monopoly...
Price
$11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average revenue)
1 revenue
0
-1 1 2 3 4 5 6 7 8 Quantity of Water
-2
-3
-4
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Profit-Maximization for a Monopoly...


2. ...and then the demand
Costs and curve shows the price 1. The intersection of
Revenue consistent with this the marginal-revenue
quantity. curve and the marginal-
cost curve determines
B the profit-maximizing
Monopoly quantity...
price

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

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

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

The Monopolist’s Profit...


Costs and
Revenue
Marginal cost

Monopoly E B
price
M pro

Average total cost


on f
op it
ol
y

Average
total cost D 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.

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

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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic
Competition
The Four Types of Market Structure
Number of Firms?

Many
firms
One Type of Products?
firm Few
firms Differentiated Identical
products products

Monopoly Oligopoly Monopolistic Perfect


Competition Competition

• Tap water • Tennis balls • Novels • Wheat


• Cable TV • Crude oil • Movies • Milk

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

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

Markets that have some


features of competition and
some features of monopoly.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Attributes of Monopolistic
Competition

‹ Large number of firms


‹ Product differentiation
‹ Free entry and exit
‹ Downward-sloping demand curve

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

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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic Competitors in
the Short Run...
(a) Firm Makes a Profit
Price
MC
ATC

Price
Average
total cost
Profit Demand
MR

0 Profit-
Quantity
maximizing quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic Competitors in
the Short Run...
(b) Firm Makes Losses
ATC
MC
Price
Losses

Average
total cost
Price

Demand
MR

0 Loss- Quantity
minimizing
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
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.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Monopolistic Competitor
in the Long Run...
Price
MC
ATC

P=ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Two Characteristics of Long-
Run Equilibrium

œAs in a monopoly, price exceeds marginal


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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Two Characteristics of Long-
Run Equilibrium

As in a competitive market, price equals


average total cost.
‹ Free entry and exit drive economic profit
to zero.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic versus Perfect
Competition
There are two noteworthy
differences between monopolistic
and perfect competition—excess
capacity and markup.

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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Excess Capacity...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
ATC ATC

P
P = MC P = MR
Excess capacity (demand
curve)
Demand

Quantity Quantity
Quantity Efficient Quantity= Efficient
produced scale produced scale

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Markup Over Marginal Cost

‹ For a competitive firm, price


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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Markup Over Marginal Cost...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
Markup MC MC
ATC ATC

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

Quantity Quantity
Quantity Quantity
produced produced

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic versus Perfect
Competition...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
Markup ATC ATC

P
P = MC P = MR
Marginal (demand
cost curve)

MR Demand

Quantity Efficient Quantity Quantity produced = Quantity


produced scale Efficient scale
Excess capacity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic Competition and
the Welfare of Society

Monopolistic competition does not


have all the desirable properties of
perfect competition.

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

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

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

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

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

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

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

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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Summary
‹ Defenders argue that firms use
advertising and brand names to inform
consumers and to compete more
vigorously on price and product quality.

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic Competitors in
the Short Run...
(a) Firm Makes a Profit
Price
MC
ATC

Price
Average
total cost
Profit Demand
MR

0 Profit-
Quantity
maximizing quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic Competitors in
the Short Run...
(b) Firm Makes Losses
ATC
MC
Price
Losses

Average
total cost
Price

Demand
MR

0 Loss- Quantity
minimizing
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Monopolistic Competitor
in the Long Run...
Price
MC
ATC

P=ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Excess Capacity...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
ATC ATC

P
P = MC P = MR
Excess capacity (demand
curve)
Demand

Quantity Quantity
Quantity Efficient Quantity= Efficient
produced scale produced scale

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Markup Over Marginal Cost...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
Markup MC MC
ATC ATC

P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

Quantity Quantity
Quantity Quantity
produced produced

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Monopolistic versus Perfect
Competition...
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
Markup ATC ATC

P
P = MC P = MR
Marginal (demand
cost curve)

MR Demand

Quantity Efficient Quantity Quantity produced = Quantity


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

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

Imperfect competition includes


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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
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 Type of Products?
firm Few
firms Differentiated Identical
products products

Monopoly Oligopoly Monopolistic Perfect


Competition Competition

• Tap water • Cell Phone • Novels • Wheat


• Cable TV • Crude oil • Movies • Milk

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

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


Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
£ Profit-maximising
Profit-maximising cartel
cartel
Industry MC

P1

Industry D ≡ AR
Industry MR
O Q1 Q
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Oligopoly

„ Tacit collusion
Ê price leadership: dominant firm
Ê price leadership: Low Cost firm
„ Collusion and the law
„ The breakdown of collusion

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

„ Non-collusive oligopoly: the kinked


demand curve theory
Êassumptions of the model

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Kinked
Kinked demand
demand for
for aa firm
firm under
under oligopoly
oligopoly
Rs

P1

O Q1 Q
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
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 MR
The MR curve
curve

P1

MR

a
D = AR

O Q1 Q
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Stable
Stable price
price under
under conditions
conditions of
of aa
kinked
kinked
£ demand
demand curve
curve

MC2

P1 MC1

a
D = AR
b

O Q1 Q
MR
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Oligopoly
„ Non-collusive oligopoly: the kinked
demand curve theory
Êassumptions of the model
Êthe shape of the demand curve
Êstable prices

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

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

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
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 • Non-price competition


• Is a policy whereby • Is a policy in which a
marketers emphasises seller elects not to focus
price as an issue and on price but to emphasis
matches or beats the prices other factors instead.
of competitors
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 • External factors


- Marketing strategies -Types of customers
.Targeting .customer perception of
.positioning and value of the product
.marketing mix strategy .elasticity of demand
-Financial strategies -the competitiveness of
.the cost base of fixed & the market place
variable costs .perfect competition
.the financial objectives of .monopolistic
.oligopolistic
the organisation .pure monopoly
Pricing Methods
Break-even analysis
Cost-based Target Rate of return
pricing
Return on investment
Payback period

Going rate
Competition-based
pricing Seal bid
Competitive reaction

Identifying customer value


Market-based Matching sellers/buyers
pricing 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 • Penetration Policy
• Price skimming involves • Penetration pricing involves the
charging a relatively high setting of lower, rather than
price for a short time higher prices in order to achieve
a large, if not dominant market
where a new, innovative,
share.
or much-improved product
is launched onto a market • This strategy is most often used
in businesses wishing to enter a
• A major disadvantage is new market or build on a
that it encourages new relatively small market share.
entrants • A successful penetration pricing
strategy may lead to large sales
volumes/market shares and
therefore lower costs per unit.
New product launch strategy
Promotion
High Low

High Rapid Slow


skimming skimming

Price
Rapid Slow
penetration penetration
Low
New product launch pricing strategies

• Rapid Skimming strategy • Slow skimming strategy


- tends to combine high price and high - tends to combine high prices with low
promotion expenditure. High prices is level of promotion expenditure - High
used to create high revenue, while high prices means high revenue but
promotion used for product awareness promotion is left to mainly word-of-
& knowledge mouth

• Rapid penetration strategy • Slow penetration strategy


- tends to combine low prices with high - tends to combine low prices with low
promotional expenditure - aims to gain promotional expenditure
market share rapidly - mainly used by Own-label brands
Conditions for charging high & low prices

• Conditions for charging high • Conditions for charging low


prices prices
-product provides high value -lack of differential advantage
-customers have high ability to pay -market presence or dominance
-lack of competition -economies of scale
-high pressure to buy -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 56 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 56 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 56 4
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 56 5
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 56 6


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 56 7


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 56 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 56 9
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 56 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 56 11


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 56 12


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 56 13


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 56 14


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 56 15


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 56 16


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 56 17


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 56 18


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 56 19


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 56 20
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 56 21


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 56 22


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 56 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 56 24


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 56 25


Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models

• Payback Period
Initial Project Expense = Rs.5,000
Payback Rs Rs
Year 1 1,000 (4,000)
Year 2 2,000 (2,000)
Year 3 2,000 0
Year 4 2,000 2,000

Copyright: Vail Training Associates 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 56 27
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 56 28


Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models

Future Value
And
Present Value
Concepts

Copyright: Vail Training Associates 56 29


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 56 30


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 56 31


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 56 32
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 56 33


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 56 34


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 56 35


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 56 36


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 56 37


Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models

• Present Value Table


Years 2% 3% 6% 10%
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 56 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 56 39
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 56 40


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 56 41
Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models
• Discounted Cash Flow
Initial Project Expense = Rs.5,000
(Payback) Discounted Cash Flow at 6%.
Future Present
Value Value
Year 1 Rs.1,000 Rs.943 (Rs.4,057)
Year 2 Rs.2,000 Rs.1,780 (Rs.2,277)
Year 3 Rs.2,000 Rs.1,697 (Rs. 580)
Year 4 Rs.2,000 Rs.1,584 Rs.1,004
Copyright: Vail Training Associates 56 42
Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models

Initial Project Expense = Rs.5,000


Payback
Year 1 Rs.1,000 (Rs.4,000)
Year 2 Rs.2,000 (Rs.2,000)
Year 3 Rs.2,000 Rs 0
Year 4 Rs.2,000 Rs.2,000

Copyright: Vail Training Associates 56 43


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 56 44


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 56 45
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 56 46
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 56 47


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 56 48
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 56 49
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 56 50
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 56 51


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 56 52
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 56 53


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 56 54
End of Cost-Benefit Analysis

Copyright: Vail Training Associates 56 55


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.

Cost Benefit
Principles Analysis, Slide 2 Ch. 20
of Macroeconomics: 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.

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

Cost Benefit
Principles Analysis, Slide 4 Ch. 20
of Macroeconomics: 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 write-
down. 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 cost-
benefit 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.

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

Cost Benefit
Principles Analysis, Slide 6 Ch. 20
of Macroeconomics: 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?

Cost Benefit
Principles Analysis, Slide 7 Ch. 20
of Macroeconomics: Second Canadian Edition
Tangible costs/benefits of urban renewal project

The
Thetangible
tangiblecosts
costsand
andbenefits
benefitsforforthe
theproject
projecthave
have
been entered in a workbook called UrbanRenewal.xls
been entered in a workbook called UrbanRenewal.xls
which
whichcan canbebedownloaded
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
Notethatthatthe
theworksheet
worksheetincludes
includesthetheDate
Dateofofthe
the
expense
expensebecause
becausenotnotall
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
stream of payments occur in different time periods,the
of payments occur in different time periods, the
XNPV function.
XNPV function.

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

Cost Benefit
Principles Analysis, Slide 9 Ch. 20
of Macroeconomics: 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
B14ononthe
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.

Cost Benefit
Principles Analysis, Slide 10 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the XNPV function

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

The
TheXNPV
XNPVfunction
functionname
namewillwillappear
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
doesnotnotfind
find
it,
it,check
checkto
tomake
makesuresurethe
theAnalysis
Analysis
Toolpak
ToolpakAdd-in
Add-inhas
hasbeen
beeninstalled.
installed.

Cost Benefit
Principles Analysis, Slide 11 Ch. 20
of Macroeconomics: 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
argument
to
to the XNPV functionisis
the XNPV function
the
thecells
cellscontaining
containingthe
the
The tangible costs, B2:B12.
Thethird
thirdargument
argumentto to tangible costs, B2:B12.
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.

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

Cost Benefit
Principles Analysis, Slide 12 Ch. 20
of Macroeconomics: Second Canadian Edition
Net present value of tangible costs

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

Cost Benefit
Principles Analysis, Slide 13 Ch. 20
of Macroeconomics: Second Canadian Edition
The table of tangible benefits - 1

The
TheXPNV
XPNVfunction
functiondiscounts
discountsthethestream
streamofofcosts
costsororbenefits
benefits
back
back to the first date in the series. For costs, the entryfor
to the first date in the series. For costs, the entry for
‘Survey
‘Surveyand
andplanning’
planning’waswasdated
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.

Cost Benefit
Principles Analysis, Slide 14 Ch. 20
of Macroeconomics: 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
entryononrow
row18 18which
whichwas
wasadded
addedasasaa
requirement
requirementofofthetheXNPV
XNPVfunction.
function.

InInthe
thecase
caseofofbenefits,
benefits,there
therewas,
was,quite
quitenaturally,
naturally,nonobenefit
benefit
totobe
berealized
realizedatatthe thestart
startofofthe
theproject.
project. ToTosatisfy
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
$0totobe
berealized
realizedatatthe
the
start
start of the project on 12-31-58. Since this entry was forzero
of the project on 12-31-58. Since this entry was for 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
meetsthetherequirement
requirementofofthetheXNPV
XNPVfunction
function
for an initial date to which all other benefits are discounted.
for an initial date to which all other benefits are discounted.

Cost Benefit
Principles Analysis, Slide 15 Ch. 20
of Macroeconomics: Second Canadian Edition
Use XNPV to calculate value of tangible benefits

First,
First,select
selectthe
thecell
cellininwhich
whichwewe
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.

Cost Benefit
Principles Analysis, Slide 16 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the XNPV function

We
Wewill
willsearch
searchforforthe
theXNPV
XNPV
function.
function.First,
First,type
typeXNPV
XNPVinin
the
theSearch
Searchforfortext
textbox,
box,and
and
click on the Go button.
click on the Go button.

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

Note:
Note:thetheXNPV
XNPVfunction
functionisispart
part
ofofthe
theAnalysis
AnalysisToolpak
Toolpakthat
thatwewe
used for Data Analysis. If Excel
used for Data Analysis. If Excel
does
doesnotnotfind
findit,
it,check
checktotomake
make
sure
surethetheAnalysis
AnalysisToolpak
ToolpakAdd-in
Add-in
has been installed.
has been installed.

Cost Benefit
Principles Analysis, Slide 17 Ch. 20
of Macroeconomics: 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
datesthethetangible
tangiblebenefits
benefits
occurred, C18:C24.
occurred, C18:C24.

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

Cost Benefit
Principles Analysis, Slide 18 Ch. 20
of Macroeconomics: Second Canadian Edition
Net present value of tangible benefits

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

Cost Benefit
Principles Analysis, Slide 19 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute the required intangible benefits

The
Theproblem
problemstatement
statementwanted
wanted
us
usto
tofind
findthe
theminimum
minimumlevellevelofof
In
intangible
intangible benefits that wouldbe
benefits that would be Incell
cellB28,
B28,enter
enterthe
theformula
formula
necessary for computing the difference
necessaryto tomeet
meetthetheminimum
minimum for computing the difference
between
benefit-cost
benefit-costratio
ratioofof1.0.
1.0. betweentangible
tangiblecosts
costsinincell
cell
B14
B14andandtangible
tangiblebenefits
benefitsinin
cell
The
The‘Required
‘Requiredintangible
intangiblebenefits’
benefits’ cellB26:
B26:=B14-B26.
=B14-B26.
are equal to the difference
are equal to the difference
In
between
betweentangible
tangiblecosts
costsand
and Inorder
orderto tosatisfy
satisfybenefit-cost
benefit-cost
criteria,
criteria, the projectplanners
tangible benefits. the project
tangible benefits. planners
would
wouldhave
haveto toidentify
identifyand
and
document $1,062,932 in
document $1,062,932 in
intangible
intangiblebenefits.
benefits.

Cost Benefit
Principles Analysis, Slide 20 Ch. 20
of Macroeconomics: 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
rate substantially changesour
substantially changes 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.

Cost Benefit
Principles Analysis, Slide 21 Ch. 20
of Macroeconomics: Second Canadian Edition
Test a higher discount rate

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

Excel
Excelhas
hasrecalculated
recalculatedthe
the
required
requiredintangible
intangiblebenefits
benefits
needed
neededtotobe
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

Cost Benefit
Principles Analysis, Slide 22 Ch. 20
of Macroeconomics: Second Canadian Edition
Test a lower discount rate

To
Totest
testaalower
lowerdiscount
discountrate,
rate,
enter
enter 5% in cell D2 to testthe
5% in cell D2 to test 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
neededtotobe
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
WeWehave
haveanswered
answeredall
all
ofofthe questions stated
the questions stated
ininthe
theproblem.
problem.

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

Cost Benefit
Principles Analysis, Slide 24 Ch. 20
of Macroeconomics: Second Canadian Edition
The benefit of travel time saved by the proposed
highways

The
Theaverage
averagetime
timespent
spentperpertrip
tripdeclines
declinesdramatically
dramatically
with
with the expansion to the 4-lane highway,and
the expansion to the 4-lane highway, andthen
then
modestly
modestlyas aswewemove
moveto tothe
the6-lane
6-lanehighway
highway
expansion.
expansion. Average
Averagedriving
drivingtimetimeperpertrip
tripon
onthe
the
existing
existinghighway
highwayisisestimated
estimatedto tobe
be3030minutes.
minutes. IfIf
the
thehighway
highwayisisexpanded
expandedto to4-lanes,
4-lanes,thetheaverage
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.

Cost Benefit
Principles Analysis, Slide 25 Ch. 20
of Macroeconomics: 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
computedbyby
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
enterthetheformula
formula
=B2/60*2.
=B2/60*2. In cell C3,enter
In cell C3, enterthe
the
formula
formula=C2/60*2.
=C2/60*2.In Incell
cellD3,
D3,
enter
enterthe
theformula
formula=D2/60*2.
=D2/60*2.

Cost Benefit
Principles Analysis, Slide 26 Ch. 20
of Macroeconomics: 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,andandthen
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
variablecostcostper
pertrip
tripisis
computed
computed by adding ‘Timecost
by adding ‘Time 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.

Cost Benefit
Principles Analysis, Slide 27 Ch. 20
of Macroeconomics: 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)andand
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
formula =B5-C5 in cell C6.C6.

The
Thecost
costsavings
savingsper
pertrip
tripwhen
when
expanding to the 6-lane highway
expanding to the 6-lane highway
isisthe
thedifference
differencebetween
betweenthethe
total
total variable costs for the4-
variable costs for the 4-
lane
lane highway ($2.50) and the6-
highway ($2.50) and the 6-
lane
lanehighway
highway($2.38)
($2.38)which
which
equals
equals$.12.
$.12.Enter
Enterthe
theformula
formula
=C5-D5
=C5-D5inincell
cellD6.
D6.

Cost Benefit
Principles Analysis, Slide 28 Ch. 20
of Macroeconomics: Second Canadian Edition
Computing cost savings on current trips

First,
First,weweenter
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
basedononthe
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
savingsperpertrip
tripon
onrow
row
66by the number of trips per
by the number of trips per
year
yearononrow
row8.8.Enter
Enter=C6*C8
=C6*C8inin
cell
cellC9
C9and
and=D6*D8
=D6*D8inincellcellD9.
D9.

Cost Benefit
Principles Analysis, Slide 29 Ch. 20
of Macroeconomics: Second Canadian Edition
Projected savings worksheet

First,
First,copy
copythe
thecost
costsavings
savingsfor
foreach
eachofofthe
the
expansion
expansion projects from cells C9 throughD9
projects from cells C9 through 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
downforforaatwenty-five
twenty-fiveyear
yeartime
time
period. For this problem, the
period. For this problem, the
present
presentvalue
valueofofthethebenefits
benefits
stream is computed by
stream is computed by
assuming
assumingthat thatthethesame
sameamount
amount
ofofbenefit
benefitwill
willaccrue
accruefor
foreach
eachofof
25
25years
yearsinto
intothethefuture.
future.
Highlight
Highlightcells
cellsB2
B2through
throughC26
C26
and select the Fill > Down
and select the Fill > Down
command
commandfromfromthetheEdit
Editmenu.
menu.

Cost Benefit
Principles Analysis, Slide 30 Ch. 20
of Macroeconomics: 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
C10ononthe
the
Cost-benefit Analysis worksheet.
Cost-benefit Analysis worksheet.

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

Cost Benefit
Principles Analysis, Slide 31 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function.First,
First,type
typeNPV
NPVinin
the
theSearch
Searchforfortext
textbox,
box,and
and
click on the Go button.
click on the Go button.

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 32 Ch. 20
of Macroeconomics: 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
whichwewe
will
willenter
enterdirectly
directlyas
as8%.
8%.

The
Thesecond
secondargument
argumenttotothe
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
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthethename
nameofofthe
the
worksheet
worksheetProjected
ProjectedSavings
Savingsbecause
becauseititcontains
containsaaspace.
space.

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

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

Cost Benefit
Principles Analysis, Slide 34 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute NPV of projected savings for 6 lane
expansion

First,
First,select
selectthe
thecell
cellininwhich
whichwe
we
Excel
Exceltotoreturn
returnthe
thepresent
presentvalue
value
ofofthe
thesavings,
savings,cell
cellD10
D10ononthe
the
Cost-benefit Analysis worksheet.
Cost-benefit Analysis worksheet.

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

Cost Benefit
Principles Analysis, Slide 35 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVinin
First, type NPV
the
theSearch
Searchforfortext
textbox,
box,
and click on the Go button.
and click on the Go button.

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 36 Ch. 20
of Macroeconomics: 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
whichwewe
will enter directly as 8%.
will enter directly as 8%.

The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theprojected
projectedsavings
savingsfor
for66lane
laneexpansion,
expansion,
'Projected
'ProjectedSavings'!C2:C26.
Savings'!C2:C26.
Remember
Remembertotoenter
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,
entered, clickon
click on
the OK button.
the OK button.

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

Cost Benefit
Principles Analysis, Slide 38 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 1

The
Theexpansion
expansiontotoaa4-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.

Cost Benefit
Principles Analysis, Slide 39 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 2

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

Cost Benefit
Principles Analysis, Slide 40 Ch. 20
of Macroeconomics: Second Canadian Edition
The costs of the highway projects - 3
The
Theincrease
increaseininmaintenance
maintenancecosts
costsare
are
computed
computed by subtracting the existingroadway
by subtracting the existing roadway
maintenance
maintenancecosts
costsfrom
fromthe
the4-lane
4-laneexpansion
expansion
maintenance
maintenancecosts
costsand
andsubtracting
subtractingthethe4-lane
4-lane
expansion maintenance costs from the 6-lane
expansion maintenance costs from the 6-lane
maintenance
maintenancecosts.
costs.

Second,
Second,enterenterthe
the
formula
formula =D14-C14inin
=D14-C14
cell
cellD15
D15totocompute
compute
the
the increaseinin
increase
First,
First,enter
enterthe
theformula
formula maintenance
maintenancecostscosts
=C14-B14
=C14-B14inincellcellC15
C15to
to associated
associatedwithwithadding
adding
compute the increase in two
two additional lanesto
compute the increase in additional lanes
maintenance to
maintenancecostscosts the
the44lane
lanehighway.
highway.
associated
associatedwith
withthethe
expansion to 4 lanes.
expansion to 4 lanes.

Cost Benefit
Principles Analysis, Slide 41 Ch. 20
of Macroeconomics: Second Canadian Edition
Annual Maintenance worksheet
First,
First,copy
copythe
theincrease
increaseininmaintenance
maintenance
costs
costs for each of the expansionprojects
for each of the expansion projects
from
fromcells
cellsC15
C15through
throughD15 D15on onthe
the‘Cost-
‘Cost-
benefit Analysis’ worksheet and Paste
benefit Analysis’ worksheet and Paste
Special
SpecialthetheValues
Valuesinto
intocells
cellsB2
B2through
throughC2 C2
on
onthe
the‘Annual
‘AnnualMaintenance’
Maintenance’worksheet.
worksheet.

Second,
Second,fillfillthe
theannual
annualmaintenance
maintenance
cost
costincreases
increasesdowndownforforaatwenty-five
twenty-five
year time period. For this problem,
year time period. For this problem,
the
thepresent
presentvalue
valueofofthe
thecost
coststream
stream
isiscomputed
computed by assuming thatthe
by assuming that the
same amount of maintenance costs
same amount of maintenance costs
will
willbe
beincurred
incurredfor foreach
eachofof2525years
years
into the future.
into the future.
Highlight
Highlightcells
cellsB2B2through
throughC26
C26and
and
select
select the Fill > Down commandfrom
the Fill > Down command from
the
theEdit
Editmenu.
menu.

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

Cost Benefit
Principles Analysis, Slide 43 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

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

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 44 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function

The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 8%.
will enter directly as 8%.

The
Thesecond
secondargument
argumenttotothe
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
Remembertotoenter
enterthe
thequote
quotemarks
marksaround
aroundthethename
nameofofthe
the
worksheet
worksheetAnnual
AnnualMaintenance
Maintenancebecause
becauseititcontains
containsaaspace.
space.

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

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

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

Cost Benefit
Principles Analysis, Slide 47 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 48 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function

The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 8%.
will enter directly as 8%.

The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theincreased
increasedmaintenance
maintenancefor
for66lane
laneexpansion,
expansion,
'Projected Savings'!C2:C26.
'Projected Savings'!C2:C26.
Remember
Remembertotoenter
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,
entered, clickon
click on
the OK button.
the OK button.

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

Cost Benefit
Principles Analysis, Slide 50 Ch. 20
of Macroeconomics: Second Canadian Edition
Total project costs
The
Thetotal
totalproject
projectcosts
costsfor
forthe
the
two
two expansion projects arethe
expansion projects are the
sum
sumofofthe
thecapital
capitalcosts
costsand
and
the
theyearly
yearlymaintenance
maintenancecosts.
costs.

Sum
Sumtotal
totalproject
projectcosts
costsfor
forthethe44
lane expansion by entering the
lane expansion by entering the
formula
formula=C13+C16
=C13+C16inincellcellC17.
C17.
Sum
Sum total project costs for the66
total project costs for the
lane
laneexpansion
expansionbybyentering
enteringthe the
formula
formula=D13+D16
=D13+D16inincellcellD17.
D17.

Cost Benefit
Principles Analysis, Slide 51 Ch. 20
of Macroeconomics: Second Canadian Edition
Compute benefit-cost ratio for the two expansion plans

Second,
First, Second,compute
computethe
First,compute
computethe the
the benefit-cost
benefit-cost benefit-costratio
ratiofor
benefit-cost ratiofor
ratio for
for the
the the6-lane
6-laneexpansion
the4-lane
4-laneexpansion expansion
expansion by
by dividing thepresent
dividing the
by
bydividing
dividingthe thepresent present
present value
value valueofofsavings
savings(D10)
value of savings(C10)
of savings (D10)
(C10) by total project costs
by
bytotal
totalproject
projectcosts by total project costs
costs (D17),
(C17), (D17),displaying
displayingthe
(C17),displaying
displayingthe the
the result in cell D18.
result
resultinincell
cellC19. result in cell D18.
C19.

Cost Benefit
Principles Analysis, Slide 52 Ch. 20
of Macroeconomics: Second Canadian Edition
Results of the benefit-cost analysis

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

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

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

Cost Benefit
Principles Analysis, Slide 55 Ch. 20
of Macroeconomics: 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
the program, one containingthe
program, one containing the
annual
annualbenefits
benefitsfor
forthe
theprogram,
program,
and
andone
onefor
forcomputing
computingthethe
benefit-cost ratio.
benefit-cost ratio.

Cost Benefit
Principles Analysis, Slide 56 Ch. 20
of Macroeconomics: Second Canadian Edition
Costs in the first year

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

First,
First,enter
enteraa Second,
Second,enter
enterthe
the
label
label Costs, first year costs,
Costs, first year costs,
year
year 1 incell
1 in cellB9. $2,220,000,
B9. $2,220,000,inincell
cellC9.
C9.

Cost Benefit
Principles Analysis, Slide 57 Ch. 20
of Macroeconomics: Second Canadian Edition
Costs in the years two through six

The
Thetotal
totalcosts
costsfor
foryears
yearstwo
two
through
through six are discountedto
six are discounted 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. Second,
Second,select
select
cell
cell C10 andinsert
C10 and insert
the
theNPV
NPVfunction.
function.

Cost Benefit
Principles Analysis, Slide 58 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 59 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function

The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
thediscount
discount
rate,
rate,which
whichwewewill
willenter
enter
directly as 10%.
directly as 10%.

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

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

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

Cost Benefit
Principles Analysis, Slide 61 Ch. 20
of Macroeconomics: Second Canadian Edition
Total Project Cost
The
Thetotal
totalproject
projectcost
costisis
computed
computed by summingthe
by summing thefirst
first
year
yearcosts
costsand
andthe
thediscounted
discounted
costs
costsfor
foryears
yearstwo
twothrough
throughsix. six.

First,
First,enter
enterthe
the Second,
Second,sum sumthe
thecosts
costsbyby
label Total Project entering
label Total Project
Cost enteringthe
theformula
formula=C9+C10
=C9+C10
Costinincell
cellB11.
B11. inincell
cellC11.
C11.The
Thetotal
totalproject
project
cost is $7,467,308.
cost is $7,467,308.

Cost Benefit
Principles Analysis, Slide 62 Ch. 20
of Macroeconomics: 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,
formula, we can dragfill
we can drag fillthe
the
other
otherbenefit
benefitcolumns.
columns.

Cost Benefit
Principles Analysis, Slide 63 Ch. 20
of Macroeconomics: 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. Second,
Second,select
select
cell
cell B10 andinsert
B10 and insert
the
theNPV
NPVfunction.
function.

Cost Benefit
Principles Analysis, Slide 64 Ch. 20
of Macroeconomics: Second Canadian Edition
Locate the NPV function

We
Wewill
willsearch
searchforforthe
theNPV
NPV
function.
function. First, type NPVininthe
First, type NPV the
Search
Searchforfortext
textbox,
box,and
andclick
clickon
on
the Go button.
the Go button.

The
TheNPVNPVfunction
functionname
namewillwill
appear in the Select a function
appear in the Select a function
list
listbox.
box.Click
Clickon
onthe
theOK OKbutton
button
access
accessthethedialog
dialogbox
boxwhere
wherethe
the
function arguments are entered.
function arguments are entered.

Cost Benefit
Principles Analysis, Slide 65 Ch. 20
of Macroeconomics: Second Canadian Edition
The arguments to the NPV function

The
Thefirst
firstargument
argumentto tothe
the
NPV
NPVfunction
functionisisthe
the
discount
discountrate,
rate,which
whichwewe
will enter directly as 10%.
will enter directly as 10%.

The
Thesecond
secondargument
argumenttotothe
theNPV
NPVfunction
functionisisthe
thecells
cells
containing
containingthe
theincreased
increasedearnings,
earnings,'Benefits
'Benefitsofofthe
the
MMTP'!B3:B7.
MMTP'!B3:B7.
Remember
Remembertotoenter
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,
entered, clickon
click on
the OK button.
the OK button.

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

Cost Benefit
Principles Analysis, Slide 67 Ch. 20
of Macroeconomics: Second Canadian Edition
Total Increased Earnings Benefit
The
Thetotal
totalfor
forthe
theincreased
increased
earnings
earnings benefit iscomputed
benefit is 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
the labelTotal
label Total
inincell
cellA11.
A11.

Second,
Second,sum sumthe
thecosts
costsbyby
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.

Cost Benefit
Principles Analysis, Slide 68 Ch. 20
of Macroeconomics: Second Canadian Edition
Drag fill the other benefit columns

The
Thebenefits
benefitsattributed
attributedtotocriminal
criminal
justice
justicesavings
savingsand andreduced
reducedheroin
heroin
consumption
consumption are computed inthe
are computed in the
same way as increased earnings.
same way as increased earnings.
We
Wecancancomplete
completethesethesecalculations
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.

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

Cost Benefit
Principles Analysis, Slide 70 Ch. 20
of Macroeconomics: Second Canadian Edition
The Benefit-cost Ratio
To
Tocompute
computethethebenefit
benefitcost
costratio
ratio
for
for the MMTP project, we enterthe
the MMTP project, we enter 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.

Cost Benefit
Principles Analysis, Slide 71 Ch. 20
of Macroeconomics: 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 Thetheory 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
Money Supply
Rate

QFixed Quantity of Money


Principles of Macroeconomics: Ch. 20 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:
– Bank reserves increase and the money
supply increases.
‹If 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
Money Supply
Rate
If the RBI buys
government
bonds, money
supply
increases.

QFixed Quantity of Money


Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Money Market
Interest
Money Supply
Rate

If the RBI sells


government
bonds, money
supply
decreases.

QFixed Quantity of Money


Principles of Macroeconomics: Ch. 20 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 Quantity of Money
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Money Market
Interest
Rate Money Demand

I1

I0

Q0 Quantity of Money
Principles of Macroeconomics: Ch. 20 Second Canadian Edition
The Money Market
Interest
Rate Money Demand

I1

I0

Q1 Q0 Quantity of Money
Principles of Macroeconomics: Ch. 20 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 Quantity of Money


Principles of Macroeconomics: Ch. 20 Second Canadian Edition
Equilibrium in the Money Market
Interest
Rate Money Supply

IE
Money Demand

QFixed Quantity of Money


Principles of Macroeconomics: Ch. 20 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 Quantity of Money


Principles of Macroeconomics: Ch. 20 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 Quantity of Money


Principles of Macroeconomics: Ch. 20 Second Canadian Edition
Changes in Money Supply
Interest
Rate MS0 MS1

IE0

Money Demand

QFixed0 Quantity of Money


Principles of Macroeconomics: Ch. 20 Second Canadian Edition
Changes in Money Supply
Interest
Rate MS0 MS1

IE0

Money Demand

QFixed0 Quantity of Money


Principles of Macroeconomics: Ch. 20 Second Canadian Edition
Changes in Money Supply
Interest
Rate MS0 MS1

IE0

IE1
Money Demand

QFixed0 QFixed1 Quantity of Money


Principles of Macroeconomics: Ch. 20 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

4 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.

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 long-
run. 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

AD2
AD1

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
AD2
AD1

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 short-
run 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
z Demand changes
z Supply changes

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 Many labor agreements are tied to an


inflation measure Æ automatic increases in
income
z Many retirees live on fixed income and
would be hurt by inflation
z If income does not increase, real
purchasing power declines with inflation
z Inflation favors those in debt
z Inflation hurts taxpayers
Rates of inflation over time
Percent Change in CPI (1984-1986=100)

20%

15%

10%

5%

0%
13

21

29

37

45

53

61

69

77

85

93

01
19

19

19

19

19

19

19

19

19

19

19

20
-5%

-10%

-15%
Who wins & who loses from
inflation?
Loses Wins
z Savers (non z Debtors
interest bearing) z Home owners
z Fixed income
z Banks,leasing
(retirees, workers companies.
with no or small pay
raise)
Causes of inflation

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

z Cost push
z Businesses raise prices
z Workers demand higher wages to keep up
with inflation
z Prices of other inputs rises
Government Policy and
Market Failures

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


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.

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


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

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


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.

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


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.

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


Externalities
„ Negative externalities occur when the
effects of a decision not taken into account
by the decision-maker are detrimental to
others.

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


Externalities
„ Positive externalities occur when the
effects of a decision not taken into account
by the decision-maker is beneficial to
others.

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


A Negative Externality
Example
„ When there is a negative externality,
marginal social cost is greater than
marginal private cost.
z 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.

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


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.

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


A Negative Externality
Example
„ When there are negative externalities, the
competitive price is too low and equilibrium
quantity too high to maximize social
welfare.

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


A Negative Externality
Cost S1 = Marginal social cost
S = Marginal private cost
Marginal cost
P1 from externality
P0

D = Marginal
social benefit
0 Q1 Q0 Quantity

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


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 co-
workers indirectly.

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


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.

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


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 Q0 Q1 Quantity

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


Alternative Methods of
Dealing with Externalities
„ Externalities can be dealt with via:
z Direct regulation.
z Incentive policies.
z Voluntary solutions.

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


Direct Regulation
„ Direct regulation –the amount of a good
people are allowed to use is directly limited
by the government.

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


Direct Regulation
„ Direct regulation is inefficient, not efficient.
z 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.

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


Incentive Policies
„ Incentive policies are more efficient than
direct regulatory policies.
„ The two types of incentive policies are
either taxes or market incentives.

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


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.

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


Tax Incentive Policies
„ This solution embodies a measure of
fairness about it – the person who
conserves the most pays the least tax.

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


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.

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


Regulation Through Taxation
Cost Marginal social cost
Marginal private cost

P1
Efficient tax
P0

Marginal social
benefit
0 Q1 Q0 Quantity

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


Market Incentive Policies
„ Market incentive program – market
participants certify they have reduced total
consumption – their own and/or other’s –
by a specified amount.

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


Market Incentive Policies
„ A market incentive program is similar to the
regulatory solution.
„ The amount of the good consumed is
reduced.

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


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.

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


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.

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


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.

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


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.

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


The Optimal Policy
„ An optimal policy is one in which the
marginal cost of undertaking the policy
equals the marginal benefit of that policy.

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


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.

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


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.

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


The Optimal Policy
„ Optimal level of pollution – the amount of
pollution at which the marginal benefit of
reducing pollution equals the marginal
cost.

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


Public Goods
„ A public good is nonexclusive and
nonrival.
z Nonexclusive – no one can be excluded from
its benefits.
z Nonrival – consumption by one does not
preclude consumption by others.

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


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.

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


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.

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


Public Goods
„ With public goods, the focus is on groups.
„ With private goods, the focus is on the
individual.

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


Public Goods
„ In the case of a public good, the social
benefit of a public good is the sum of the
individual benefits.

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


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.

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


The Market Value of a Public
Good
Price

1.00
0.50
.80
.60 0.10 Market demand
.40 DB
0.60 0.40
0.50
.20
DA
0.10
1 2 3 Quantity
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Informational Problems
„ Perfectly competitive markets assume
perfect information.
„ Real-world markets often involve
deception, cheating, and inaccurate
information.

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


Informational Problems
„ When there is a lack of information, buyers
and sellers do not have equal information,
markets may not work properly.

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


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.

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


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.

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


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.

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


A Market in Information
„ If the government regulates information,
then markets for information will not
develop.

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


Licensing of Doctors
„ Currently all doctors practicing medicine
are required to be licensed.
„ Licensing of doctors is justified by
informational problems.

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


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.

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


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.

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


An Informational Alternative
to Licensure
„ In this scenario, the government would
require doctors to post their:
z Grades in college.
z Grades in medical school.
z Success rate for various procedures.
z References.
z Medical philosophy.
z Charges and fees.

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


An Informational Alternative
to Licensure
„ This information alternative would provide
much more useful information to the public
than the present licensing procedure.

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


Government Failures and
Market Failures
„ Market failures should not automatically
call for government intervention.
„ Why? Because governments fail too.

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


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.

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


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.

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


Reasons for Government
Failures
„ The bureaucratic nature of government
intervention does not allow fine tuning.
„ Government intervention leads to more
government intervention.

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