Description
topics like demand analysis, demand schedule, demand curve, demand analysis, supply analysis, elasticity of demand, demand evaluation, demand forecasting, cost analysis
Economic Analysis
Module-I Theory of Demand & Supply
Introduction
• Effective managerial decision making/Economic Analysis is the process of finding the best solution to a given problem. Both the methodology and tools of managerial economics play an important role in this process. • Each of the further mentioned concepts such as revenue realization followed by profit maximization etc are fruitfully applied in the practical analysis of managerial decision problems. Explained in subsequent modules, basic economic relations provide the underlying framework for the analysis of all profit, revenue, and cost relations.
2
Methods
• The decision alternative that produces a result most consistent with managerial objectives is the optimal decision. • Marginal revenue equals marginal cost at the point of profit maximization so long as total profit is falling as output expands from that point. • The breakeven point identifies an output quantity at which total profit is zero. Marginal revenue equals zero at the point of revenue maximization as long as total revenue is falling beyond that point.
3
Methodology Cont’nd…
• Average cost minimization occurs when marginal and average costs are equal and average cost is increasing as output expands. • Multivariate optimization is the process of optimization for equations with three or more variables. Managers in several functional areas frequently face constrained optimization problems: decision situations that involve limited choice alternatives. • The incremental concept is often used as the practical equivalent of marginal analysis. Incremental change is the total change resulting from a decision. Incremental profit is the profit gain or loss associated with a given managerial decision.
4
Tools
• Tables are the simplest and most direct form for listing economic data. When these data are displayed electronically in the format of an accounting income statement or balance sheet, the tables are referred to as spreadsheets. • In many instances, a simple graph or visual representation of the data can provide valuable insight. • In other instances, complex economic relations are written using an equation, or an analytical expression of functional relationships. – The value of a dependent variable in an equation depends on the size of the variable (s) to the right of the equal sign, which is called an independent variable. – Values of independent variables are determined outside or independently of the functional relation expressed by the equation.
5
Tools…
• A marginal relation is the change in the change in the dependent variable caused by a 1-unit change in an independent variable. – Marginal revenue is the change in total revenue associated with a 1-unit change in output; – marginal cost is the change in total cost following a 1-unit change in output; and – marginal profit is the change in total profit due to a 1-unit change in output. • A derivative is a precise specification of the marginal relation.
6
Tools…
• A tangent is a straight line with the same slope as a given curve at their single point of intersection. • In graphic analysis, slope is a measure of the steepness of a line and is defined as the increase (or decrease) in height per unit of movement along the horizontal axis. – An inflection point reveals a point of maximum or minimum slope. – A second derivative is the derivative of derivative and is positive when an inflection point indicated a relative minimum and negative when an inflection point reveals a relative maximum.
7
Problem
• In 2004, the second-largest U.S. long-distance telephone company eliminated about 2,000 jobs at four call centers in Colorado, Iowa, Kansas, and South Carolina. “MCI must continue to revamp its cost structure to better position the company for future success,” a company spokesperson said. Does this decision reflect an application of the global or partial optimization concept? Explain. • “The personal computer is a calculating device and a communicating device. Spreadsheets incorporate the best of both characteristics by allowing managers to determine and communicate the optimal course of action.” Discuss this statement and explain why computer spreadsheets are a popular means for expressing and analyzing economic relations.
8
Demand Analysis
• Demand is the quantity of a good or service that customers are willing and able to purchase under a given set of economic conditions.
– Direct demand is the demand for products that directly satisfy consumer desires. – The value or worth of a good or service, its utility, is the prime determinant of direct demand. – The demand for all inputs is derived demand and determined by the profitability of using various inputs to produce output.
9
Demand Schedule & Demand Curve
• In economics, the demand curve can be defined as the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at the given price ceteris paribus. • A Demand Schedule is a table listing quantities demanded of a good at different prices • A Demand Curve displays the information on cartesian plane about the relation mentioned exactly in demand schedule. • Individual demand curve can be derived from personal income of individual while market demand curve depends upon the income segment of the segment of consumers. – Note: the market demand curve is the curve related to the demand of the commodity demanded by the group of people to the at different price.
10
Demand Analysis
• The market demand function for a product is a statement of the relation between the aggregate quantity demanded and all factors that affect this quantity.
– The demand curve expresses the relation between the price charged for a product and the quantity demanded, holding constant the effects of all other variables.
• A Change in the quantity demanded is a movement along a single demand curve. • A Shift in demand, or shift from one demand curve to another, reflects a change in one or more of the nonprice variables in the product demand function. • Unequal shift in demand & supply curve shifts equilibrium.
11
Total-market demand and Market-segment demand • Demand for a product can be studied in its aggregate or in its parts by breaking the total demand into different segments on the basis of geographical areas, price sensitive’s, sub-product, product uses, distribution channels, customer’s size, sex etc.
– Problems such as sales forecasting calls for an analysis of total market demand, but – problem such as pricing, delivery and promotion require analysis of market segments.
• Market segments may differ significantly in respect of delivery prices, delivery quotas, profit margins, seasonal patens, cyclical sensitivities and market competition. • Management may have to follow different sets of policies for different market segments, say, home market and foreign market or say, wholesale market and retail market.
12
Supply Analysis
• The term supply refers to the quantity of a good or service that producers are willing and able to sell under a given set of conditions. • The market supply function for a product is a statement of the relation between the quantity supplied and all factors affecting that quantity. • A Supply curve expresses the relation between the price charged and the quantity supplied, holding constant the effects of all other variables. • Movements along a supply curve reflect Change in the quantity supplied. • A shift in supply, or a switch from one supply curve to another, indicates a change in one or more of the nonprice variables in the product supply function.
13
Supply Analysis
• A market is in equilibrium when the quantity demanded and the quantity supplied are in perfect balance at a given price. • Surplus describes a condition of excess supply. • Shortage is created when buyers demand more of a product at a given price than producers are willing to supply. The market equilibrium price just clears the market of all supplied product. • In comparative statics analysis, the role of factors influencing demand or supply is analyzed while holding all else equal. • A fundamental understanding of demand and supply concepts is essential to the successful operation of any economic organization. The concepts introduced in this chapter provide the structure for the more detailed analysis of demand and supply in subsequent chapters.
14
Problem
• What key ingredients are necessary for the creation of economic demand? • The Energy Department estimates that domestic demand for natural gas will grow by more than 40 percent between now and 2025. Distinguish between a demand function and a demand curve. What is the difference between a change in the quantity demanded and a shift in the demand curve? • Distinguish between a supply function and a supply curve. What is the difference between a change in the quantity supplied and a shift in the supply curve?
15
Demand Analysis-II
• The market demand curve shows the total amount of a specific good or service customers are willing to buy at various prices under present market conditions. For example, many firms serve various customer groups like retail and wholesale, domestic and foreign, student and non-student customers, and so on. • Factors such as price and advertising that are within the control of the firm are called endogenous variables; • Factors outside the control of the firm such as consumer incomes, competitor prices, and the weather are called exogenous variables. • Elasticity is the percentage change in a dependent variable Y, resulting from a 1 percent change in the value of an independent variable X. • Point elasticity measures elasticity at a point on a function. • Arc elasticity measures the average elasticity over a given range of a function.
16
Elasticity of Demand
• The price elasticity of demand measures the responsiveness of the quantity demanded to changes in the price of the product, holding constant the values of all other variables in the demand function. • With elastic demand, a price increase will lower total revenue and a decrease in price will raise total revenue. • Unitary elasticity describes a situation in which the effect of a price change is exactly offset by the effect of a change in quantity demanded. Total revenue, the product of price times quantity, remains constant. • With inelastic demand, a price increase produces a less than proportionate decline in quantity demanded, so total revenues rises. Conversely a price decrease produces less than a proportionate increase in quantity demanded, so total revenue falls.
17
Elasticity of Demand
• There is a relatively simple mathematical relation among marginal revenue, price, and the point price elasticity of demand. This relationship greatly simplifies the process of finding the price/ output combination that will maximize profits for firms facing a downward-sloping demand curve. • The optimal price formula can be written P = MC/[1+(1/ep)]. Given any point price elasticity estimate, relevant marginal revenues can be determined easily. When this marginal revenue information is combined with pertinent marginal cost data, the basis for an optimal pricing policy is created.
18
Elasticity of Demand
• A direct relation between the price of one product and the demand for another holds for all substitutes.
– A price increase for a given product will increase demand for substitutes; – a price decrease for a given product will decrease demand for substitutes. – Goods that are inversely related in terms of price and quantity are known as complements; they are used together rather than in place of each other. – The concept of cross-price elasticity is used to examine the responsiveness of demand for one product to changes in the price of another.
19
Elasticity of Demand
• The income elasticity of demand measures the responsiveness of demand to changes in income, holding constant the effect of all other variables. • For normal goods, individual and aggregate demand is positively related to income. Income and the quantity purchased typically move in the same direction; that is, income and sales are directly rather than inversely related. Therefore, ?Q/?I and hence e1 are positive. • This does not hold for inferior goods. Individual consumer demand for such products as beans and potatoes, for example, tends to fall as incomes rise because consumers replace them with more desirable alternatives. • Demand for such products is countercyclical, actually rising during recessions and falling during economic booms.
20
Elasticity of Demand
• Goods for which 0 < e1 <1 are often referred to as no cyclical normal goods because demand is relatively unaffected by changing income. For goods having e1 > 1, referred to as cyclical normal goods, demand is strongly affected by changing economic conditions. • Demand analysis and estimation is one of the most interesting and challenging topics in microeconomics. This chapter provides a valuable, albeit brief, introduction to several key concepts that are useful in the practical analysis and estimation of demand.
21
Problem
• Is the economic demand for a product determined solely by its usefulness? • “When I go to the grocery store, I find cents-off coupons totally annoying. Why can’t they just cut the price and do away with the clutter?” Discuss this statement and explain why coupon promotions are an effective means of promotion for grocery retailers, and popular with many consumers.
22
Demand Evaluation
• This chapter introduces methods for characterizing and estimating demand relations. An understanding of these techniques is necessary not only for the successful analysis of demand relations but also for understanding the nature of any statistical relation. • The best technique for estimating the market demand curve is the method that provides necessary accuracy at minimum cost. In many instances, simple demand curve estimation techniques are the most sophisticated approach when sophisticated is taken to mean effective and cost-efficient. In many instances, liner demand curved can be easily estimated and profitably employed.
23
Demand Evaluation
• Because the market price/ output equilibrium at any point in time is determined by the forces of demand and supply, a simultaneous relation, or concurrent association, exists between demand and supply. • The problem of estimating an economic relation in the presence of such simultaneity is the identification problem. • The consumer interview, or survey, method customers to estimate demand relations. An alternative technique for obtaining useful information about product demand involves market experiments. • Regression analysis is a powerful statistical technique that describes the way in which a dependent Y variable is related to one or more independent X variables.
24
Demand Evaluation
• A deterministic relation is a relation known with certainty. • A statistical relation exists if the average of one variable is related to another, but it is impossible to predict with certainty the value of one based on the value of another. • A time series is a daily, a weekly, a monthly, or an annual sequence of data on an economic variable such as price, income, cost, or revenue. • A cross section of data is a group of observations on an important economic variable at any given point in time.
25
Demand Evaluation
• The simplest means for analyzing a sample is to plot and visually study the data.
– A scatter diagram is a data illustration in which the dependent variable is plotted on the vertical axis, and the independent variable is shown on the horizontal axis. – The most common regression model specification is a linear model or straight-line relation. – Another common regression model form is a multiplicative model, which involves interactions among all the X variables. – A simple regression model involves one dependent Y variable and one independent X variable. – A multiple regression model entails one Y variable but includes two or more X variables.
26
Demand Evaluation
• A useful measure for examining the overall accuracy of regression models is the standard error of the estimate (SEE), or the standard deviation of the dependent Y variable after controlling for the influence of all X variables. • In a simple regression model with only one independent variable, the correlation coefficient, r, measures goodness of fit. • The square of the coefficient of multiple correlation, called the Coefficient of determination, or R2, shows how well a multiple regression model explains changes in the value of the dependent Y variable. • In statistical studies, the sample analyzed must be large enough to provide 30 or more degrees of freedom, or observations beyond the minimum needed to calculate a given regression statistic. • The corrected coefficient of determination, denoted by the symbol R2, is a downward adjustment in R2, in light of the number of data points and estimated coefficients.
27
Demand Evaluation
• The F statistic offers evidence on the statistical significance of the proportion of dependent variable variation that has been explained. • The t statistic is a test statistic that has an approximately normal distribution with a mean of zero and a standard deviation of 1. • Hypothesis tests that simply relate to matters of effect or influence of the independent variables are called two-tail t tests. • Tests of direction (positive or negative) or comparative magnitude are called one – tail t tests Such hypothesis tests are used to evaluate demand models derived from economic theory. • Methods examined in this chapter are commonly used by large and small organizations in their statistical analysis of demand relations. Given the continuing rise in the diversity and complexity of the economic environment, the use of such tools is certain to grow in the years ahead.
28
Problem
• “Rapid innovation in the development, assembly, and delivery of personal computers has led to a sharply downward-sloping market demand curve for Dell, Inc.” Discuss this statement. • “Demand for higher education is highest among the wealthy. This has led to an upward-sloping demand curve for college education. The higher the tuition charged, the greater is demand.” Discuss this statement.
29
Demand Forecasting
• Managerial decision making is often based on forecasts of future events. This chapter examines several techniques for economic forecasting, including qualitative analysis, trend analysis and projection, econometric models, and input/output methods. • Qualitative analysis is an intuitive judgmental approach to forecasting that is useful when based on unbiased, informed opinion. The personal insight method is one in which an informed individual uses personal or organizational experience as a basis for developing future expectations. The panel consensus method relies on the informed opinion of several individuals. In the delphi method, responses from a panel of experts are analyzed by an independent party to elicit a consensus opinion. • Survey techniques that skillfully use interviews or mailed questionnaires constitute another important forecasting tool, especially for short-term projections.
30
Demand Forecasting
• Trend analysis involves characterizing the historical pattern of an economic variable and then projecting or forecasting its future path based on past experience. A secular trend is the long-run pattern of increase or decrease in economic data. Cyclical fluctuation describes the rhythmic variation in economic series that is due to a pattern of expansion or contraction n the overall economy. Seasonal variation, or seasonality, is a rhythmic annual pattern in sales or profits caused by weather, habit, or social custom. Irregular or random influences are unpredictable shocks to the economic system and the pace of economic activity caused by wars, strikes, natural catastrophes, and so on. A simple linear trend analysis assumes a constant period-by-period unit change in an important economic variable over time. Growth trend analysis assumes a constant period-by-period percentage change in an important economic variable over time. Macroeconomic forecasting involves predicting the pace of economic activity, employment, or interest rates at the international, national, or regional level. Microeconomic forecasting involves predicting economic performance, say, profitability, at the industry, firm, or plant level.
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31
Demand Forecasting
• The business cycle is the rhythmic pattern of contraction and expansion observed in the overall economy. Economic indicators are series of data that successfully describe the pattern of projected, current, or past economic activity. A composite index is a weighted average of leading, coincident, or lagging economic indicators. An economic recession is a significant decline in activity spread across the economy that lasts more than a few months. Recessions are visible in terms of falling industrial production, declining real income, shrinking wholesale-retail, and rising unemployment. An economic expansion exhibits rising economic activity. Exponential smoothing (or “averaging”) techniques are among the most widely used forecasting methods. In two-parameter (Holt) exponential smoothing, the data are assumed to consist of fluctuations about a level that is changing with some constant or slowly drifting linear trend. The three-parameter (Winters) exponential smoothing method extends the two-parameter technique by including a smoothed multiplicative seasonal index to account for the seasonal behavior of the forecast series. Econometric methods use economic theory and mathematical and statistical tools to forecast economic relations. Identities are economic relations that re true by definition. Behavioral equations are hypothesized economic relations that are estimated by using econometric methods.
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•
32
Demand Forecasting
• Forecast reliability, or predictive consistency, must be accurately judged in order to assess the degree of confidence that should be placed in economic forecasts. A given forecast model is often estimated by sing a test group of data and evaluated by using forecast group data. No forecasting assignment is complete until reliability has been quantified and evaluated. The sample mean forecast error is one useful measure of predictive capability. • The appropriate technique to apply in a given forecasting situation depends on such factors as the distance into the future being forecast, the lead time available, the accuracy required, the quality of data available for analysis, and the nature of the economic relations involved in the forecasting problem.
33
Demand Forecasting
• Accurate company sales and profit forecasting requires careful consideration of firm-specific and broader influences. Discuss some of the microeconomic and macroeconomic factors a firm must consider in its own sales and profit forecasting. • “Interest rates were expected to increase by 85 percent of all consumers in the May 2004 survey, more than ever before,” said Richard Curtin, the director of the University of Michigan’s Surveys of Consumers. “More consumers in the May 2004 survey cited the advantage of obtaining a mortgage in advance of any additional increases in interest rates than any other time in nearly 10 years,” said Cu7rtin. Discuss this statement and explain why consumer surveys are an imperfect guide to consumer expectations.
34
• Cost analysis plays a key role in most managerial decisions. • For tax purposes, historical cost, or historical cash outlay, is the relevant cost. This is also generally true for annual 10-K reports to the Securities and Exchange Commission and for reports to stock-holders. • Current cost, the amount that must be paid under prevailing market conditions, is typically more relevant for decision-making purposes. • Current costs are often determined by replacement costs, or the cost of duplicating productive capability using present technology. Another prime determinant of current cost is opportunity cost, or the foregone value associated with the current rather than the next-best use of a given asset. Both of these cost categories typically involve out-ofpocket costs, or explicit costs, and noncash costs, called implicit costs. 35
Cost Analysis
Cost Analysis
• Incremental cost is the change in cost caused by a given managerial decision, and often involves multiple units of output. Incremental costs are a prime determinant of profit contribution, or profit before fixed charges. Neither are affected by sunk costs, which do not vary across decision alternatives. • Proper use of relevant cost concepts requires and understanding of the cost/output relation, or cost function. Short-run cost functions are used for daytoday operating decision; long-run cost functions are employed in the long-range planning process. The short run is the operating period during which the availability of a at least one input is fixed. In the long run, the firm has complete flexibility.
36
Cost Analysis
• Long-run cost curves are called planning curves; short-run cost curves are called operating curves.
– Fixed costs do not vary with output and are incurred only in the short run. – Variable costs fluctuate with output in both the short and the long run. A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a given operating environment. – A long-run cost curve shows the minimum cost impact of output changes for the optimal plant size using current technology in the present operating environment.
• Economies of scale originate from production and market-related sources, and cause long-run average costs to decline. • Cost elasticity, etc’ measures the percentage change in total cost associated with a 1 percent change in output. • Capacity refers to the output level at which short-run average costs are minimized. • Minimum efficient scale (MES) is the output level at which long-run average costs are minimized.
37
Cost Analysis
• Multi-plant economies of scale are cost advantages that arise from operating multiple facilities in the same line of business or industry. Conversely, multi-plant diseconomies of scale are cost disadvantages that arise from managing multiple facilities in the same line of business or industry. • When knowledge gained from manufacturing experience is used to improve production methods, the resulting decline in average cost reflects the effects of the firm’s learning curve. Economies of scope exist when the cost of joint production is less then the cost of producing multiple outputs separately. • Cost-volume-profit analysis, sometimes called breakeven analysis, is used to study relations among costs, revenues, and profits. A breakeven quantity is a zero profit activity level. The degree of operating leverage is the percentage change in profit that results from a 1 percentage change in units sold; it can be understood as the elasticity of profits with respect of output.
38
Problem
• What is the relation between production functions and cost functions? Be sure to include in your discussion the effect of competitive conditions in input factor markets. • With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck and must meet an annual deductible of a few hundred dollars. After that, insurance picks up most of their health care costs. Companies complain that this gives workers little incentive to help control medical insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better ince3ntives to control employer medical insurance costs?
39
doc_848434029.pptx
topics like demand analysis, demand schedule, demand curve, demand analysis, supply analysis, elasticity of demand, demand evaluation, demand forecasting, cost analysis
Economic Analysis
Module-I Theory of Demand & Supply
Introduction
• Effective managerial decision making/Economic Analysis is the process of finding the best solution to a given problem. Both the methodology and tools of managerial economics play an important role in this process. • Each of the further mentioned concepts such as revenue realization followed by profit maximization etc are fruitfully applied in the practical analysis of managerial decision problems. Explained in subsequent modules, basic economic relations provide the underlying framework for the analysis of all profit, revenue, and cost relations.
2
Methods
• The decision alternative that produces a result most consistent with managerial objectives is the optimal decision. • Marginal revenue equals marginal cost at the point of profit maximization so long as total profit is falling as output expands from that point. • The breakeven point identifies an output quantity at which total profit is zero. Marginal revenue equals zero at the point of revenue maximization as long as total revenue is falling beyond that point.
3
Methodology Cont’nd…
• Average cost minimization occurs when marginal and average costs are equal and average cost is increasing as output expands. • Multivariate optimization is the process of optimization for equations with three or more variables. Managers in several functional areas frequently face constrained optimization problems: decision situations that involve limited choice alternatives. • The incremental concept is often used as the practical equivalent of marginal analysis. Incremental change is the total change resulting from a decision. Incremental profit is the profit gain or loss associated with a given managerial decision.
4
Tools
• Tables are the simplest and most direct form for listing economic data. When these data are displayed electronically in the format of an accounting income statement or balance sheet, the tables are referred to as spreadsheets. • In many instances, a simple graph or visual representation of the data can provide valuable insight. • In other instances, complex economic relations are written using an equation, or an analytical expression of functional relationships. – The value of a dependent variable in an equation depends on the size of the variable (s) to the right of the equal sign, which is called an independent variable. – Values of independent variables are determined outside or independently of the functional relation expressed by the equation.
5
Tools…
• A marginal relation is the change in the change in the dependent variable caused by a 1-unit change in an independent variable. – Marginal revenue is the change in total revenue associated with a 1-unit change in output; – marginal cost is the change in total cost following a 1-unit change in output; and – marginal profit is the change in total profit due to a 1-unit change in output. • A derivative is a precise specification of the marginal relation.
6
Tools…
• A tangent is a straight line with the same slope as a given curve at their single point of intersection. • In graphic analysis, slope is a measure of the steepness of a line and is defined as the increase (or decrease) in height per unit of movement along the horizontal axis. – An inflection point reveals a point of maximum or minimum slope. – A second derivative is the derivative of derivative and is positive when an inflection point indicated a relative minimum and negative when an inflection point reveals a relative maximum.
7
Problem
• In 2004, the second-largest U.S. long-distance telephone company eliminated about 2,000 jobs at four call centers in Colorado, Iowa, Kansas, and South Carolina. “MCI must continue to revamp its cost structure to better position the company for future success,” a company spokesperson said. Does this decision reflect an application of the global or partial optimization concept? Explain. • “The personal computer is a calculating device and a communicating device. Spreadsheets incorporate the best of both characteristics by allowing managers to determine and communicate the optimal course of action.” Discuss this statement and explain why computer spreadsheets are a popular means for expressing and analyzing economic relations.
8
Demand Analysis
• Demand is the quantity of a good or service that customers are willing and able to purchase under a given set of economic conditions.
– Direct demand is the demand for products that directly satisfy consumer desires. – The value or worth of a good or service, its utility, is the prime determinant of direct demand. – The demand for all inputs is derived demand and determined by the profitability of using various inputs to produce output.
9
Demand Schedule & Demand Curve
• In economics, the demand curve can be defined as the graph depicting the relationship between the price of a certain commodity, and the amount of it that consumers are willing and able to purchase at the given price ceteris paribus. • A Demand Schedule is a table listing quantities demanded of a good at different prices • A Demand Curve displays the information on cartesian plane about the relation mentioned exactly in demand schedule. • Individual demand curve can be derived from personal income of individual while market demand curve depends upon the income segment of the segment of consumers. – Note: the market demand curve is the curve related to the demand of the commodity demanded by the group of people to the at different price.
10
Demand Analysis
• The market demand function for a product is a statement of the relation between the aggregate quantity demanded and all factors that affect this quantity.
– The demand curve expresses the relation between the price charged for a product and the quantity demanded, holding constant the effects of all other variables.
• A Change in the quantity demanded is a movement along a single demand curve. • A Shift in demand, or shift from one demand curve to another, reflects a change in one or more of the nonprice variables in the product demand function. • Unequal shift in demand & supply curve shifts equilibrium.
11
Total-market demand and Market-segment demand • Demand for a product can be studied in its aggregate or in its parts by breaking the total demand into different segments on the basis of geographical areas, price sensitive’s, sub-product, product uses, distribution channels, customer’s size, sex etc.
– Problems such as sales forecasting calls for an analysis of total market demand, but – problem such as pricing, delivery and promotion require analysis of market segments.
• Market segments may differ significantly in respect of delivery prices, delivery quotas, profit margins, seasonal patens, cyclical sensitivities and market competition. • Management may have to follow different sets of policies for different market segments, say, home market and foreign market or say, wholesale market and retail market.
12
Supply Analysis
• The term supply refers to the quantity of a good or service that producers are willing and able to sell under a given set of conditions. • The market supply function for a product is a statement of the relation between the quantity supplied and all factors affecting that quantity. • A Supply curve expresses the relation between the price charged and the quantity supplied, holding constant the effects of all other variables. • Movements along a supply curve reflect Change in the quantity supplied. • A shift in supply, or a switch from one supply curve to another, indicates a change in one or more of the nonprice variables in the product supply function.
13
Supply Analysis
• A market is in equilibrium when the quantity demanded and the quantity supplied are in perfect balance at a given price. • Surplus describes a condition of excess supply. • Shortage is created when buyers demand more of a product at a given price than producers are willing to supply. The market equilibrium price just clears the market of all supplied product. • In comparative statics analysis, the role of factors influencing demand or supply is analyzed while holding all else equal. • A fundamental understanding of demand and supply concepts is essential to the successful operation of any economic organization. The concepts introduced in this chapter provide the structure for the more detailed analysis of demand and supply in subsequent chapters.
14
Problem
• What key ingredients are necessary for the creation of economic demand? • The Energy Department estimates that domestic demand for natural gas will grow by more than 40 percent between now and 2025. Distinguish between a demand function and a demand curve. What is the difference between a change in the quantity demanded and a shift in the demand curve? • Distinguish between a supply function and a supply curve. What is the difference between a change in the quantity supplied and a shift in the supply curve?
15
Demand Analysis-II
• The market demand curve shows the total amount of a specific good or service customers are willing to buy at various prices under present market conditions. For example, many firms serve various customer groups like retail and wholesale, domestic and foreign, student and non-student customers, and so on. • Factors such as price and advertising that are within the control of the firm are called endogenous variables; • Factors outside the control of the firm such as consumer incomes, competitor prices, and the weather are called exogenous variables. • Elasticity is the percentage change in a dependent variable Y, resulting from a 1 percent change in the value of an independent variable X. • Point elasticity measures elasticity at a point on a function. • Arc elasticity measures the average elasticity over a given range of a function.
16
Elasticity of Demand
• The price elasticity of demand measures the responsiveness of the quantity demanded to changes in the price of the product, holding constant the values of all other variables in the demand function. • With elastic demand, a price increase will lower total revenue and a decrease in price will raise total revenue. • Unitary elasticity describes a situation in which the effect of a price change is exactly offset by the effect of a change in quantity demanded. Total revenue, the product of price times quantity, remains constant. • With inelastic demand, a price increase produces a less than proportionate decline in quantity demanded, so total revenues rises. Conversely a price decrease produces less than a proportionate increase in quantity demanded, so total revenue falls.
17
Elasticity of Demand
• There is a relatively simple mathematical relation among marginal revenue, price, and the point price elasticity of demand. This relationship greatly simplifies the process of finding the price/ output combination that will maximize profits for firms facing a downward-sloping demand curve. • The optimal price formula can be written P = MC/[1+(1/ep)]. Given any point price elasticity estimate, relevant marginal revenues can be determined easily. When this marginal revenue information is combined with pertinent marginal cost data, the basis for an optimal pricing policy is created.
18
Elasticity of Demand
• A direct relation between the price of one product and the demand for another holds for all substitutes.
– A price increase for a given product will increase demand for substitutes; – a price decrease for a given product will decrease demand for substitutes. – Goods that are inversely related in terms of price and quantity are known as complements; they are used together rather than in place of each other. – The concept of cross-price elasticity is used to examine the responsiveness of demand for one product to changes in the price of another.
19
Elasticity of Demand
• The income elasticity of demand measures the responsiveness of demand to changes in income, holding constant the effect of all other variables. • For normal goods, individual and aggregate demand is positively related to income. Income and the quantity purchased typically move in the same direction; that is, income and sales are directly rather than inversely related. Therefore, ?Q/?I and hence e1 are positive. • This does not hold for inferior goods. Individual consumer demand for such products as beans and potatoes, for example, tends to fall as incomes rise because consumers replace them with more desirable alternatives. • Demand for such products is countercyclical, actually rising during recessions and falling during economic booms.
20
Elasticity of Demand
• Goods for which 0 < e1 <1 are often referred to as no cyclical normal goods because demand is relatively unaffected by changing income. For goods having e1 > 1, referred to as cyclical normal goods, demand is strongly affected by changing economic conditions. • Demand analysis and estimation is one of the most interesting and challenging topics in microeconomics. This chapter provides a valuable, albeit brief, introduction to several key concepts that are useful in the practical analysis and estimation of demand.
21
Problem
• Is the economic demand for a product determined solely by its usefulness? • “When I go to the grocery store, I find cents-off coupons totally annoying. Why can’t they just cut the price and do away with the clutter?” Discuss this statement and explain why coupon promotions are an effective means of promotion for grocery retailers, and popular with many consumers.
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Demand Evaluation
• This chapter introduces methods for characterizing and estimating demand relations. An understanding of these techniques is necessary not only for the successful analysis of demand relations but also for understanding the nature of any statistical relation. • The best technique for estimating the market demand curve is the method that provides necessary accuracy at minimum cost. In many instances, simple demand curve estimation techniques are the most sophisticated approach when sophisticated is taken to mean effective and cost-efficient. In many instances, liner demand curved can be easily estimated and profitably employed.
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Demand Evaluation
• Because the market price/ output equilibrium at any point in time is determined by the forces of demand and supply, a simultaneous relation, or concurrent association, exists between demand and supply. • The problem of estimating an economic relation in the presence of such simultaneity is the identification problem. • The consumer interview, or survey, method customers to estimate demand relations. An alternative technique for obtaining useful information about product demand involves market experiments. • Regression analysis is a powerful statistical technique that describes the way in which a dependent Y variable is related to one or more independent X variables.
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Demand Evaluation
• A deterministic relation is a relation known with certainty. • A statistical relation exists if the average of one variable is related to another, but it is impossible to predict with certainty the value of one based on the value of another. • A time series is a daily, a weekly, a monthly, or an annual sequence of data on an economic variable such as price, income, cost, or revenue. • A cross section of data is a group of observations on an important economic variable at any given point in time.
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Demand Evaluation
• The simplest means for analyzing a sample is to plot and visually study the data.
– A scatter diagram is a data illustration in which the dependent variable is plotted on the vertical axis, and the independent variable is shown on the horizontal axis. – The most common regression model specification is a linear model or straight-line relation. – Another common regression model form is a multiplicative model, which involves interactions among all the X variables. – A simple regression model involves one dependent Y variable and one independent X variable. – A multiple regression model entails one Y variable but includes two or more X variables.
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Demand Evaluation
• A useful measure for examining the overall accuracy of regression models is the standard error of the estimate (SEE), or the standard deviation of the dependent Y variable after controlling for the influence of all X variables. • In a simple regression model with only one independent variable, the correlation coefficient, r, measures goodness of fit. • The square of the coefficient of multiple correlation, called the Coefficient of determination, or R2, shows how well a multiple regression model explains changes in the value of the dependent Y variable. • In statistical studies, the sample analyzed must be large enough to provide 30 or more degrees of freedom, or observations beyond the minimum needed to calculate a given regression statistic. • The corrected coefficient of determination, denoted by the symbol R2, is a downward adjustment in R2, in light of the number of data points and estimated coefficients.
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Demand Evaluation
• The F statistic offers evidence on the statistical significance of the proportion of dependent variable variation that has been explained. • The t statistic is a test statistic that has an approximately normal distribution with a mean of zero and a standard deviation of 1. • Hypothesis tests that simply relate to matters of effect or influence of the independent variables are called two-tail t tests. • Tests of direction (positive or negative) or comparative magnitude are called one – tail t tests Such hypothesis tests are used to evaluate demand models derived from economic theory. • Methods examined in this chapter are commonly used by large and small organizations in their statistical analysis of demand relations. Given the continuing rise in the diversity and complexity of the economic environment, the use of such tools is certain to grow in the years ahead.
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Problem
• “Rapid innovation in the development, assembly, and delivery of personal computers has led to a sharply downward-sloping market demand curve for Dell, Inc.” Discuss this statement. • “Demand for higher education is highest among the wealthy. This has led to an upward-sloping demand curve for college education. The higher the tuition charged, the greater is demand.” Discuss this statement.
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Demand Forecasting
• Managerial decision making is often based on forecasts of future events. This chapter examines several techniques for economic forecasting, including qualitative analysis, trend analysis and projection, econometric models, and input/output methods. • Qualitative analysis is an intuitive judgmental approach to forecasting that is useful when based on unbiased, informed opinion. The personal insight method is one in which an informed individual uses personal or organizational experience as a basis for developing future expectations. The panel consensus method relies on the informed opinion of several individuals. In the delphi method, responses from a panel of experts are analyzed by an independent party to elicit a consensus opinion. • Survey techniques that skillfully use interviews or mailed questionnaires constitute another important forecasting tool, especially for short-term projections.
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Demand Forecasting
• Trend analysis involves characterizing the historical pattern of an economic variable and then projecting or forecasting its future path based on past experience. A secular trend is the long-run pattern of increase or decrease in economic data. Cyclical fluctuation describes the rhythmic variation in economic series that is due to a pattern of expansion or contraction n the overall economy. Seasonal variation, or seasonality, is a rhythmic annual pattern in sales or profits caused by weather, habit, or social custom. Irregular or random influences are unpredictable shocks to the economic system and the pace of economic activity caused by wars, strikes, natural catastrophes, and so on. A simple linear trend analysis assumes a constant period-by-period unit change in an important economic variable over time. Growth trend analysis assumes a constant period-by-period percentage change in an important economic variable over time. Macroeconomic forecasting involves predicting the pace of economic activity, employment, or interest rates at the international, national, or regional level. Microeconomic forecasting involves predicting economic performance, say, profitability, at the industry, firm, or plant level.
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31
Demand Forecasting
• The business cycle is the rhythmic pattern of contraction and expansion observed in the overall economy. Economic indicators are series of data that successfully describe the pattern of projected, current, or past economic activity. A composite index is a weighted average of leading, coincident, or lagging economic indicators. An economic recession is a significant decline in activity spread across the economy that lasts more than a few months. Recessions are visible in terms of falling industrial production, declining real income, shrinking wholesale-retail, and rising unemployment. An economic expansion exhibits rising economic activity. Exponential smoothing (or “averaging”) techniques are among the most widely used forecasting methods. In two-parameter (Holt) exponential smoothing, the data are assumed to consist of fluctuations about a level that is changing with some constant or slowly drifting linear trend. The three-parameter (Winters) exponential smoothing method extends the two-parameter technique by including a smoothed multiplicative seasonal index to account for the seasonal behavior of the forecast series. Econometric methods use economic theory and mathematical and statistical tools to forecast economic relations. Identities are economic relations that re true by definition. Behavioral equations are hypothesized economic relations that are estimated by using econometric methods.
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32
Demand Forecasting
• Forecast reliability, or predictive consistency, must be accurately judged in order to assess the degree of confidence that should be placed in economic forecasts. A given forecast model is often estimated by sing a test group of data and evaluated by using forecast group data. No forecasting assignment is complete until reliability has been quantified and evaluated. The sample mean forecast error is one useful measure of predictive capability. • The appropriate technique to apply in a given forecasting situation depends on such factors as the distance into the future being forecast, the lead time available, the accuracy required, the quality of data available for analysis, and the nature of the economic relations involved in the forecasting problem.
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Demand Forecasting
• Accurate company sales and profit forecasting requires careful consideration of firm-specific and broader influences. Discuss some of the microeconomic and macroeconomic factors a firm must consider in its own sales and profit forecasting. • “Interest rates were expected to increase by 85 percent of all consumers in the May 2004 survey, more than ever before,” said Richard Curtin, the director of the University of Michigan’s Surveys of Consumers. “More consumers in the May 2004 survey cited the advantage of obtaining a mortgage in advance of any additional increases in interest rates than any other time in nearly 10 years,” said Cu7rtin. Discuss this statement and explain why consumer surveys are an imperfect guide to consumer expectations.
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• Cost analysis plays a key role in most managerial decisions. • For tax purposes, historical cost, or historical cash outlay, is the relevant cost. This is also generally true for annual 10-K reports to the Securities and Exchange Commission and for reports to stock-holders. • Current cost, the amount that must be paid under prevailing market conditions, is typically more relevant for decision-making purposes. • Current costs are often determined by replacement costs, or the cost of duplicating productive capability using present technology. Another prime determinant of current cost is opportunity cost, or the foregone value associated with the current rather than the next-best use of a given asset. Both of these cost categories typically involve out-ofpocket costs, or explicit costs, and noncash costs, called implicit costs. 35
Cost Analysis
Cost Analysis
• Incremental cost is the change in cost caused by a given managerial decision, and often involves multiple units of output. Incremental costs are a prime determinant of profit contribution, or profit before fixed charges. Neither are affected by sunk costs, which do not vary across decision alternatives. • Proper use of relevant cost concepts requires and understanding of the cost/output relation, or cost function. Short-run cost functions are used for daytoday operating decision; long-run cost functions are employed in the long-range planning process. The short run is the operating period during which the availability of a at least one input is fixed. In the long run, the firm has complete flexibility.
36
Cost Analysis
• Long-run cost curves are called planning curves; short-run cost curves are called operating curves.
– Fixed costs do not vary with output and are incurred only in the short run. – Variable costs fluctuate with output in both the short and the long run. A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a given operating environment. – A long-run cost curve shows the minimum cost impact of output changes for the optimal plant size using current technology in the present operating environment.
• Economies of scale originate from production and market-related sources, and cause long-run average costs to decline. • Cost elasticity, etc’ measures the percentage change in total cost associated with a 1 percent change in output. • Capacity refers to the output level at which short-run average costs are minimized. • Minimum efficient scale (MES) is the output level at which long-run average costs are minimized.
37
Cost Analysis
• Multi-plant economies of scale are cost advantages that arise from operating multiple facilities in the same line of business or industry. Conversely, multi-plant diseconomies of scale are cost disadvantages that arise from managing multiple facilities in the same line of business or industry. • When knowledge gained from manufacturing experience is used to improve production methods, the resulting decline in average cost reflects the effects of the firm’s learning curve. Economies of scope exist when the cost of joint production is less then the cost of producing multiple outputs separately. • Cost-volume-profit analysis, sometimes called breakeven analysis, is used to study relations among costs, revenues, and profits. A breakeven quantity is a zero profit activity level. The degree of operating leverage is the percentage change in profit that results from a 1 percentage change in units sold; it can be understood as the elasticity of profits with respect of output.
38
Problem
• What is the relation between production functions and cost functions? Be sure to include in your discussion the effect of competitive conditions in input factor markets. • With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck and must meet an annual deductible of a few hundred dollars. After that, insurance picks up most of their health care costs. Companies complain that this gives workers little incentive to help control medical insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better ince3ntives to control employer medical insurance costs?
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