Session 1

Essentials of Economics

Session Objectives
After this session, you should be able to:
1)

Discuss these three important economic ideas: People are rational.

People respond to incentives. Optimal decisions are made at the
margin.

2)

A preliminary overview on the theory of firms.

3)

Understand the role of constraints in economic analysis.

4)

Distinguish between microeconomics and macroeconomics.

The Disney Corporation: Expansion of the

Magic Kingdom

The Walt Disney Company, often simply known as Disney, is

one of the largest media and entertainment conglomerate in
the world, known for its family-friendly products.

Founded on October 16, 1923, by brothers Walt Disney and

Roy Disney as an animation studio, it has become one of the
biggest Hollywood studios, and owner and licensor of eleven
theme parks and several television networks, including ABC
and ESPN.

After its founder Walt Disney died in 1966, the company was
adrift for decades. Though the company retained the high
brand recognition, its managers seemed unable to turn this
recognition into increased sales and profits.
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The Disney Corporation: Expansion of the

Magic Kingdom

Given this lack of performance, Walt Disney narrowly survived

takeover attempts by corporate raiders. Its shareholders Sid
Bass and Roy E. Disney brought in Michael Eisner as the new
CEO to turn the company around.

Eisner and his management team have unlocked the value of

the Disney name and positioned the Magic Kingdom for the
twenty-first century.

In less than twenty years, Eisners team has increased

revenues tenfold to over $23 billion in 1999. Disney now ranks
as one of the 100 biggest global firms and the second largest
global media company (behind Time-Warner).

The Disney Corporation: Expansion of the

Magic Kingdom
In expanding their Magic Kingdom, Eisners team has used analyses
that are based on managerial economics !

Studies indicated that increases in advertising would raise theme park

attendance and raise profits. According they launched a series of
successful advertising campaigns (to be discussed in Sessions under
Managerial Decisions for Firms with Market Power)

Eisners team has also shown its ability to use both simple and
sophisticated pricing techniques to improve firm performance. When
the Disney animated classic film Pinocchio was released on
videocassette, it was initially priced at $79.95 (as were most
videocassettes). At this price only 1,00,000 copies were sold in the
first two months. Eisners team decided to drop the price to $29.95,
and promptly sold over 3,00,000 copies (to be discussed in Sessions
under Demand Elasticity and Its Applications)
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The Disney Corporation: Expansion of the

Magic Kingdom

Disney under Eisners initiative, has also been a leader in using

sophisticated pricing strategies such as bundling. They have bundled
together a Disney cruise with a stay at their Disneyland theme park in
Florida, a McDonald kids meal and several other such packaging. They
also practice price discrimination. Consumers who buy a Disney
videocassette will find coupons for merchandise at Disney retail stores
(to be discussed in Session under Pricing Techniques)

The firms board of directors agreed to pay Eisner a salary of

$750,000, plus a $750,000 bonus for signing on, plus an annual bonus
equal to 2 percent of the dollar amount by which the firms net income
exceeded a 9 percent return on shareholders equity. In addition, he
received options on 2 million shares of Disney stock, which meant that
he could purchase them from the firm at any time during the five-year
life of the contract for only $14 per share (to be discussed in Session
under Managing Incentives: Principal Agent Problems and Moral
Hazard )
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Airbus and Boeings Strategy to Retain

Market Leadership

To illustrate the strategic issues managerial economics can help

managers solve, consider the worlds two largest producers of
commercial aircraft, Airbus and Boeing.

Airbus product line includes the A330, A340, and the

mammoth A380 which first flew in April 2005. In 2005, Airbus
received orders for 1111 aircraft and earned revenue of 22.3
billion.

Boeings product line includes the 737, 777, and 747. In 2005,
Boeing received orders for 1031 aircraft and earned revenue of
$22.7 billion from sale of commercial aircraft.

Airbus and Boeings Strategy to Retain

Market Leadership

Beginning in the 1970s Boeing managers mapped out a twoprong approach to retaining market leadership. The company
would be the low-cost producer and the technological leader in
the industry.

By 1980, the company had achieved a market share of 81

percent, a seven-fold lead over its nearest competitor.

And, Boeing was able to achieve this feat while maintaining

high profit margins. One industry expert has estimated that in
1991, Boeing realized a profit of $45 million on every 747
aircraft it sold for $150 million.

Airbus and Boeings Strategy to Retain

Market Leadership

Boeings principal rival since late 1970s has been Airbus, a joint
venture of British, French, German and Spanish aerospace firms.

Until 2001, Airbus was a marketing consortium established under

French law as a Groupe dIntrt Economique (Economic Interest
Group). The four shareholders AerospatialeMatra (37.9%), British
Aerospace (20%), Construcciones Aeronauticas (4.2%) and Daimler
Aerospace (37.9%) performed dual roles as owners and industrial
contractors.

Starting with the delivery of their first plane in 1974, Airbus quickly
moved into the number-two spot behind Boeing. By 1997, Airbus
achieved a market share of 33 percent, while Boeings share was
reduced to under 65 percent.

And, not only did Airbus reduced Boeings market share, the company
also assumed the lead in technological advances and challenged
Boeing for low-cost leadership.
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Airbus and Boeings Strategy to Retain

Market Leadership

The dual role of owners and industrial contractors led to

inefficiencies due to the inherent conflicts of interest that the
four partner companies faced; they were both shareholders of,
and subcontractors to, the consortium. The objective was to
streamline operations across national boundaries, reduce costs,
and speed production.

Consolidation of European defence and aerospace companies

around the turn of the century allowed the establishment of a
simplified joint stock company in 2001, owned by EADS (80%)
and BAE Systems (20%). After a protracted sales process BAE
sold its shareholding to EADS on 13 October 2006.

The re-organization coincided with a consolidation of Airbus

market position. From 31% in 1996, Airbus had steadily
increased its share of the market to 57% in 1999, but then
dipped sharply to 47% in 2000. Following the re-organization,
Airbus recovered and maintained its share in the mid- to high
50s until 2005.
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Airbus and Boeings Strategy to Retain

Market Leadership

In April 2004, Boeing launched the new 787 Dreamliner with 50

firm orders from All Nippon Airways of Japan - a major Japanese
and international carrier. The deal was worth about $6 billion,
with deliveries scheduled to begin in 2008. The Dreamliner was
targeted to serve the market segment of twin-engine medium to
long-range jets with capacity of 200-300 passengers.

Eight months later, in December 2004, following considerable

speculation, Airbus announced that it would develop the A350 to
compete with Boeings 787.

At that time, Boeing had secured just 52 firm orders, far below
its target of 200 orders by the end of 2004. Richard Aboulafia of
industry consultants Teal Group remarked that Airbus had
succeeded in its goal of disrupt[ing] the business case for the
787. Airbus Chief Commercial Officer John Leahy predicted that
the A350 would attract a substantial number of Boeing
customers and put a hole in Boeing's Christmas stocking.
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Airbus and Boeings Strategy to Retain

Market Leadership
The December 2004 announcement from Airbus raised several
questions for Boeing.

Should Boeing proceed with its plan to develop the Dreamliner

or should it alter its development plans.

Should Boeing respond by changing its pricing for its new jet?

How much would development and manufacturing cost, and

how do these costs depend on sales volume?

Finally, did Airbus respond correctly to Boeings Dreamliner?

All these are questions of managerial economics !

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What is Managerial Economics?

Managerial economics is the science of directing scarce

resources to manage effectively.

Wants, desires: unlimited

Resources: scarce

Economic choice

Economics: How people use scarce resources to satisfy

unlimited wants
Whenever resources are scarce, a manager can make more
effective decisions make the best of scarce resources by
applying the discipline of managerial economics
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What is Managerial Economics?

Boeing has limited financial, human and physical resources.

Boeing managers seek to maximize the financial return from
these limited resources. They should apply managerial
economics to develop pricing and R & D strategies, design
their organizations and manage purchasing. The same is true
for Airbus.

Managerial
economics is the
application of
economic theory to
management decision
making
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How People Make Decisions Principle 1

Decision-making is at the heart of Managerial
Economics

Every decision involves tradeoffs (Principle #1)

Guns and Butter The more we spend on national defense

(guns) to protect our borders, the less we can spend on consumer
goods (butter) to raise our standard of living at home.
Having more money to buy a flat in Delhi requires working longer
hours, which leaves less time for leisure.
Laws that require firms to reduce pollution raise the cost of
producing goods and services.

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How People Make Decisions Principle 1

Society faces an important trade-off: efficiency vs. equity

Efficiency: getting the most out of its scarce resources

Equity: distributing the benefits of those resource fairly

among societys members.

Tradeoff: To increase equity, can redistribute income from

the well-off to the poor. But this reduces the incentive to
work and produce and shrinks the size of the economic
pie.

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How People Make Decisions Principle 2

The Cost of Something is What You Give up to Get

Something (Principle #2)

Making decisions requires comparing the costs and benefits

of alternative choices.
Example: The decision to join the MBA Programme
Benefits: intellectual enrichment and better job opportunities
Costs: money spend on the course, including tuition, books, library
and computer facilities.

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How People Make Decisions Principle 2

But Think!

The sacrifice you make by forgoing opportunities

for jobs after completion of your graduate studies.
The opportunity cost of an item is what you give up
to get that item.
It is the relevant cost for decision-making

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How People Make Decisions Principle 2

Usually, in choosing an alternative A, a number of alternatives

will be forgone, say, B, C, D etc. It is the next best alternative
that should be considered in calculating the opportunity cost of
A.

Suppose you spend an extra hour watching TV. You should

have studied either Physics or Mathematics or Botany during
that one hour. By studying an extra hour, you have got 5 more
marks in Physics, 6 more marks in Mathematics and 3 more
marks in Botany. The opportunity cost of watching TV for one
hour is therefore the 6 marks you lost by not studying
Mathematics during that time, since that is the best you could
have done otherwise

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How People Make Decisions Principle 2

Suppose you are deciding whether to go to a one-day cricket

match between India and Australia.

Benefit: The rupee value of the psychic satisfaction from going

to the game is, say, Rs. 1000.

Costs:
Explicit costs include: Rs. 300 (price of a ticket)
Rs. 100 (cost of transportation)
Rs 50 (cost of a coke and vada pao)
Implicit costs include: Rs.100 (if you had not gone to the game, you
could have made this money in the share market)
Rs. 40 (you are shy, reclusive and normally
dislike crowds)

The total cost = Explicit + Implicit costs = Rs. 590. This is

exceeded by the benefits and hence the decision should go to
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the match

How People Make Decisions Principle 2

Some costs should not be included in the opportunity cost but

often are. People should include sunk costs in their calculations
of their opportunity cost, even though they should not do so.

A sunk cost is one that cannot be recovered, for example, the

cost of repairing your car which broke down a day before the
match.

In practice, you might think that having incurred the

expenditure, you are under an obligation to go to the match.
This cost is however irrecoverable and should not enter into the
decision to attend the match since one should not cry over
spilt milk.

In other words, the cost of resources forgone here (the cost of

repairing the car) is independent of the decision made (to
attend the match or not) and should not be included in the cost
of taking the decision.
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How People Make Decisions Principle 2

Example :
You need Rs.1,00,000 to start your business. The interest rate
is 5%.
Case 1: borrow Rs.1,00,000
explicit cost = Rs.5000 interest on loan
Case 2: use Rs.40,000 of your savings, borrow the other
Rs.60,000

explicit cost = Rs.3000 (5%) interest on the loan

implicit cost = Rs.2000 (5%) foregone interest you could have

earned on your Rs.40,000

In both cases, total (exp + imp) costs are Rs.5000.

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How People Make Decisions Principle 2

This example shows that an important implicit cost is the cost

of capital, the foregone returns you could have earned had you
used your savings to buy bonds or other assets instead of
investing them in your business.

Accounting profit
= total revenue minus total explicit costs
Accountants keep track of how much money flows into and out of
the firm, so they ignore implicit costs.

Economic profit
= total revenue minus total costs (including explicit and implicit
costs)
Economists study the pricing and production decisions of firm,
which are affected by implicit as well as explicit costs

Accounting profit ignores implicit costs, so its higher than

economic profit.

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How People Make Decisions Principle 3

Rational People Think at the Margin (Principle #3)

Rational: The standard assumption in managerial
economics is that people make decisions rationally.
Rationality means that, when presented with various
alternatives, individuals choose the alternative that gives them
the greatest difference between value and cost. This means
that their behaviour will follow some predictable patterns based
on what they judge to be in their best interest.
For instance, if Microsoft charges a price of $239 for a copy of
Windows, economists assume that the managers at Microsoft
have estimated that a price of $ 239 will yield Microsoft the
most profit. The managers may be wrong; perhaps a price of
$265 would be more profitable, but economists assume that
the managers at Microsoft have acted rationally on the basis of
information available to them in choosing the price.

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How People Make Decisions Principle 3

Many decisions are not all or nothing, but involve marginal
changes small incremental adjustments to a plan of action

When examination is near your decision is not between not studying at all
or studying 24 hours a day, but whether to spend an extra hour reviewing
your notes instead of watching TV.

Evaluating the costs and benefits of marginal changes is an

important part of decision-making

Your decision whether to join the MBA course is arrived at by

comparing the extra fees you pay and the extra time you forgo
to the extra income you could earn by an additional degree

The firm decides whether to increase output, comparing the

cost of the additional labour and materials to the extra
revenue

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How People Make Decisions Principle 3

Quick Thinking!

Suppose that flying a 200-seat Indian plane from Bhubaneswar to

Delhi costs the airline Rs.1o,00,000 which means that the average
cost of each seat is Rs.5ooo. Suppose further that the plane is an
hour from departure and a passenger is willing to pay Rs.2500 for a
seat. Should the airline sell it to him?

Suppose Apple is currently selling 30,00,000 iPods per year.

Managers at Apple are considering whether to raise production to

33,00,000 iPods per year. One manager argues, Increasing
production from 30,00,000 to 33,00,000 is a good idea because we
will make a total profit of $100 million if we produce 33,00,000. Do
you agree with his reasoning? What, if any, additional information do
you need to decide whether Apple should produce the additional
3,00,000 iPods?
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How People Make Decisions Principle 3

Should Apple produce an additional 300,000 iPods?
In solving the problem, consider the following:

Optimal decisions are made at the margin.

An activity should be continued to the point where the marginal benefit is equal to
the marginal cost. In this case, that involves continuing to produce iPods up to the
point where the additional revenue Apple receives from selling more iPods is equal
to the marginal cost of producing them. The Apple manager has not done a
marginal analysis, so you should not agree with his reasoning.

In this case, the correct decision requires information about additional revenue and
additional cost. You will need to know the additional revenue Apple would earn
from selling 3,00,000 more iPods and the additional cost of producing them.

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How People Make Decisions Principle 4

People Respond to Incentives (Principle #4)

incentive: something that induces a person to act, i.e., the

prospect of a reward or punishment

Because rational people make decisions by weighing costs and

benefits, their decisions may change in response to incentives.

When the price of a good rises, consumers will buy less of it

because its cost has risen.
When the price of the same good rises, producers will allocate more
resources to the production of the good because the benefit from
producing the good has risen.

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How People Make Decisions Principle 4

According to an article in the Wall Street Journal, the FBI couldnt

understand why banks were not taking steps to improve security in
the face of an increase in robberies.

FBI officials suggest that banks place uniformed, armed guards

outside their doors and install bullet-resistant plastic, known as
bandit barrier, in front of teller windows.

FBI officials were surprised that few banks took their advice. But the
article also reported that installing bullet-resistant plastic costs
$10,000 to $20,000 and a well-trained security guard receives
$50,000 per year in salary and benefits. The average loss in a bank
robbery is only about $1,200.

The economic incentive to bank is clear: It is less costly to put up

with bank robberies than to take additional security measures. That
banks respond as they do to the threat of robberies may be surprising
to the FBI but not the economists.
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The Theory of Firm

Managerial economics is based on the model of

the firm.

The model of the firm is based on the assumption

that firms, or managers of firms, are optimizers.
What is it that managers optimizei.e., what is
the nature of the managerial objective function?

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The Theory of Firm

In its most stripped-down version, the theory of firm assumes

that the firm tries to maximize its profits. The firms ownermanager is assumed to be working to maximize the firms
short-run profits.

But this version is too nave to be useful in many

circumstances, particularly where a problem facing the firm
has important dynamic elements and where risk is involved.

A richer version of the theory assumes that the firm tries to

maximize its wealth or value.

A firms value will be defined as the present value of its

expected future cash flows. For the moment, we can regard a
firms cash flow as being same as its profit.
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The Theory of Firm

Thus, expressed as an equation, the value of the firm (V)
= Present value of expected future profits

Rn C n
R i C i R1 C 1 R 2 C 2

...
V

2
n
n

(
1
r
)
(
1
r
)
(
1
r
)
(
1
r
)
i 1

Where:
Ri is sales revenues of the firm in period i (quarter i, year i);
Ci is cost of the firm in period i (quarter i, year i);
r is the discount / interest rate; and
t goes from 1(next year) to n (the last year in the planning horizon)

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The Theory of Firm

A careful inspection of the equation suggests how a firms

managers and workers can influence its value.

Consider, for example, the Tata Motor Company. Its marketing

managers and sales representatives work hard to increase its
total revenues, while its production managers and
manufacturing engineers strive to reduce its total costs.

At the same time, its financial managers play a major role in

obtaining capital, and hence influence the equation.

Finally, its research and development personnel invent new

products and processes that both increase the firms total
revenues and reduce its total costs.

All these diverse groups affect Tata Motors value, defined here
as the present value of its expected profits.
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The Role of Constraints

Managerial economists generally assume that managers want to

maximize firm value. However, this does not mean that managers
have complete control over firm value and can set it at any level
they choose. On the contrary, managers must cope with the fact
that there are many constraints on what they can achieve in this
regard.

Types of constraints:

a)

The amount of certain types of inputs may be limited. In the

relevant period of time, managers may be unable to obtain more
than a particular amount of specialized equipment, skilled labour,
essential materials, or other inputs. Particularly, if the period of
time is relatively short, these input constraints may be quite severe.
For example, because it takes many months to expand the capacity
of a steel plant, many short-run problems facing a steel firm must
be solved on the basis of the recognition that plant capacity is
essentially fixed. However, in dealing with longer-run problems, the
firm has more flexibility and can alter (within limits) its capacity.
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The Role of Constraints

Types of constraints:
b)

Another important type of constraint that limits managerial

actions is legal or contractual in nature. For example, a firm
may be bound to pay wages exceeding a certain level
because minimum wage laws stipulate that it must do so.
Also, it must pay taxes in accord with central, state and local
laws. Further, it must act in accord with its contracts with
customers and suppliers take the legal consequences. A
wide variety of laws (ranging from environmental laws to
antitrust laws to tax laws) limit what managers can do, and
the contracts and other legal agreements made by them
further constrain their actions.

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Microeconomics and Macroeconomics

Microeconomics focuses on the individual parts of

the economy.

It is the study of how households and businesses make

choices, how they interact in markets, and how the
government attempts to influence their choices

Macroeconomics looks at the economy as a whole.

It is the study of economy-wide phenomena, including

inflation, unemployment, and economic growth

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