The Economic Environment of Business

It concerns of Business a) Allocation of society scarce resources among alternative uses & the distribution of collects output among Individuals & groups at a point In time.

B) The way In which allocation & dilutions change over time. C) The efficiencies & Inefficiencies of economic systems. Since the real world is so complex, when economists face a problem, where they have to make a decision, they first start by making simplifying assumptions where they build a model much simpler than the real world.If the model was done properly, then it should predict how the real world will behave. A basic assumption in economics, is that economic players behave rationally. It means that once they’ve selected their objectives, they will try to achieve them in a rational way.

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Therefore individuals believe in is “utility” minimization, which refers to any objective that leads to satisfaction of the economic player. Thus paying to charity may lead to utility minimization.What Is managerial economics? Managerial Economics Is a marriage of economics & decision sciences In order to solve complex business problems.

This applies for both private firms & public institutions. According to Keats & Young It Is “the use of economic analysis to make equines decisions involving the best use of an organization’s scarce resources”. It brings together economic concepts & tools, financial analysis, strategic planning, & the techniques of the decision sciences.Examples of questions that managerial economists are concerned with: a) In the private sector: What will be produced? How to produce it? What is the level of production? How much to charge for it?… B) In the public sector: What projects should we implement (e. G.

Infrastructure)? Should we impose a tax? How to prioritize our budgetary spending?… Goals of the firm – an economist’s perspective: The firm In economic theory is expected to want to maximize profits (of course subject to constraints).This Is known as the profit minimization hypothesis. How Economists Define? Resources (factors of production): a) Land (land, forests, minerals, etc) b) Labor (physical + mental) c) Capital (tools, machinery, factories) Production: the act of making commodities (goods and services) Goods: a) Tangible e. G. Cars, chairs b) Services: Intangible e.

G. Education, health care Efficiency of production: maximizing output using a given amount of resources Or maligning resources used to achieve a given amount of output.Efficiency of distribution: the economy’s output is said to be efficiently distributed if no one could Effectiveness: the extent to which an intervention does what it is intended to do Firm: A firm is an organization which takes resources & transforms them into products (goods & services) that are demanded by consumers. Industry: A group of firms that sells a well-defined product or closely related set of products. Market: An “area” over which buyers & sellers negotiate the exchange of a well-defined commodity. N. B. : Not necessarily physical, for example the NASDAQ stock exchange is an electronic arrest.

Revenue & Profit:Revenue refers to all the proceeds (money) that a firm gains from selling its product or service. It depends on the quantity of units it sells and the price of each unit. Revenue = no. Of units sold X price of unit The difference between the revenue a firm receives and the costs of production it incurs is the “profit”. Micro vs..

Macro Economics a) Macro economics: the study of the determination of economic aggregates & averages, such as total output, total employment, the general price level & rate of economic growth. ) Micro economics: deals with firms, markets or sectors of the economy rather than aggregates. It studies the allocation of resources and the distribution of income as they are affected by the workings of the price system & by the policies of the authorities. Command vs..

Market Economies a) Command economy: an economy in which the planning & decisions of central authorities (as distinct from households & firms) exert the major influence over the allocation of resources & the distribution of income. ) Market economy: refers too society in which people specialize in productive activities & meet most of their material wants through exchanges voluntarily agreed upon by the contracting arties. Decisions made by firms & households depends on market signals as prices & profits.

Demand & Supply Definition of Demand: It is the willingness & ability to pay for a good Definition of Quantity demanded is the entire relationship between the quantity of a commodity that buyers wish to purchase per period of time & the price of that commodity, other things equal.The demand relationship can be presented verbally [aforementioned], graphically or mathematically Graphically: A basic hypothesis is that the lower the price of a commodity, the larger the quantity that will be demanded, other things being equal. Notice that quantity demanded is a “desired” quantity. It is how much households “wish” to purchase, not necessarily how much they actually succeed in purchasing. Notice also that quantity demanded is a flow, that is it has a time dimension.Determinants of Demand: a) The price of the good b) The price of substitute goods c) The price of complementary goods d) Households income & wealth (when dealing with market demand we should consider income distribution) e) Tastes and preferences f) Future expectations g) Sociological & demographic factors e.

G. Number of buyers, number of children, lace of residence What happens to the demand curve if there is a change in any of the factors that determine demand? Changes in price 0 movements along the demand curve.Changes in other determinants 0 shift in the demand curve 1- Changes in Household Income: If households receive more income, they can be expected to purchase more of most goods even though prices remain unchanged. Normal Goods & Inferior Goods. A commodity whose demand increases when income increases is called a normal good (majority of goods). A commodity whose demand decreases when income increases is called an inferior good. 2- Changes in Other Prices: Commodities that can be used in place of each other (I.

E. Substitute each other) are called substitutes.Where as commodities that tend to be used Jointly with each other are called complements. 3- Change in tastes & 4- Change in sociological factors Use the correct terminology: Change in demand = shift in the whole demand curve Change in quantity demand = movement along a demand curve Definition of Quantity Supplied: It is the entire relationship between the quantity of a commodity that firms are able and willing to offer for sale per period of time and the price of that commodity, other eke demand it is a flow, that is, it has time dimension.The supply relationship can be presented verbally [aforementioned], graphically or mathematically All other things equal, the quantity of any commodity that firms will produce & offer for sale is positively related to the commodity own price, rising when price rises & falling when price falls.Note: We will discuss in a later presentation why the firm’s supply curve looks the way it is, so we will take its shape as given for the time being. The shape of the market supply curve depends on the market structure (the number of suppliers n the market), again this will be studied in some detail later, so we will take the shape of the market supply curve (in the previous slide) as given.

Mathematically via “the supply schedule” or demand “function”: Determinants of Supply a) The price of the commodity b) The prices of factors of production c) The goals of producing firms d) Future expectations e) Weather conditions f) The state of technology g) For the market supply curve: imports, number of sellers What happens to the supply curve if there is a change in any of the factors that determine supply? Changes in price 0 movements along the . Changes in determinants 0 shift in the supply curve. Apply curve Change in supply = shift in the whole supply curve Change in quantity supplied = movement along a supply curve The Determination of Price So far, demand and supply have been considered separately. How do they interact to determine price in a competitive market? Point E represents the equilibrium price & quantity The Laws of Demand & Supply Elasticity Assume that the supply of a certain commodity increases, we know from the previous lecture that price will fall and quantity consumed will increase.But! Will these changes be large or small? The Effect of the Shape of the Demand Curve The Responsiveness of Demand to Price The degree to which quantity demanded responds to changes in the commodity own price is called the responsiveness of demand. Price Elasticity of Demand Price elasticity of demand is the responsiveness of demand to price change. It is defined as: The percentage (proportionate) change in quantity demanded divided by the percentage (proportionate) change in price that brought it about.It is usually symbolized by the Greek letter eat: 0 a) If quantity changes, but the percentage change in quantity is less than the regenerate change in price 0 elasticity < 1, demand is said to be INELASTIC.

b) If the percentage change in quantity is equal to the percentage change in price elasticity = 1 0 Demand is said to be of UNIT ELASTICITY c) If the percentage change in quantity is more than the percentage change in price elasticity > 1 0 demand is ELASTIC. N.B.: Elasticity may vary along the same demand curve depending on the shape of the curve. ) Perfectly elastic (completely elastic) demand curve is the last case. Where elasticity is infinitely large, there exists some small price reduction that will raise demand from ere to infinity.

Above the critical price, consumers will buy nothing. At the critical price, they will buy all that they can obtain. Completely Elastic Demand Curve 0 = Relation between Elasticity & Revenue In case of elastic goods, an increase in price leads too larger reduction in quantity consumed, thus causing revenue to decline (since revenue is quantity multiplied by price).In case of inelastic goods, an increase in price still leads too reduction in quantity consumed, but the percentage change in quantity is less than the percentage change in price, thus causing revenue to increase. Price elasticity of emend will help us to answer important policy questions.

Examples: 1 . What will happen to revenue as price changes? 2. What will happen to consumption of cigarettes if the tax increases? What determines elasticity? The main determinant of elasticity is the availability of substitutes & whether the commodity is a necessity.A commodity with no close substitutes tends to have an inelastic demand. Also, what proportion of income is spent on the good, is it a durable product, can purchases be postponed,…

Also, time factor has a role in determining elasticity. Because it takes time to develop satisfactory substitutes, emend that is inelastic in the short run may prove elastic in the long run. A good example is the change in elasticity when oil prices increased in 1974-75.

The concept of demand elasticity can be broadened to measure the response to change in any of the factors that influence demand, not only price.Elasticity of Supply Elasticity of supply measures the response of quantity supplied to changes in any of the factors that influence it. Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price that brought it about. Market Structure The profitability of a firm depends on a number of factors.

It is not only the number/ size of sellers in the market that matters but also the nature of the product, the nature and number of purchasers of the product, the ease of entering and leaving the market and a multitude of other factors.To reduce these characteristics to manageable proportions, economists have focused on few theoretical market structures that explain what we encounter in real life: a) Perfect competition b) Monopoly c) Monopolistic competition & d) Oligopoly Before delving into specific market structures, we have to remember that to maximize refits we have to consider two variables at the same time: Cost and Revenue. The profit maximizing level (or range) of output will depend on the interaction of the two variables. Level of Competition in the Market There are a number of key determinants of the level of competition. ) Product differentiation: Products may be differentiated in a number of ways.

They may actually be physically different, performing different tasks; alternatively, they may have cosmetic differences & perform the same task, but the small differences in style, shape, color, etc. Enable consumers to differentiate between them. In some cases the products may have no differences at all, however, they can be differentiated as a result of the different images that are generated in the course of promoting them. ) Substitutability of the goods produced by different firms (or the potential for substitution).

C) Production scale is an important determinant. If substantial economies of scale exist, then efficient plant must be of an appropriately large size; thus, it is impractical to expect a large number of firms to exist because the available market is not large enough. D) Another hindrance to competition in an industry is he existence of barriers to entry & barriers to exit. Perfect Competition [Firms without Market Power] Assumptions of Perfect Competition a) Price taking firms (I. .

Has no market power) c) No barriers to entry or exit from the market d) No government intervention e) The product must be identical f) Perfect information on market conditions & prices by both buyers & sellers g)Profit maximizing firms h) The market clears so that all goods produced are sold I) “u” shaped short run average & marginal cost curves j) The firm’s demand curve is perfectly elastic (horizontal) & P = AR = MR. What level of output would a profit maximizing firm choose in a perfectly competitive market?The firm faces two questions: First: should the firm produce or not in the short run (since the firm always has the option to produce nothing)? In the short run, a firm should produce if and only if average revenue is not less than average variable cost. Second: if the firm decides to produce, what should the level of production be? For a firm to maximize profits, the output should be the one at which marginal revenue (MR.) equals marginal cost (MAC), and the MAC curve cuts the MR. line from below. The firm will keep increasing output so long as it can add more to revenue than it adds to cost.

When the firm has chosen its optimum output, it is in equilibrium because it has no incentive to alter its behavior in the short run. Supply Curve of the Firm Remember? The supply curve shows the relation between quantity supplied & market price. In the last few slides we agreed that: For prices below PVC, the firm will supply zero units For prices above PVC the firm will equate price and marginal cost Concluding Remarks a) In perfect competition it is difficult for a firm to make high profits, the entry of new rims will eventually ensure that all economic profit is eliminated by the lowering of price.

) Although in theory, economic profits should be equal to zero, in reality, excess profits can still be earned in competitive industries. This happens if the industry is in a disequilibrium position, or if the firm can earn economic rent derived form a unique advantage. Monopoly [Firms with total Market Power] Monopoly markets consist of one supplier who has total control over the price I. E. , the monopolist is a price maker & exercises considerable market power. The strategy in monopoly scenario typically involves the maintenance of the monopoly advantage.That is, the creation & maintenance of barriers to entry to other firms & fending off attempts by government to interfere with the monopoly market outcome. A monopoly exists when only one firm supplies a unique product, with no substitutes, to a market in which entry by other firms is prohibited and the dissemination of market information is poor.

Unlike the perfectly competitive firm, the monopolist will be confronted by a downward sloping demand curve for its product which is also the industry demand curve.Since a monopolist must generally lower its price to all selling one additional unit of output must necessarily be less than the price for which the unit is sold (because there will be a reduction in revenue from the previous sales level resulting from the price fall). Since the change in revenue as a result of changing sales by one unit is marginal revenue, the marginal revenue curve of the monopolist is shown as declining more rapidly than its demand curve. The rule for finding the profit maximizing level of output remains unaltered (equating MAC and MR.).Price however is determined by the market demand curve.

The problem for the monopolist is that unless it is sanctioned by the government it is likely to be the subject of government anti-monopoly legislation. Poor management or inability to compete with new competitors in a global market place can also be factors. The demise of the British automobile industry is an interesting example, where all major British manufacturers progressively exited the industry during the second half of the 20th century. Pricing in a Monopoly We have already seen that monopolists should attempt to set MR. = MAC.

However, in doing so, they may also be able to take advantage of the fact that they can discriminate between groups of customers, in a way that would be more difficult for a non-monopolist to do, in order to increase their profits further. In the following slides we will see how monopolists can further exploit their market position in deriving more than fair profits in the market place. A)Price Discrimination Price discrimination is often a means by which profits from sales can be substantially increased.First-degree price discrimination is said to exist when a firm s able to sell each unit at a different price as indicated by the price on the product demand curve at which the particular unit falls. Such price discrimination is rare. Second-degree price discrimination occurs when prices are set on the basis of quantities purchased. This is a common way of discriminating between wholesale & retail customers. The most common form of price discrimination is third-degree price discrimination.

This occurs when suppliers are able to divide their markets up into segments and charge a different price to each segment, equating MR. = MAC in each of the sub-markets. By discriminating in the price charged according to the relative elasticity of demand in each market the firm can increase its total profits. B) Two-Part Tariffs Increasingly, consumers are exposed to two-part tariffs?particularly from public utilities for the supply of electricity, water, gas, etc. The two-part tariff involves the charge off fee for the right to buy a product plus a usage fee for each unit of the product purchased.Clearly, firms that implement two-part tariff regimes will have some monopoly over the market. A firm using this approach must determine both the bevel of the initial fee and the per unit usage cost. Monopolistic Competition [Where competition is almost perfect, but not quite] Monopolistic competition is perhaps most similar to perfect competition except that the firm is faced with a downward a unapologetically competitive scenario is typically exemplified by attempts by a firm to differentiate its product from those of its competitors.

Although there exists many firms in the industry, consumers perceive some differences in the products of each firm. Thus, rather than having one demand curve for the product of the industry, here is a multitude of demand curves one for each firm. Thus, each firm is confronted by its individual, downward sloping demand curve. The extent to which an individual firm’s demand curve slopes down is determined by the level of product differentiation that it has been able to attain. The more differentiated the product, the steeper the demand curve.The unapologetically competitive firm behaves Just as the monopolist would.

It equates MR. with MAC and chooses that price and output level which maximizes profits. However, this is not monopoly and in the long run, such a situation cannot be sustained. Oligopoly [Where firms tend to compete on anything but price] Oligopoly, where only a few large firms producing a unique product (such as petroleum) exist, is a quite common form of market structure & non-price forms of market competition conducted by oligopolies can often be extremely aggressive.Entry to & exit from the industry is generally prohibited & very little ‘market sensitive’ information is available & buyers are largely kept uninformed. Oligopolies firms would prefer to operate in some form of cartel arrangement, in which they would all agree to operate in a manner similar to that of a monopoly.

Such behavior is illegal in most countries. Two models are commonly presented in an attempt to explain the behavior of oligopolies. The first is a model of price leadership.

The second is the model of the kinked demand curve. Apart from the theories, there are a number of possibilities that can exist in an oligopolies market: Oligopoly Possibilities 1. Collusion or tacit collusion (cartels). 2.

One firm (price leader) behaves like a monopolist in his share of the market, other firms follow the price leader’s prices closely. Under such circumstances, if the price deader tries to change his prices, he cannot benefit much from such change!If he raises prices, other firms may not follow him & he loses market share; if he lowers prices the competition also reduces pieces. Thus competition is always on aspects other than the price. 3. Fierce price competition, where all of them loose their supernormal profits. Cartels A cartel is created when a few firms agree to collude on prices to derive the benefits of a monopolist. Whilst the establishment of a cartel results in the product being marketed under monopoly-like conditions, it pays off if one firm decides to heat the cartel agreement.

In this case, the firm by reducing price below the agreed on price, can acquire a larger market share & increase its profits. This triggers retaliation from the remaining cartel members, which makes cartels quite unstable. Game Theory In an oligopolies market, decision makers have no clear theoretic background that helps them in setting their direction, or guides them as how the competition will react to any change in price. Game theory may help the decision maker in selecting a strategy by attempting to estimate the pay off for each strategy. This