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Introduction. Markets and national welfare
Esh Trushin and Kevin Hinde
Business Economics part
The Nature of Planning and Controlling…, but often forgetting about the economy
Corrections and revisions plans and actions
New items report
Managers can be effective without economics, but a business leader improves firm competitive advantage and needs economic perspectives
Strategic management needs economics
Competitive advantage of a firm is based on:
•Supply – through cost advantages, often due toknow-how protected by secrecy/patents and
•Barriers to entry for rivals
•Demand – access to market via key distribution channels, customer captivity through habit formation, high costs of switching/searching or experiencing alternative products
•Economies of scale or specialisation – costs decline with more and focused production
Which economic theory we study in this module?
•Out of 9 (or more) economic schools (Classical, Neoclassical, Marxist, development, Austrian, Schumpeterian, Keynesian, Institutional, Behaviourist), we focus on Neoclassical economics with own political, ethical, modelling assumptions and values
•Major assumptions of neoclassical economics are free markets, selfish rational individual choices with a focus on exchange, consumption and incentives through prices
•We consider some concepts and applications of economics to managerial economics in this module.
•Also watch a good introduction in microeconomics at
• Watch an entertaining presentation on economics by Prof. Chang at
Your learning objectives
After this session, you should be able to:
Consider market mechanism and its failures
Assess minimum market size for a given cost structure
Apply demand and supply analysis and critically examine their national welfare implications
Examine situations where governments might need to intervene because markets don’t work effectively
The Market Economy
A market is any arrangement that enables buyers and sellers to exchange goods and services for a price.
Markets for homogeneous products (e.g. gold, grain) tend to have one price. Markets for differentiated products (cars, toothpaste) tend to have a wider spread of prices
Markets can involve simple or complex transactions, requiring institutions (rules, monitoring and prosecution) to ensure transactions. Out of 200+ market economies, only economies with proper institutions can prosper
“One-handed” economist? What do economists
Tariffs reduce economic welfare
Flexible exchange rates are
effective for international
Rent controls reduce the quality
Government should redistribute
Government should hire the
‘If all economists were laid end to end,
they would never reach a conclusion.’ George Bernard Shaw
What is economics about?
• We seem to ‘want, want, want’. INSATIABLE WANTS?
Far beyond need?
•We cannot satisfy all these wants because SCARCITY exists
•To address the distribution and production problems, free MARKETS can maximize National Welfare though PRICE mechanism
•Scarcity represents CONSTRAINTS on the DEMANDand SUPPLY side. For example are choices are restricted by
Financial constraints (Budget)
Limits on our Productive Time
The current state of technology
Physical and human capital shortages
Limited information and uncertainty about the environment.
•Economics assumes agents (consumers, firms) maximize their utility or profit/value given technological, information, and price constraints.
Choice involves a cost
•A choice represents a tradeoff (substitutability) — we give up something to get something else — andthe highest valued alternative we give up is the opportunity cost of the activity chosen.
•Alternative cost is one of the key concepts – is a cost of the second best available alternative
•Example 1: your opportunity cost this year is income lost from employment while studying;
•Your opportunity cost of studying for life is different!
•Example 2: If you live in a house with a spare room, the opportunity cost is net rent you lose
suphakit73 / FreeDigitalPhotos.net
And a benefit
•Remember we want or require products and services and derive benefit from their consumption. Economists refer to this as UTILITY
•Utility – is assumed increasing function in consumption which follows from axioms of choice
(preferences), higher utility is preferred
•The optimal choice we make is where the benefit from consuming an additional (marginal) unit equals the cost of consuming that unit
•Formally, Marginal Benefit = Marginal Cost
•Customers make choices by maximising their utility of consumption given their budget constraints
•Quantity demanded Qd is a function f of price Px for a good or service, and preferences, substitutes and complementary goods available
•Important assumption - Ceteris paribus – “other things being equal” (may not work)
•Under axioms of consumer choice, Demand typically has the property that as Price falls Q rises and vice versa
•Demand curve is the maximum price at which a representative consumer wishes to buy amount of
Supply reflects marginal costs
•Supply (Qs) reflects costs as a function f of price Px and underlying technology: Qs = f(Px)
•Under typical conditions as price of production Px rises, the output Qs increases and vice versa
•Costs of producing one additional unit of goods/services is called marginal costs
•Suppliers are motivated by profit, which is the difference between price of a good /service and marginal costs of supply
•Producer supplies additional good/service if price is higher or equals marginal costs
•Supply curve represents the marginal costs of production an amount of goods Q
Shifts in demand and supply curves
with prices of different goods Py,Pz, own price Px, Technology T, Preferences U,Z
Movements along the demand curve
Qd = f(Px, Py…Pz, Y, T, U)
Shifts in the demand curve Movements along the supply curve
Qs = g (Px, Pa, Pi, Te, Z)
Shifts in the supply curve
Change in demand – a shift of the entire demand curve caused by a change in a non- price factor that affects demand
Change in supply – a shift of the entire supply curve caused by a change in a non- price factor that affects supply
The “market” “equilibrium” scheme
At prices above the equilibrium there is a surplus, supply exceeds demand. Suppliers will sell excess stocks at lower prices.
Consumers will lower their offer prices
The market scheme (continued)
At prices below the equilibrium there is a shortage, demand exceeds supply. Consumers (with higher incomes?) will offer higher prices. Suppliers will make more in search of higher returns from the shortage.
Consumers are willing to pay more than they have to because of the operation of the market
National welfare analysis
Supply = sum of
the marginal cost
curves for all
The difference between what
the producer receives and the
marginal cost of supplying
The coffee market – what you may infer from this graph? (not much)
What drives market prices – supply or demand?
Slopes of demand and supply matter, i.e. ratio of “rise over run”, dP/dQ
prices fell – the
case of parallel
shifts in 1997
(97) vs 2005 (05)
Markets work…don’t they?
•Well, usually imperfectly
•When they don’t operate perfectly we need
–Incentives to ensure markets work
–Self-imposed rules – self-regulation, usually within an industry to prevent government regulation “overdose”
–Court and enforcement systems, norms, procedures, often referred as government institutions
•One of the key question for a start-up or new product:
There is a gap in the market, but is there a market in the gap? How to balance costs and revenues?
Fixed and variable costs when costing mechanism is complicated…
Economists simply separate Costs into FIXED (FC), which do not depend on output (Q) level, and VARIABLE (VC), that change with output level. Total Costs (TC) = Fixed (FC) + Variable (VC) Costs
Market (niche) size does matter!
•Especially with high R&D and marketing costs of new goods
•The break-even point (analysis) is a minimum market size (sales/output Q) at which total costs equal total revenue
•Opportunity costs of production are paid, but zero profit
•Recall that in economics marginal costs and revenue matter – how many thing you need to sell to cover total Variable Costs (VC) = Unit Variable Costs (UVC)*Q ?
•Total Revenue = P*Q = Total Costs = FC + UVC*Q
•P*Q – UVC*Q = FC, hence, (P - UVC)*Q = FC
Break-even output Q = BEP =
More details from accounting perspectives will follow in the
accounting part of the module
Break-even point (BEP) – minimum output
Margin of safety is difference between number of current units sold and BEP
In output units: Margin of safety = Sales - BEP
In-class exercise on minimum market for soda
•Costs are in p – pence per one can of soda drink
•(direct) Materials cost: Electricity – (1p),
-Aluminum cover - (2p), cover paint – (1p),
-Cola concentrate (3p), purified water – (1p)
“Secret” ingredient (2p) – reflects a differentiation strategy or unique selling point
-Managerial – (£1000.00), renting equipment – (£2000.00) Other overheads:
Marketing – (£2500.00), Administrative (£500.00)
-Separate costs and find Variable(VC) and Fixed(FC) costs
If wholesale price of one can of soda is 20p, find minimum market size (BEP) for this soda company
When markets may not work (effectively)?
–If transactions costs of using markets are much higher than that of other institutional arrangements
Example – within firms - why in a firm often there is no clear market for every job/responsibility allocation?
–Demand is too small to cover the marginal cost of supply; for example, development of drugs for neglected diseases
–information is NOT perfect, i.e. somebody has better access to important information (Adverse selection, Moral hazard)
–Price may be influenced by a seller/buyer (market power)
–Externalities – the third party, which has not participated in market transactions, is essentially affected, e.g. “too big to fail” when public is affected by bankruptcy of a large bank
–Public goods (non-rival and non-excludable in consumption)
–Markets do not automatically reduce income inequality…
Demand is insufficient to cover the marginal cost of supply – no supply
28 MPG -
Markets do not address normative (ethical?) income distribution (not quite a market failure)
Explaining Consumer Complaints
•Most markets work well
•Particularly where there are frequent and very low cost transactions
•Question: Why is it easier to find a high quality supplier of fruit and vegetables than it is to find a high quality firm to carry out domestic building/reparment work correctly?
•(see the case of rogue traders on duo)
Adverse Selection (market for “lemons”)
double glazing example
•75 % chance of high quality units and service
•25% chance of poor quality units and service
–High quality units, fitting and installation costs £1200
–Low quality units, fitting and installation costs £600
•Consumer expected willingness to pay
–(0.75 x £1200) + (0.25 x £600) = £1050
•Thus, market has a problem. High quality suppliers will not be able to operate and ‘rational’ consumers will note that only low quality suppliers will operate in the market for a surplus/profit of £1050 - £600 = £450.
•As a result we might have MARKET FAILURE.
•Market double glazing may disappear as nobody would purchase local units and services…
•Defined as a process by which an undesirable population of buyers or sellers with an imperfect information participate in voluntary exchange
•In this instance the ‘undesirable population’ are sellers (‘cowboys’)
•In contract theory this is one of Principal
(employer) - Agent (employee) problems
•The Principal (uninformed party) does not knowcharacteristics of the agent (informed party – service provider) and the uninformed party moves first by contracting the informed party
•An action taken not in the interests of Principal by the informed party after a contract is signed
•An ex post contractual opportunism
•Example – after a contract is signed, a CEO plays golf all days instead of increasing firm value
•Customer chooses a supplier, pays over a deposit, but once ‘locked in’ to the transaction, the supplier may ‘act with guile’
•Behaviour of Mr Simpson (in the cartoon
“Simpsons”) with and without life insurance
–Market prices do not always incorporate all impacts of activities of either producer or consumer
–Consumption or production has indirect effect on other parties; the national welfare not reflected in market prices/transactions
–Externalities could be positive, e.g. a smart student asking questions in class that benefit other students
–Or negative, e.g. pollution from cars or factories
–In modern knowledge-based economy externalities are rather systemic
External Costs – plant dumping waste;
S – Social, M - private
The efficient output level is q* where Marginal Social Costs (MSC) =Marginal Social Benefits.
S = MCI