Finance 30210: Managerial
Economics
Introduction
“Economics deals with the Allocation of
scarce resources to satisfy unlimited
wants”
“You can’t always get what you
want…”
- Mick Jagger
Consumers have
limited incomes to
spend on a wide
variety of goods and
services (both now
and in the future)
Workers have a finite
number of hours in
the day to work, relax,
go to school, etc
Firms have finite
capacity and limited
financial resources, to
produce goods and
services
Microeconomics is all about making the most of these limits
If we can’t have everything we want, so we need to decide what to do with the limited
resources we do have.
Efficiency vs. Equity
An allocation of resources
that maximum total welfare
Under certain
circumstances, the
market process
guarantees this
An allocation of resources
provides a “fair”
distribution of welfare
Can we trust markets to
produce a desirable
outcome?
When thinking about efficiency, think about the impact on individuals!
VS.
Suppose that Exxon acquires drilling
rights within a remote area where
there will be negligible
environmental damage in the
traditional sense
The Sierra club files a lawsuit to block the drilling
(Their personal serenity has been threatened by the
knowledge that the oil is being removed from it’s
natural habitat)
If you are the judge, who should prevail?
VS.
If Exxon Wins:
•Exxon stockholders
gain
•Workers gain from
added jobs
•Motorists see falling
gasoline prices
If Exxon Wins:
•Sierra club members
lay awake at night
screaming
-$5M
$10M
A ruling against Exxon in this example would be inefficient – a missed opportunity
to make everyone better off.
Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace
"Greed captures the essence of the
evolutionary spirit."
-Gordon Gekko
Introducing homo economicus….also known as
“Economic Man”
Economic man is a RATIONAL being
The Fundamental Rule of Economics: Individuals are rational
beings and therefore respond to incentives
Economic Incentive = (Expected) Benefit – Opportunity Cost
Opportunity cost = Direct (Money) Costs + Indirect Costs
In other words, think about opportunity cost as the value of
ALL the resources that have been consumed
Example: Do you have an incentive to be here?
Costs
Benefits (Mendoza Grads)
Tuition & Fees: $39,920
Median Salary: $56,000
Room & Board: $10,870
- HS Grad Salary: $26,000
Books/Supplies: $1,000
Other Expenses: $900
Transportation: $500
Lost Salary: $26,000
Total: $67,820 X 4 = $271,280
Difference: $30,000/yr
Think of the salary differential as
interest being collected from an
initial investment
$30,000/yr
= .011 (11.0%)
$271,280
Competitive markets will yield efficient outcomes (that is, maximize total gains), but not
necessarily equitable outcomes.
•Many producers/consumers
•Homogeneous product
•No taxes, subsidies, tariffs, quotas, etc.
•Perfect information
•No externalities
Consumers with the
highest values stand
to gain the most
The average
consumer/producer
stands to gain very
little
This is where the equity issues arise!
Producers with
the lowest
costs stand to
gain the most
Markets are all about taking advantage of differences in opportunity cost.
Consider the following example. Two countries (the US and Mexico) producing
two different goods (Agriculture and Manufacturing).
Mexico
USA
Manufacturing
4 units/hr
5 units/hr
Agriculture
5 units/hr
4 units/hr
Note: Assume that wages are equal across sectors
Everything we do involves a cost (Time, money, or both). Opportunity cost measures all
the costs involved with an activity. In this example, the cost of manufacturing in Mexico
is the time spent. We need to value that time.
1 Unit of
manufactured goods
5/4 units of agriculture
lost
¼ hour of time spent
5 units of
agriculture
per hour
Mexico
5A
Manufacturing
Agriculture
4 units/hr
5 units/hr
A
hr
OC M 
 1.25
M
M
4
hr
4 units of
manufacturing
per hour
1.25 units of
agriculture per
unit of
manufacturing
We could work this the other way and figure the opportunity cost for Mexico of
producing agriculture.
1 Unit of
agriculture
4/5 units of
manufacturing lost
1/5 hour of time spent
4 units of
manufacturing
per hour
Mexico
4M
Manufacturing
Agriculture
4 units/hr
5 units/hr
M
hr
OC A 
 .80
A
A
5
hr
5 units of
agriculture
hour
per
.80 units of
manufacturing
per unit of
agriculture
In terms of opportunity cost, Mexico has the lower cost of agriculture (in terms of lost
manufacturing) and the US has a lower cost of Manufacturing (in terms of lost
agriculture). We would say that Mexico has a comparative advantage in agriculture
while the US has a comparative advantage in manufacturing
Mexico
USA
Manufacturing
1.25 Units of
Agriculture
.80 Units of
Agriculture
Agriculture
.80 Units of
Manufacturing
1.25 Units of
Manufacturing
Suppose that both the US and Mexico had 40 hrs per week available to
produce both goods:
For every unit of
agriculture produced, the
US gives up 1.25 units of
manufactured products
M
For every unit of
agriculture produced,
Mexico gives up .80 units
of manufactured products
M
200
Slope = 1.25
Slope = .80
160
100
80
80
160
A
If the US devoted half its resources to each sector, it
could have 80 units of agriculture and 100 units of
manufacturing
100
200
A
If Mexico devoted half its resources to each sector,
it could have 100 units of agriculture and 80 units of
manufacturing
Prices will determine what actually gets produced in each country:
Suppose that the wage rate in
the US is $10/hr
USA
Manufacturing
5 units/hr
1 unit = 1/5 hr
$2 unit
cost
Agriculture
4 units/hr
1 unit = 1/4 hr
$2.50
unit cost
Lets look at the profitability of each
industry in the US
Profit  (Price - Cost)Q A
With a wage of $10/hr, the
price of agriculture has to be
at least $2.50/unit while
manufacturing has to be at
least $2 to be profitable
How do markets provide efficient outcomes? PRICES!!
A unit of manufacturing sells for $2.00
A unit of agriculture sells for $2.50
The relative price of agriculture (in terms of manufacturing) is
$2.50
$2.00
= 1.25 (Units of manufacturing per unit of agriculture)
Why should we only be interested in relative prices?
Relative price of agriculture (in terms of
manufactured goods)
Profit  (Price - Cost)Q A
Profit from producing
agriculture (in terms of
manufactured goods)
M
200
Relative cost of agriculture (in terms of
manufactured goods) (equals 1.25)
If the relative price of agriculture is below 1.25, labor in the US is
dedicated to manufacturing
QA  0
If the relative price of agriculture is above 1.25, labor in
the US is dedicated to agriculture
160
A
QA  160
We get similar results in Mexico
Profit  (Price - Cost)Q A
In Mexico, the relative cost of agriculture is
.80
M
If the relative price of agriculture is below .80, labor in Mexico is
dedicated to manufacturing
QA  0
160
If the relative price of agriculture is above .80, labor in
Mexico is dedicated to agriculture
200
A
QA  200
For any relative price of agriculture between .80 and 1.25, Mexico will specialize in
agriculture and the US will specialize in manufacturing. Suppose the price of
agriculture is one (each agricultural item is traded for one manufactured item)
With trade, The US specializes
in manufacturing (produces
200 units) and then sells 100
units of them for 100 units of
agriculture
M
With trade, Mexico specializes in
agriculture (produces 200 units) and then
sells 100 units of them for 100 units of
manufacturing
M
Production point
200
Consumption point
160
Consumption point
100
80
100
80 100 160
Gain = 20 Agricultural Goods
A
Production point
100
200
A
Gain = 20 Manufactured Goods
Suppose the agreed upon price of agriculture is .80 (each agricultural item is traded
for .80 manufactured items
With trade, The US specializes in
manufacturing (produces 200 units) and
then sells 100 units of them for 125 units
of agriculture
M
With trade, Mexico specializes in
agriculture (produces 200 units) and then
sells 125 units of them for 100 units of
manufacturing
M
200
160
100
100
80 125 160
A
Gain = 45 Agricultural Goods
75
Gain = 0
200
A
Suppose the agreed upon price of agriculture is 1.25 (each agricultural item is traded
for 1.25 manufactured items
With trade, The US specializes in
manufacturing (produces 200 units) and
then sells 100 units of them for 80 units
of agriculture
M
With trade, Mexico specializes in
agriculture (produces 200 units) and then
sells 80 units of them for 100 units of
manufacturing
M
200
160
100
100
80
Gain = 0
160
A
120
200
A
Gain = 20 Agriculture, 20 Manufacturing
How do we know what price will actually be?
PA
S
For prices above 1.25, both countries specialize
in agriculture
1.25
For prices between .80 and 1.25, both
countries are completely specialized (US in
manufacturing, Mexico in Agriculture)
.80
200
360
A
For prices below .80, neither country produces agriculture
But supply is only half the story!!
The location of the demand curve will determine the price!!
PA
In equilibrium, demand must equal
supply. In this case, 200 units of
agriculture are produces (all in Mexico)
and are sold at a relative price of 1.15
S
1.25
1.15
.80
200
D
A
Note: We would get a similar
picture for Manufacturing
Suppose we change this example slightly. Now, the US has an absolute advantage in
everything. However, Mexico still has a comparative advantage in agriculture.
Mexico
USA
Manufacturing
4 units/hr
10 units/hr
Agriculture
5 units/hr
8 units/hr
1 Unit of
agriculture
1/8 hour of time spent
10/8 = 1.25 units of
manufacturing lost
1 Unit of
agriculture
1/5 hour of time spent
4/5 = .80 units of
manufacturing lost
Multiple Producers/Consumers
Suppose that you have been elected president of the US. Your job is to find the
most efficient production/consumption pattern for wheat. You know that different
consumers/producers have different values/costs
Producers
Consumers
Producer
Unit Cost
Capacity
#1
6
200
#2
4
100
#3
3
400
#4
5
300
Consumer Reservation Demand
Price
#1
3
200
#2
5
100
#3
4
400
#4
6
200
However, you can’t tell them apart! What do you do?
Note: All values are relative to some general price index
Competitive markets provide the efficient solution
The Supply curve sorts potential
producers by cost
The Demand curve sorts potential
buyers by value
S
PW
PW
6
6
5
5
4
4
3
3
400 500
800
1000
W
200 300
What should the equilibrium price be?
700
900
D
W
Competitive markets provide the efficient solution
Note that the gains are not
distributed equally!!
Producer
S
PW
6
5
4
Production
Profit
#1 (C = 6) 0
0
#2 (C = 4) 100
0
#3 (C = 3) 400
400
#4 (C = 5) 0
0
#4
Consumer Consumption “Profit”
#2
#3
3
D
200 400
500
W
#1 (V = 3) 0
0
#2 (V = 5) 100
100
#3 (V = 4) 200
0
#4 (V = 6) 200
400
Total “Profit” = 900
The Average Shopping cart in the US today is
approximately three times as big as its 1975
counterpart
Ralph Nader has argued that this is a prime example of
consumers being manipulated by unscrupulous
capitalists – bigger carts shame consumers into bigger
purchases.
What’s wrong with this argument?
Microsoft’s new Xbox 360 gaming console was released in North America on
November 22, 2005 at a retail price of $299.99. Available supply sold out almost
immediately as Christmas shoppers stood in line for this year’s hot item. (Microsoft
has increased its sales target from 3M units to 6M units).
What’s odd about this??
In the years following a divorce, statistics show that the
woman’s living standard falls 27% while the man’s living
standard rises by 10%
Feminists such as Patricia Ireland (NOW) would
argue that this proves divorce is unfair to women
Couldn’t you just as easily argue that marriage is
unfair to men?
On December 22, 2001, Richard Reid was arrested trying
to blow up an American Airlines flight from Paris to
Miami with a bomb hidden in his shoes.
Many human rights groups have fought
heavily against the practice of racial
profiling by airline security
Isn’t there a better way to secure the safety of our
airplanes? (Hint: could we create a marketplace?)
Paul “Freck” Morgan started a website in 2001 offering a $20 Pay
Per View event…..to watch him cut off his feet with a homemade
guillotine.
Note: The site turned out to be a
hoax…Paul never actually went
through with it!
How should we feel about this entrepreneurial effort? (i.e. could
we/should we repress this market?)