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
We have limited incomes
to spend on a wide
variety of goods and
services (both now and in
the future)
We 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
The economy as a whole has a finite number of resources trying to satisfy a
population with unlimited wants! We need to make choices!!
What’s the difference between Macroeconomics and Microeconomics?
Nothing!!!
Both are interested in allocations of resources….
Macro
•We allocate our time towards either
leisure or labor
•We allocate our available resources
towards either consumption ,investment,
or government
Macro allocations determine the
size of the pie
Micro
•We allocate our time towards a variety
of different activities
•We allocate consumption/investment
goods across a range of uses
Micro allocations determine who
gets what slice
Macro Example: The US Economy
Consumption
GDP
Business
Investment
Government
1950
1960
•Consumption (62%)
•Investment (12%)
•Government(24%)
•Net Exports (2%)
1970
1980
1990
2000
2010
•Consumption (69%)
•Investment (17%)
•Government(18%)
•Net Exports (-4%)
Micro Example: Uses of corn
1950
1960
•Fed to livestock (75%)
•Exported (13%)
•Food and Industrial Products
(12%)
1970
1980
1990
2000
2010
•Fed to livestock (60%)
•Exported (22%)
•High Fructose corn syrup (6%)
•Ethanol Production (6%)
•Food and Industrial Products (6%)
How do we rank various allocations?
Efficiency vs. Equity
An allocation of
resources that maximize
total welfare
An allocation of resources
provides a “fair”
distribution of welfare
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?
If you are interested in efficiency you are trying to allocate resources to their highest
value
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.
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 – i.e. they respond to
opportunities with Economic Profit
Economic Profit = Benefit – Opportunity Cost
Opportunity cost = Direct (Money) Costs + Implicit Costs
In other words, think about opportunity cost as the value of
ALL the resources that are being used
Example: What would be the opportunity cost of attending Notre Dame as an
undergraduate? Do students have an incentive to go to Notre Dame?
Item
Average 2011/2012 Expense
Tuition and Fees
$41,420
Room & Board
$11,390
Books & Supplies
$950
Personal Expenses
$1,000
Transportation
$500
Total
$55,260
$55,260 x 4 = $221,040
So if you wanted a 10% return on
your college education, you would
need to earn $22,000 a year more
per year after college
Is this right?
Example: What is IBM’s opportunity cost? Is IBM earning economic profit?
Item
2010*
Current Stock Price: $166
Shares Outstanding: 1,287M
Net Sales
99,870
Cost of Goods Sold
(49,358)
Depreciation
(4,831)
Gross Income
45,681
Selling, General, and Adm. Expense
(27,025)
Operating Income
18,656
Interest Income/Expense
1,067
Pretax Income
19,723
Income Taxes
(4,890)
Net Income
14,833
$166 * 1,287M = $213.6B
Is 5% a reasonable rate
of return?
$213.6B * .05 = $213.6B = $10.7B
* In Millions
Economic Profit = $14.8B - $10.7B = $4.1B
What does this mean from a business perspective? That is, why should we care?
Efficiency vs. Equity
An allocation of resources
that maximum total welfare
If we have an efficient outcome,
there are no opportunities to
create wealth.
An allocation of resources
provides a “fair”
distribution of welfare
With inefficient outcomes, there
are wealth creating
opportunities.
An inefficiency offers an opportunity to create wealth by moving resources to higher value
uses! This is done through voluntary transactions.
From a business standpoint, an inefficiency offers an opportunity to create wealth by
moving resources to higher value uses! This is done through voluntary transactions.
My Value - $80,000
Consumer Surplus
= $5,000
Suppose that you own a Porsche
that you value at $65,000, but I
value at $80,000
Example: Sale Price = $75,000
Producer Surplus =
$10,000
Your Value - $65,000
The sale of your
car creates
$15,000 of new
wealth. The sale
price determines
how that wealth
is allocated
between us
Exxon- $10M
Consumer Surplus
= $2M
Rather than bringing a judge
into the Exxon/Sierra Club
problem, we could let the
free market solve the
problem
Example: Sale Price = $8M
Producer Surplus = $3M
Sierra Club- $5M
The sale creates
$5M of new
wealth. The sale
price determines
how that wealth
is allocated
“A subtle but damaging factor in this is the dominance of economists at business
schools. Although there is no evidence that economists are less ethical than
members of other discipline, approaching the world through the dollar sign does
make people more cynical”*
Amitai Etzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002
“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500 above
its usual rate of $149”*
Ethicist Joe Holt responds…
“It is an act of moral abdication for businesses to pretend that they have no choice but to charge as much as
they can based on supply and demand”
* Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006
ALL voluntary
transactions create
wealth!!
Value = $700/Night
Consumer
Surplus = $50
Consumer
Surplus =
$550
Price = $650
Either way,
$600 of
wealth is
created!
Price = $150
Producer
Surplus = $50
Cost = $100/Night
Producer
Surplus =
$550
Cost = $100/Night
Cost = $100/Night
Value = $1000/Night
You have three
rooms to rent.
How do you set
the price to
create the most
wealth?
Value = $200/Night
Value = $600/Night
Cost = $100/Night
Value = $800/Night
Value = $400/Night
Value = $1000/Night
CS = $400
PS = $500
At a $600 per night price
we create $2100 of
wealth
Cost = $100/Night
CS = $200
Value = $800/Night
PS = $500
Cost = $100/Night
Value = $600/Night
Cost = $100/Night
PS = $500
CS = $600
PS = $1500
Value = $1000/Night
CS = $850
PS = $50
At a $150 per night price
we could create $2100 of
wealth
Cost = $100/Night
CS = $650
Value = $800/Night
PS = $50
Cost = $100/Night
CS = $450
Value = $600/Night
PS = $50
Cost = $100/Night
CS = $1950
PS = $150
Value = $200/Night
CS = $50
At a $150 per night price
we could create $900 of
wealth
PS = $50
Cost = $100/Night
CS = $250
Value = $400/Night
PS = $50
CS = $750
PS = $150
Cost = $100/Night
CS = $450
Value = $600/Night
PS = $50
Cost = $100/Night
If Marriott charged $150
per night, what should
happen?
Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace
"Greed captures the essence of the
evolutionary spirit."
-Gordon Gekko
Markets and prices allow resources to be distributed in a way to take advantage
of differences. Consider the following example. Two countries (the US and
Mexico) producing two different goods (Agriculture and Manufacturing).
Mexico
USA
Manufacturing
4 units/hr
10 units/hr
Agriculture
5 units/hr
8 units/hr
The United States has an Absolute advantage in both goods (we
require less labor for everything we produce)
Opportunity cost measures all the costs involved with an activity. In this example, the
cost of agriculture in the USA is the time spent. We need to value that time.
1 Unit of
agricultural
goods
1/8 hour of time spent
USA
Manufacturing
10 units/hr
Agriculture
8 units/hr
10/8 = 5/4 units of
agriculture lost
10 units of
manufacturing
per hour
10 M
M
hr
OC A 
 1.25
A
A
8
hr
8 units of
agriculture per
hour
1.25 units of
manufacturing
per unit of
agriculture
Now, lets figure out the opportunity cost for Mexico of producing agriculture.
1 Unit of
agriculture
1/5 hour of time spent
4/5 units of
manufacturing lost
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 per
hour
.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) . Likewise, 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
400
Slope = 1.25
Slope = .80
300
160
80
80
320
A
If the US devotes 10 hours to agriculture and 30
hours to manufacturing, we could have 80 units of
agriculture and 300 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
Suppose that, rather than producing both goods, the US specialized in
Manufacturing and Mexico specialized in Agriculture…we could both be better off!
With trade, The US could
specialize in manufacturing
(produce 400 units) and then
trade 100 units of them for
100 units of agriculture
M
With trade, Mexico could specialize in
agriculture (produces 200 units) and then
trade 100 units of them for 100 units of
manufacturing
M
Production point
400
300
Consumption point
160
Consumption point
100
80
200
80 100
320
Gain = 20 Agricultural Goods
A
Production point
100
200
A
Gain = 20 Manufactured Goods
Prices will determine what actually gets produced in each country:
Suppose that the wage rate in
the US is $10/hr
USA
Manufacturing
10 units/hr
1 unit = 1/10 hr
$1 unit
cost
Agriculture
8 units/hr
1 unit = 1/8 hr
$1.25
unit cost
Lets look at the profitability of each
industry in the US
Profit  (Price - Cost)Q
With a wage of $10/hr, the
price of agriculture has to be
at least $1.25/unit while
manufacturing has to be at
least $1 to be profitable
Suppose that manufactured goods sell for $4, while agricultural goods sell for $5
Suppose that the wage rate in
the US is $10/hr
USA
Manufacturing
10 units/hr
1 unit = 1/10 hr
$1 unit
cost
Agriculture
8 units/hr
1 unit = 1/8 hr
$1.25
unit cost
Manufacturing
Profit  ($4 - $1)Q  $3Q
Every hour of labor
generates $30 of profit
Agriculture
Profit  ($5 - $1.25)Q  $3.75Q
Every hour of labor
generates $30 of profit
Let’s look at these prices in relative terms…
A unit of manufacturing sells for $4.00
A unit of agriculture sells for $5.00
The relative price of agriculture (in terms of manufacturing) is
$5.00
$4.00
= 1.25 (Units of manufacturing per unit of agriculture)
When the relative price of agriculture equals 1.25 (the relative cost), both
industries are equally profitable!
Suppose that manufactured goods sell for $4.50, while agricultural goods sell for $5
Suppose that the wage rate in
the US is $10/hr
USA
Manufacturing
10 units/hr
1 unit = 1/10 hr
$1 unit
cost
Agriculture
8 units/hr
1 unit = 1/8 hr
$1.25
unit cost
Manufacturing
Profit  ($4.50 - $1)Q  $3.50Q
Every hour of labor
generates $35 of profit
Agriculture
Profit  ($5 - $1.25)Q  $3.75Q
Every hour of labor
generates $30 of profit
Let’s look at these prices in relative terms…
A unit of manufacturing sells for $4.50
A unit of agriculture sells for $5.00
The relative price of agriculture (in terms of manufacturing) is
$5.00
$4.50
= 1.11 (Units of manufacturing per unit of agriculture)
When the relative price of agriculture is less than 1.25 (the relative cost),
manufacturing is more profitable!
Suppose that manufactured goods sell for $4.00, while agricultural goods sell for $5.50
Suppose that the wage rate in
the US is $10/hr
USA
Manufacturing
10 units/hr
1 unit = 1/10 hr
$1 unit
cost
Agriculture
8 units/hr
1 unit = 1/8 hr
$1.25
unit cost
Manufacturing
Profit  ($4 - $1)Q  $3Q
Every hour of labor
generates $30 of profit
Agriculture
Profit  ($5.50 - $1.25)Q  $4.25Q
Every hour of labor
generates $34 of profit
Let’s look at these prices in relative terms…
A unit of manufacturing sells for $4.00
A unit of agriculture sells for $5.50
The relative price of agriculture (in terms of manufacturing) is
$5.50
$4.00
= 1.38 (Units of manufacturing per unit of agriculture)
When the relative price of agriculture is more than 1.25 agriculture is more
profitable!
So relative prices are driving production patterns…
Example #2:
manufactured goods
sell for $4.50, while
agricultural goods sell
for $5
M
400
Relative price of
agriculture is less
than 1.25
Example #1:
manufactured goods
sell for $4.50, while
agricultural goods sell
for $5
320
A
Relative price of
agriculture is equal
to 1.25
Example #3:
manufactured goods
sell for $4.00, while
agricultural goods sell
for $5.50
Relative price of
agriculture is
greater than 1.25
Note that, keeping relative prices constant, changing absolute prices
and wages has no affect on production, but alters the distribution of
gains between workers and factory owners.
Manufacturing
Agriculture
10 units/hr
8 units/hr
Manufacturing
Suppose that manufactured goods sell for $4,
while agricultural goods sell for $5, the wage
rate is $10/hr
Agriculture
1 Hour of Labor
1 Hour of Labor
$40 of Output
$10 of Wages
$30 of Profits
$40 of Output
$10 of Wages
$30 of Profits
Note that, keeping relative prices constant, changing absolute prices
and wages has no affect on production, but alters the distribution of
gains between workers and factory owners.
Manufacturing
Agriculture
10 units/hr
8 units/hr
Manufacturing
Suppose that manufactured goods sell for $8,
while agricultural goods sell for $10, the wage
rate is $10/hr
Agriculture
1 Hour of Labor
1 Hour of Labor
$80 of Output
$10 of Wages
$70 of Profits
$80 of Output
$10 of Wages
$70 of Profits
Note that, keeping relative prices constant, changing absolute prices
and wages has no affect on production, but alters the distribution of
gains between workers and factory owners.
Manufacturing
Agriculture
10 units/hr
8 units/hr
Manufacturing
Suppose that manufactured goods sell for $4,
while agricultural goods sell for $5, the wage
rate is $20/hr
Agriculture
1 Hour of Labor
1 Hour of Labor
$40 of Output
$20 of Wages
$20 of Profits
$40 of Output
$20 of Wages
$20 of Profits
We get similar results in Mexico
Relative price of
agriculture is less
than .80
M
Relative price of
agriculture is equal
to .80
Relative price of
agriculture is
greater than .80
160
200
A
M
This leaves us with three possibilities…
400
#1: The relative price of
agriculture is below .80 – both
countries specialize in
manufacturing (no trade)
Slope = 1.25
A
320
M
160
#2: The relative price of
agriculture is between .80 and
1.25 – US produces manufactured
goods, Mexico produces
agriculture countries specialize in
manufacturing (trade)
#3: The relative price of
agriculture is above 1.25 – both
countries specialize in agriculture
(no trade)
Slope = .80
200
A
Suppose that the relative price of
agriculture is 1
Price of manufacturing equals $8
Price of agriculture equals $8
Wages equal $10/hr
With trade, The US specializes
in manufacturing (produces
400 units) and then trades 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
400
300
Consumption point
160
Consumption point
100
80
200
80 100
320
Gain = 20 Agricultural Goods
A
Production point
100
200
A
Gain = 20 Manufactured Goods
Suppose that the relative price of
agriculture is 1
Price of manufacturing equals $8
Price of agriculture equals $8
Wages equal $10/hr
M
M
400
400
300
300
200
80
320
Manufacturing (30 hours):
•Output: $2400
•Wages Paid: $300
•Profits: $2100
Agriculture (10 Hours):
•Output: $640
•Wages Paid: $100
•Profits: $540
A
Net gain is $160 in extra
profits (i.e. 20
agricultural goods)
80 100
320
Manufacturing (40 hours):
•Output: $3200
•Wages Paid: $400
•Profits: $2800
Agriculture (0 Hours):
•Output: $0
•Wages Paid: $0
•Profits: $0
A
Suppose the agreed upon relative
price of agriculture is .80
Price of manufacturing equals $10
Price of agriculture equals $8
Wages equal $10/hr
With trade, Mexico specializes in
agriculture (produces 200 units)
and then sells 125 units of them
for 100 units of manufacturing
With trade, The US specializes in
manufacturing (produces 400 units)
and then sells 100 units of them for
125 units of agriculture
M
M
Production point
400
300
Consumption point
200
160
100
80 125
320
Gain = 45 Agricultural Goods
A
75
Gain = 0
200
A
Suppose the agreed upon price of
agriculture is .80 (each agricultural
item is traded for .80 manufactured
items
Price of manufacturing equals $10
Price of agriculture equals $8
Wages equal $10/hr
M
M
400
400
300
300
200
80
320
Manufacturing (30 hours):
•Output: $3000
•Wages Paid: $300
•Profits: $2700
Agriculture (10 Hours):
•Output: $640
•Wages Paid: $100
•Profits: $540
A
Net gain is $360 in extra
profits (i.e. 45
agricultural goods)
80 125
320
Manufacturing (40 hours):
•Output: $4000
•Wages Paid: $400
•Profits: $3600
Agriculture (0 Hours):
•Output: $0
•Wages Paid: $0
•Profits: $0
A
Suppose the agreed upon relative
price of agriculture is 1.25
Price of manufacturing equals $10
Price of agriculture equals $12.50
Wages equal $10/hr
With trade, Mexico specializes in
agriculture (produces 200 units)
and then sells 100 units of them
for 125 units of manufacturing
With trade, The US specializes in
manufacturing (produces 400 units)
and then sells 125 units of them for
100 units of agriculture
M
M
Production point
400
275
Consumption point
200
160
125
80
100
Gain = 0
320
A
100
200
Gain = 45
Manufactured Goods
A
Suppose the agreed upon price of
agriculture is 1.25
Price of manufacturing equals $10
Price of agriculture equals $12.50
Wages equal $10/hr
M
M
400
400
300
300
200
80
320
Manufacturing (30 hours):
•Output: $3000
•Wages Paid: $300
•Profits: $2700
Agriculture (10 Hours):
•Output: $1000
•Wages Paid: $100
•Profits: $900
A
Net gain is $0 in extra
profits
80
320
Manufacturing (40 hours):
•Output: $4000
•Wages Paid: $400
•Profits: $3600
Agriculture (0 Hours):
•Output: $0
•Wages Paid: $0
•Profits: $0
A
We can actually sketch out the world supply curve for
agriculture…
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
520
A
For prices below .80, neither country produces agriculture
Producer surplus measures he difference between price and cost for every good
sold…
PA
1.25
.45
M
A
S
M
250
Gain = 90
Manufactured
foods
160
Gain = 90
Manufactured foods
.80
200
520
A
200
A
200 A
M

PS  200 A .45   90 M
A

At a relative price of agriculture equal to 1.25,
Mexico’s potential producer surplus would be
90 Manufactured goods if they traded
everything. Note that US gains are zero
We could also sketch out the world supply curve for
manufacturing…
PM
S
For prices above 1.25, both countries specialize
in ,manufacturing
1.25
For prices between .80 and 1.25, both
countries are completely specialized (US in
manufacturing, Mexico in Agriculture)
.80
400
520
M
For prices below .80, neither country produces manufacturing
Producer surplus measures he difference between price and cost for every good
sold…
PM
1.25
.45
A
M
S
M
400
Gain = 180
Manufactured
foods
Gain = 180
Manufactured
foods
.80
400
560
A
320
500
400M
A

PS  400 M  .45   180 A
M

At a relative price of manufacturing equal to
1.25, USA’s potential producer surplus would
be 180 agricultural goods if they traded
everything. Note that Mexico’s gains are zero
A
Suppose we add another country…
Manufacturing
4 units/hr
10 units/hr
7 units/hr
Agriculture
5 units/hr
8 units/hr
7 units/hr
.80 units of
manufacturing
per unit of
agriculture
1.25 units of
manufacturing
per unit of
agriculture
Again, assume each country has 40 hrs available…
1units of
manufacturing
per unit of
agriculture
Suppose we add another country…
S
No Trade
Mexico and
Canada Exports
Agriculture to USA
Mexico Exports
Agriculture to USA
and Canada
No Trade
PA
1.25
1.00
.80
200
480
800
A
Just as with the previous example, relative prices determine trading
patterns and gains to each country.
So, the moral of this story is…
Free markets with prices that reflect the proper information
creates allocations of resources that are efficient (i.e. wealth
maximizing). With an efficient allocation, no more wealth
creating transactions are possible.
However, an efficient allocation of resources makes
no guarantees of equity…we will have winners and
losers in a market system. Are we willing to
sacrifice efficiency to improve equity?
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?)