Chapter 1

Introduction to Managerial Economics

Definition of Economics

Economics is a social science concerned with the production, distribution, and consumption of
goods and services. It studies how individuals, businesses, governments, and nations make choices
about how to allocate resources.
Economics can generally be broken down into macroeconomics, which concentrates on the
behavior of the economy as a whole, and microeconomics, which focuses on individual people and
businesses.
Importance of Economics
• Dealing with a shortage of raw materials. Economics provides a mechanism to compute the
possible loss if businesses run out of raw materials and to which product should be prioritize.
• How to distribute resources. How resources like machine time, raw materials and etc. should be
distributed to products or department for profit maximization.
• The role of government in our economy and how the government intervene with economy
• Opportunity cost of decisions. Economics takes opportunity cost into consideration in making
decisions.
• Social efficiency. Economics provide solutions to overcome market failure or economic failure of
government.
• Forecasts. Economics can help decision makers predict the possible future scenarios
• Evaluation. Economics could be used to evaluate past decisions.

Definition of Managerial Economics

Managerial Economics is the use of economic analysis to make business decisions involving the
use or allocation of an organization’s scarce resources. In other words, Managerial Economics is applied
economics.
Economic Systems
An economic system is a means by which societies or governments organize and distribute available
resources, services, and goods across a geographic region or country. Economic systems regulate factors
of production, including capital, labor, physical resources, and entrepreneurs. An economic system
encompasses many institutions, agencies, and other entities.
Types of Economic Systems
There are many economies around the world. Each has its own distinguishing characteristics, although
they all share some basic features. Each economy functions based on a unique set of conditions and
assumptions. Economic systems can be categorized into four main types: traditional economies,
command economies, mixed economies, and market economies.
1. Traditional economic system
The traditional economic system is based on goods, services, and work, all of which follow certain
established trends. It relies a lot on people, and there is very little division of labor or specialization. In
essence, the traditional economy is very basic and the most ancient of the four types.
Some parts of the world still function with a traditional economic system. It is commonly found in rural
settings in second- and third-world nations, where economic activities are predominantly farming or
other traditional income-generating activities.
There are usually very few resources to share in communities with traditional economic systems. Either
few resources occur naturally in the region or access to them is restricted in some way. Thus, the
traditional system, unlike the other three, lacks the potential to generate a surplus. Nevertheless,
precisely because of its primitive nature, the traditional economic system is highly sustainable. In
addition, due to its small output, there is very little wastage compared to the other three systems.
 
2. Command economic system
In a command system, there is a dominant, centralized authority –  usually the government – that
controls a significant portion of the economic structure. Also known as a planned system, the command
economic system is common in communist societies since production decisions are the preserve of the
government.
If an economy enjoys access to many resources, chances are that it may lean towards a command
economic structure. In such a case, the government comes in and exercises control over the resources.
Ideally, centralized control covers valuable resources such as gold or oil. The people regulate other less
important sectors of the economy, such as agriculture.
In theory, the command system works very well as long as the central authority exercises control with
the general population’s best interests in mind. However, that rarely seems to be the case. Command
economies are rigid compared to other systems. They react slowly to change because power is
centralized. That makes them vulnerable to economic crises or emergencies, as they cannot quickly
adjust to changed conditions.
3. Market economic system
Market economic systems are based on the concept of free markets. In other words, there is very little
government interference. The government exercises little control over resources, and it does not
interfere with important segments of the economy. Instead, regulation comes from the people and the
relationship between supply and demand.
The market economic system is mostly theoretical. That is to say, a pure market system doesn’t really
exist. Why? Well, all economic systems are subject to some kind of interference from a central
authority. For instance, most governments enact laws that regulate fair trade and monopolies.
From a theoretical point of view, a market economy facilitates substantial growth. Arguably, growth is
highest under a market economic system.
A market economy’s greatest downside is that it allows private entities to amass a lot of economic
power, particularly those who own resources of great value. The distribution of resources is not
equitable because those who succeed economically control most of them.
4. Mixed system
Mixed systems combine the characteristics of the market and command economic systems. For this
reason, mixed systems are also known as dual systems. Sometimes the term is used to describe a
market system under strict regulatory control.
Many countries in the West follow a mixed system. Most industries are private, while the rest,
comprised primarily of public services, are under the control of the government.
Mixed systems are the norm globally. Supposedly, a mixed system combines the best features of market
and command systems. However, practically speaking, mixed economies face the challenge of finding
the right balance between free markets and government control. Governments tend to exert much
more control than is necessary.
Wealth Creation of the Government
Capitalism and Socialism (Communism) are economics systems that countries use to manage their
economic resources and regulate their means of production.
Capitalism is where private individuals or businesses own and controls factors of production, in a
capitalism, the government earns money by selling rights, licence and contracts to individuals. While in
socialism, the government earns money by producing their products and services.

Activity
Identify an unconsummated wealth-creating transaction (or a wealth destroying one) created by some
tax, subsidy, price control, or other government policy and then figure out how to profitably
consummate it (or deter it). Estimate how it can change our present economic status if this wealth is
consummated (or deter).

Chapter 2
Tactical Decision Making
Relevant Cost vs Irrelevant Cost

Relevant costs are cost that changes depending on the decision, it behaves like variable cost, the
difference is that variable cost depends on the production level while relevant cost depends on the
decision. Generally all variable costs are relevant cost.

Irrelevant cost are cost that doesn’t change whatever the decision, it behaves like fixed cost. Generally
all fixed costs are irrelevant cost.

Example:

In a company there are 500 employees. The employees union proposes collective negotiation
agreement (CNA) whereby air-conditioning units shall only be open 9am-4pm instead of 8am-5pm, this
form part of a saving to be distributed as a bonus of P25,000 per employee. Considering the company
saves 500 KWh a day which cost P10/KWh because of this agreement and there are 300 working days a
year, and basic salary of all employees is P6,250,000.00 should the company agree to the CNA?

Accept Reject
Bonus 25,000 * 500 = 1,250,000 0
Accept Reject
Electricity savings 10*500*300 = 1,500,000 0
Relevant cost:
Relevant revenue

Irrelevant cost:

Accept Reject
Basic Salary of Employees 6,250,000 6,250,000
Note that accepting or rejecting the offer will not change the basic salary of the employees.

Marginal Analysis

Marginal Analysis is an examination of the additional benefits of an activity compared to additional cost
incurred by the activity.

Marginal analysis compares the Marginal Revenue (MR) and the Marginal Cost (MC).

Marginal Revenue (MR) is the additional revenue gained from selling one more unit.

Marginal Cost (MC) is the additional cost incurred by producing and selling one more unit.

If MR > MC; sell more. If MR < MC; sell less. If MR = MC, you are selling the right amount (maximizing
profit)

The marginal revenue decreases as the number unit increases this may be due to the quantity discount
or bargains.

Example:

No. of Units Marginal Revenue Marginal Cost

1 5 3
2 4 3
3 3 3
4 2 3
To maximize the profit, the company should sell 3 units of the product, because if the company sells 4
units the marginal revenue would then be 2 which is less than the cost of 3

Sometimes it’s not the marginal revenue that decreases but each additional unit sold would be harder
and will cost more, this is true for Advertising Expense.

The demand created in advertising a product for the first time is greater than the demand created for
the subsequent advertisement.

Example:

Advertising Expense Additional Customers Cost per new customers

P10,000 2,000 5.00
P20,000 3,386 7.21
P40,000 4,773 14.42
P42,000 4,870 20.62
P44,000 4,963 21.51
Cost per new customer = Additional Advertising Expense / Additional Customer
Example: 7.21 = (20,000-10,000)/(3,386/2,000)

If the Marginal Revenue is 21, the best advertising plan is the P42,000

Presenting the advertising plan in income statement:

10,000 20,000 40,000 42,000 44,000

Marginal Revenue/customer P21 P21 P21 P21 P21
x additional customer 2,000 3,386 4,773 4,870 4,963
Total Marginal Revenue 42,000 71,106 100,233 102,270 104,223
Total Marginal Cost/Adv. Ex. (10,000) (20,000) (40,000) (42,000) (44,000)
Marginal Income 32,000 51,106 60,233 60,270 60,223

Deciding between alternatives

Managers often have to decide between competing strategies to achieve the same end. Marginal
Analysis could be used to decide which alternatives yield to the highest income

Example:

There are two movies in a cinema, one movie is an action movie while the other is an horror movie, over
advertising one movie will make the other movie under advertise. The cinema only has 100,000 budget
on advertising

Action Movie Horror Movie Total

Viewers
Ad Expense # Viewers MC Ad Expense #Viewers MC

P10,000 3,386 2.95 P90,000 3430 63.69 6,816

P20,000 4,197 12.33 P80,000 3273 56.18 7,470
P30,000 4,773 17.36 P70,000 3095 48.54 7,867
P40,000 5,219 22.42 P60,000 2889 41.15 8,108
P50,000 5,584 27.39 P50,000 2646 33.55 8,229
P60,000 5,892 32.46 P40,000 2348 26.11 8,240
P70,000 6,159 37.45 P30,000 1965 18.48 8,124
P80,000 6,394 42.55 P20,000 1424 10.82 7,819
P90,000 6,605 47.39 P10,000 500 20.00 7,105
Advertising expense of 60,000 to Action Movie and 40,000 to horror movie will yield to the most
number of viewers.

Incentive Pay

Payment of incentive encourages hard work. Example: There are two employees, during the month
Employee A was able to make 100 units of product Z and Employee B was able to make 50 units of
product Z. Both A and B have a fixed salary of 20,000. Next month Employee A only made 60 units of
product Z because even if he make 100 units or 60 units he will still earn 20,000 a month.

An incentive pay is necessary for those working in production and sales department as more units
produce and sold increases income.
On the other hand if salaries are mainly incentive based, employee may rush their work sacrificing
quality to achieve speed. Going back to the example even if Employee A produces more product than
Employee B, due to his speed Employee A might produce more damaged product than Employee B.

Legend: AC = Average Cost

MC = Marginal cost

MR = Marginal Revenue

Activity
Multiple Choice Questions:

1. When economist speak of “marginal” they mean

a. Opportunity

b. Scarcity

c. Incremental

d. Unimportant

2. Managers undertake an investment only if

a. Marginal benefits of the investment are greater that zero

b. MCs of the investment are greater than marginal benefits of the investment

c. Marginal Benefits are greater than MCs

d. Investment decisions do not depend on marginal analysis

3. A firm produces 500 units per week. It hires 20 full-time workers (40 hours/week) at an hourly wage
of P15. Raw materials are ordered weekly, and they cost P10 for every unit produced. The weekly cost of
the rent payment for the factory is P2,250. How do the overall costs break down?

a. Total variable cost is P17,000; total fixed cost is P2,250; and total cost is P19,250.

b. Total variable cost is P12,000; total fixed cost is P7,250; and total cost is P19,250.

c. Total variable cost is P5,000; total fixed cost is P14,250; and total cost is P19,250.

d. Total variable cost is P5,000; total fixed cost is P2,250; and total cost is P7,250.

4. Total costs increase from P1,500 to P1,800 when a firm increases output from 40 to 50 units. Which of
the following is true if MC is constant?

a. FC = P100

b. FC = P200

c. FC = P300
 d. FC = P400

5. A manager of a clothing firm is deciding whether to add another factory in addition to one already in
production. The manager would compare

a. the total benefits gained from the two factoies to the total cost of running the two
factories.

b. the incemental benefit expected from the second factory to the total cost of running the two
factories.

c. the incremental benefit expected from the second factory to the total costs of running
the two factories.

d. the total benefits gained from the two factories to the incremental costs of running the two
factories.

6. the firm is thinking of hiring an additional worker to their organization who can increase total
productivity by 100 units a week. The cost of hiring him is 1,500 per week. If the price of each unit is
P12.

a. the MR of hiring the worker is 1,500.

b. the MC of hiring the worker is 1,200

c. the firm should not hire the worker since MR < MC

d. all of the above

7. A retailer has to pay P9 per hour to hire 13 workers. If the retailer only needs to hire 12 workers, a
wage rate of P7 per hour is sufficient. WHat is the MC of the 13th worker?

a. P117

b. P9

c. P33

d. P84

8. If a firm's AC is rising, then

a. MC is less than AC

b. MC is rising

c. MC is greater than AC

d. the firm is making an economic profit

9. A company is producing 15,000 units. At this output level, MR is P22 and the MC is P18. The firm sells
each unit for P48 and average total cost is P40. What can we conclude from this information?

a. The company is making a loss

 b. The cost needs to cut production

c. The company needs to increase production

d. Not enough information is provided

10. Food Fanatics caters meals where its cost of producing an extra meal is P25. Each of its meals sells
for P20. At this rate, what should the company do?

a. Produce more meals and increase its profit

b. Produce fewer meals and increase its profit

c. Not change production

d. None of the Above

Problems:

1. You run a game day shuttle service for parking services for the local ball club. Your cost for different
customer loads are 1- P30; 2- P32; 3- P35; 4- P38; 5- P42; 6- P48; 7- P57; and 8- P68. What are your MCs
for each customer load level? What is the AC? If you are compensated P10 per ride, what customer load
would you want?

2. Children in poor neighborhoods have bleak outlooks on life and do not see much gain to studying. A
recent experiment is paying children in poor neighborhoods $100 for each A rating they earn in a six-
week grading period. How does this affect the children's behavior?

3. Your insurance firm processes claims through its newer, larger, high-tech facility and its older, smaller,
low-tech facility. Each month, the high-tech facility handles 10,000 claims, incurs P100,000 fixed costs
and P100,000 in variable costs. Each month, the low-tech facility handles 2,000 claims, incurs P16,000 in
fixed costs and P24,000 in variable costs. If you anticipate a decrease in the number of claims where will
you lay off workers?

4. A copier comapny wants to expand production. It currently has 20 workers who share eight copiers.
Two months ago, the firm added two copier, and output increased by 100,000 pages per day. One
month ago, it added five workers and productibity also increased by 50,000 pages per day. Copiers cost
about twice as much as workers. Would you recommend it hire another employee or buy another
copier?

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