Managerial Economics

(MBA 661)

B
y
Mesfin M.
(PhD)
 Chapter One: Introduction
❖ Managerial Economics is a blend of two important issues:
✓ Economics and Management

❖ Economics deals with economic problems of the

individuals, business units, society and that of the globe.
❖ Economics is a logic of choice. It teaches the art of rational
decision making in economizing behavior to deal with the
problem of scarcity.

❖ An economic problem arises on account of the following

reasons
✓ Unlimited wants
✓ Limited resources
✓ Alternative use of resources
✓ Problem of choices/decision-making
 Introduction--
▪ Management is the science and art of getting things
done through people in formally organized groups to
achieve its desired goals.

▪ Management includes a number of functions: Planning,

organizing, staffing, directing, and controlling.

▪ The manager while directing the efforts of his staff

communicates to them the goals, objectives, policies,
and procedures; coordinates their efforts; motivates
them to sustain their enthusiasm; and leads them to
achieve the corporate goals.
 Introduction--
o Basically, the terms Managerial Economics and Business
Economics interchangeably used
o Lately, the term managerial economics has become more
popular and is displacing business economics
o Business Economics is a science which deals with the
application of economic theories, techniques, principles
and concepts to business management in order to solve
business problems to take sound business decisions
o Business economics was focused primarily to business
decision making
o Managerial economics applies to both business and non
business decision making, as well as to public and private
organizations/ institutions.
 Nature of Managerial Economics
▪ Manager’s prime function is decision making (selecting
one of the many alternative decisions) and forward
planning (establishing plans or future)

▪ The question of choice arises due to scarcity (limited

resources and their possible alternative uses and
unlimited human wants).

▪ Thus, decision making function is one of making choices

for the most efficient use of resources or desired ends.

▪ Once a decision is made or a goal is set, forward planning

has to be made to achieve the targets in terms of
production, pricing, capital, raw materials, labour etc.,

▪ Thus, decision making and forward planning go hand in

hand.
 Decision-making and
Uncertainty
▪ Uncertainty is the typical characteristic of decision- making

▪ It makes decision making and forward planning complicated

▪ If there was no uncertainty in future, or knowledge about

future was perfect, plans could be formulated without any
need for subsequent revision.

▪ When plan execution begins, new facts come to light

requiring alterations in past decisions and plans.

▪ Managers are thus engaged in continuous process of decision

making through an uncertain future
▪ Adjusting to uncertainty is managers main challenge.
 Managerial Economics and Decision-making
▪ Economic theory is of considerable help to managers in
fulfilling the function of ‘decision-making’ in an uncertainty
frame-work.

▪ This is because economics deals with a number of concepts

and principles relating to profit, demand, cost, supply,
pricing, production, competition, business cycles, national
income, etc.,

▪ This help is enhanced when economics is aided by disciplines

like accounting, statistics, and mathematics.

▪ The two together aid the process of business decision making

and planning

▪ The subject-matter of managerial economics revolves around

as to how economic analysis can be used in solving business
problems
 Managerial Economics
defined
o According to McNair and Meriam, Business economics consists of
the use of economic models/modes of thought to analyze business
situations.

o Acc to Prof. Spencer and Seigelman, Managerial economics is the

integration of economic theory with business practice for the
purpose of facilitating decision making and forward planning.

o Hence, it is the discipline that deals with application of economic

concepts, theories and methodologies to practical problems of
businesses/firms. It helps managers to determine an optimum
allocation of the limited resources.

o It is the application of economic theory and the tools of decision

science to examine how an organization can achieve its aims or
objectives most efficiently.
o Managerial economics offers a comprehensive application of
economic theory and methodology to management decision
making.
Managerial economics is the synthesis of microeconomic theory and quantitative methods
(mathematics and statistical methods) to find optimal solutions to managerial decision-
making problems.
Managerial Decision Problems
Decision Sciences
Economic theory Mathematical Economics
Microeconomics Econometrics
Macroeconomics
Statistics

MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems

OPTIMAL SOLUTION TO
MANAGERIAL DECISION PROBLEMS
o In Detail:
 Objectives of managerial economics
➢ To integrate economic theory with management practice
➢ To apply economic concepts and principles to solve
management problems
➢ To employ most modern instruments and tools to find
solutions to business/management problems
➢ To make optimum use of scarce resources of a
firm/organization
➢ To help in making overall development of a
firm/industry/company
➢ To help the manager to understand the complexities of
business problems and to make right decision at the right
time
 Role of Managerial Economist
❑ Able to identify various business/management problems, their
causes and suggest remedial measures.

❑ Able to provide a quantitative base for decision making and

forward planning.

❑ Act as a thinker, economic advisor to the firm/company.

❑ Responds to the dynamic changes taking place in market

situation.

❑ Conducts various types of research studies.

❑ Able to synthesize various policies.

 Role ---
❑ Able to collect complete information about the
environment factors.

❑ Acts as decision-maker and forward planner.

❑ He/she assists the business planning process of a firm.

❑ He/she also carries cost-benefit analysis.

❑ In order to perform all these roles, a managerial economist

has to conduct an elaborate statistical analysis.
Characteristics of Managerial Economics
• It is a highly specialized and separate branch of economics

• Managerial economics is micro-economic in character-

uses broadly theory of the firm concepts; hence, it is an
applied microeconomics

• Also seeks to apply profit theory which forms part of

distribution theories

• Is pragmatic as it avoids difficult abstract issues of

economic theory, but involves dealing with real life
complications of business world
 Characteristics--
• It is based on normative concept- It involves judgement as to what is
good/bad for business, or deals with which decision needs to be made
on the basis of its merits and demerits; hence, it is therefore described
as ‘normative micro-economics of the firm.’

• Is prescriptive (goal oriented- as profit maximization, sales (revenue)

maximization, and maximizing market share, etc ).
• Science of choice and Allocation

• Economic theory does not go into judging decisions, but managerial

economics tells what the aims and objectives of a firm should be, then
it tells how best these can be achieved.

• Macro-economics is also useful to managerial economics as it

provides an intelligent understanding of the environment in which the
business must operate, because the macroeconomics conditions of
the
economy are also seen as limiting factors for the firm to operate.

• Thus, managerial economist has to be aware of the limits set by the

macroeconomics conditions such as government industrial policy,
inflation and so on.
 Characteristics--
• New discipline and of recent origin
• Multi-disciplinary and Applied, because it needs understanding of
various disciplines:
❖Economics, due to problems of scarcity and resource allocation
❖Management, knowledge of management principles is important to
sound decision-makings
❖Accounting, because a proper knowledge of accounting techniques-cost
and revenue is very essential for the success of the firm because profit
maximization is the major objective of the firm.
❖Statistics, because managerial economics make use of statistical tools like
the probability theory in uncertain situation, correlation and multiple
regressions in related variables like price and demand to estimate the
extent of dependence of one variable on the other, and also statistical
tools are used in collecting data and analyzing them to help in the decision
making process
❖Mathematics, because mathematical methods (linear programming,
inventory models, etc) help to estimate and predict the economic
factors for decision making and forward planning
 Characteristics--
❖Operations research, because it provides a scientific model of the system and it helps
managerial economists in the field of product development, material management, and
inventory control, quality control, marketing and demand analysis. The varied tools of
operations Research are helpful to managerial economists in decision- making.
❖Computer sciences, now a days computerization of business activities on a large scale has
reduced the workload of managerial personnel; hence, knowledge of computer science, is
a compulsory programme for managerial trainees.

• To conclude, managerial economics, which is an offshoot traditional

economics, has gained strength to be a separate branch of knowledge.

• It strength lies in its ability to integrate ideas from various specialized

subjects to gain a proper perspective for decision-making.

• A successful managerial economist must be a mathematician, a statistician

and an economist.

• In short managerial practices with the help of other allied sciences.

 Characteristics--
• Generally, managerial economics attempts to bring economic theory into
the real world through use of quantitative methods
• Quantitative methods refer to the tools and techniques of analysis,
including optimization analysis, statistical methods, game theory, and
capital budgeting.
• Managerial economics makes special use of mathematical economics and
econometrics to derive optimal solutions to managerial decision-making
problems.
❖Consider, for example, the formal (mathematical) demand model represented by
Equation:

❖This equation says that the quantity demand of a good or service commodity QD is
functionally related to its selling price P, per-capita income I, the price of a
competitor’s product Ps, and advertising expenditures A.
❖By collecting data on Q, P, I, Ps and A, it should be possible to quantify this
relationship. If we assume that this relationship is linear, the above equation may be
specified as:
❖It is possible to estimate the parameters of the second equation by using the
methodology of regression analysis (Econometrics is vital, here)
❖The resulting estimated demand equation, as well as other estimated relationships,
may then be used by management to find optimal solutions to managerial decision-
making problems.
❖Such decision-making problems may entail optimal product pricing or optimal
advertising expenditures to achieve such organizational objectives as revenue
maximization or profit maximization.
 Scope of Managerial Economics
• Managerial economics is primarily concerned with the
application of economic principles and theories to five
types of resource decisions made by all types of business
organizations.
✓ The selection of product or service to be produced (what to
produce).
✓ The choice of production methods and resource

combinations (how to produce).

✓ The determination of the best price and quantity combination

✓ Promotional strategy and activities (Optimal solution).

✓ The selection of the location from which to produce and sell

goods or service to consumer (where to produce)

 Scope---
• The production department, marketing and sales department and
the finance department usually handle these five types of
decisions.
• The scope of managerial economics covers two areas of decision
making
✓ Operational or Internal issues
✓ Environmental or External issues

a. Operational issues:
• Operational issues refer to those, which wise within the business
organization and they are under the control of the management.
Those are:
1. Theory of demand and Demand Forecasting
2. Pricing and Competitive strategy
3. Production and cost analysis
4. Resource allocation
5. Profit analysis
6. Capital or Investment analysis
7. Strategic planning
 Demand Analyses and Forecasting
• A firm can survive only if it is able to the demand for its product at
the right time, within the right quantity.
• Understanding the basic concepts of demand is essential for
demand forecasting.
• Demand analysis should be a basic activity of the firm because
many of the other activities of the firms depend upon the outcome
of the demand fore cost.
• Demand analysis provides:
1. The basis for analyzing market influences on the firms; products and thus
helps in the adaptation to those influences.
2. Demand analysis also highlights for factors, which influence the demand
for a product. The demand analysis studies not only the price elasticity but
also income elasticity, cross elasticity as well as the influence of advertising
expenditure with the advent of computers, demand forecasting has
become an increasingly important function of managerial economics.
 Pricing and competitive strategy
• Pricing decisions have been always within the preview of
managerial economics.

• Pricing policies are merely a subset of broader class of managerial

economic problems.

• Price theory helps to explain how prices are determined under

different types of market conditions.

• Competitions analysis includes the anticipation of the response of

competitions the firm’s pricing, advertising and marketing strategies.

• Product line pricing and price forecasting occupy an important place

here.
 Production and Cost Analysis
• Production analysis is in physical terms.

• While the cost analysis is in monetary terms cost

concepts and classifications

• Cost-out-put relationships, economies and

diseconomies of scale and production functions are some
of the points constituting cost and production analysis.
 Resource Allocation
• Managerial Economics is the traditional economic theory
that is concerned with the problem of optimum allocation
of scarce resources.

• Marginal analysis is applied to the problem of determining

the level of output, which maximizes profit.

• In this respect linear programming techniques has been

used to solve optimization problems.

• In fact lines programming is one of the most practical and

powerful managerial decision making tools currently
available.
 Profit Analysis
• Profit making is the major goal of firms.

• There are several constraints here an account of

competition from other products, changing input prices and
changing business environment hence in spite of careful
planning, there is always certain risk involved.

• Managerial economics deals with techniques of averting of

minimizing risks.

• Profit theory guides in the measurement and management of

profit, in calculating the pure return on capital, besides future
profit planning.
 Capital or Investment Analysis
• Capital is the foundation of business.
• Lack of capital may result in small size of
operations.
• Availability of capital from various sources like equity
capital, institutional finance etc, may help to undertake large-scale
operations.
• Hence efficient allocation and management of capital is one of
the
most important tasks of the managers.
• The major issues related to capital analysis
are:
1. The choice of investment project

2. Evaluation of the efficiency of capital

3. Most efficient allocation of capital

• Knowledge of capital theory can help very much in taking
investment decisions.
• This involves, capital budgeting, feasibility studies, analysis of
cost
of capital etc.
 Strategic Planning
• Strategic planning provides management with a framework on
which long-term decisions can be made which has an impact on
the behavior of the firm.
• The firm sets certain long-term goals and objectives and
selects the strategies to achieve the same.
• Strategic planning is now a new addition to the scope of
managerial economics with the emergence of multinational
corporations.
• The perspective of strategic planning is global and is in
contrast to project planning which focuses on a specific project
or activity.
• In fact the integration of managerial economics and strategic
planning has given rise to be new area of study called corporate
economics.
 Environmental or External issues
• An environmental issue in managerial economics refers to
the general business environment in which the firm operates.
• They refer to general economic, social, cultural, natural catospheres
and political atmosphere within which the firm operates.
• A study of economic environment should include:
a. The type of economic system in the country.

b. The general trends in production, employment, income, prices,

saving and investment.

c. Trends in the working of financial institutions like banks,

financial corporations, insurance companies

d. Magnitude and trends in foreign trade;

e. Trends in labour and capital markets;

f. Government’s economic policies viz. industrial policy monetary

policy, fiscal policy, price policy etc.

 External issues---
• The social environment refers to social structure as well as social
organization like trade unions, consumer’s co-operative etc.
• The Political environment refers to the nature of state activity,
chiefly states’ attitude towards private business, political stability etc.

• The environmental issues highlight the social objective of a firm

i.e.; the firm owes a responsibility to the society.
• Private gains of the firm alone cannot be the goal.

• The environmental or external issues relate managerial economics

to macro economic theory while operational issues relate the scope to
micro economic theory.
• The scope of managerial economics is ever widening with the
dynamic role of big firms in a society.
 Theory of the Firm
• A firm is an association of individuals who have organized themselves
for the purpose of turning inputs into output.
• Firms are major economic institutions in market economies.
• They come in all shapes and sizes, but have the common
characteristics: Owners, Managers and Objectives.
• The basic model of the business enterprise is called the theory of the
firm
• The theory of the firm assumes that the firm seeks to maximize profits
and minimize cost and on the basis of that it predicts how much of a
particular commodity the firm should produce under different forms
of market structure or organization.
• Theory of firm
▪ Combines and organizes resources for the purpose of producing goods and/or
services for sale.
▪ Internalizes transactions, reducing transactions costs.
▪ Primary goal is to maximize the wealth or value of the firm.
 Theory--
❖The firm can be viewed as a confluence of contractual relationships
that connect suppliers, investors, workers, and management in a
joint effort to serve customers.
 Theory--
oThe ultimate goal of the firm is profit maximization.

oToday, the emphasis on profits has been broadened

to encompass uncertainty and the time value of
money.

oIn this more complete model, the primary goal of the firm is
long-term expected value maximization.
 Value of the Firm
➢ The value of the firm is the present value of the firm’s expected
future
net cash flows.
➢ If cash flows are equated to profits for simplicity, the value of the
firm
today, or its present value, is the value of expected profits or cash
flows, discounted back to the present at an appropriate interest rate
➢ The present value of all expected future profits is given in the model:

➢ Discounting is required because profits obtained in the future are less

valuable than profits earned presently (time value of money).
 Numerical Examples
Q1. The owner of a firm expects to receive a profit of $ 100 in each
of the next three years and to be able to sell the firm at the end of
the third year for $ 700. The owner believes that the appropriate
discount rate for the firm is 10 percent per year. Calculate

(a) the value of the firm (PV)

(b) the value of the firm when a discount rate of 20 percent

(c) what is the effect on the value of the firm of using a higher
discount rate.
 Solution
- Using the formula:

100 100 100 700

(a) 1
+ 2
+ 3
+ 3 = 774.6
1.1 1.1 1.1 1.1

100 100 100 700

(b) 1.2 1 + 1.2 2 + 1.2 3 + 1.2 3 = 615.73

(c) The higher discount rates reduces the value of the firm.
 Examples---
Q2. The costs of attending a state college for one year are $ 2,000 for
tuition, $ 1,500 for the room, $1,000 for meals, and $500 for books and
supplies. As an alternative the student could earn $13,000 by getting a
job instead of going to college and in adddition, earn 8 percent interest
by saving the money not spent on attending. Calculate

(a) the explicit cost

(b) the implicit costs

(c) the total economic costs that the student faces by attending the
college for one year.

Answer: 5000, 13,400 and 18,400, respectively.

 Limitations of the Theory of the Firm
oSome critics question why the value maximization criterion is used as
a foundation for studying firm behavior.
oDo managers try to optimize (seek the best result) or merely satisfice
(seek satisfactory rather than optimal results)?
oIt is impossible to give definitive answers to questions like these, and
this dilemma has led to the development of alternative theories of
firm behavior.
oSome of the more prominent alternatives are:
✓ models in which size or growth maximization is the assumed primary objective
of management,
✓ models that argue that managers are most concerned with their own personal
utility or welfare maximization, and
✓models that treat the firm as a collection of individuals with widely divergent
goals rather than as a single, identifiable unit.
 Other Objectives of the firm
oThe other major objectives of the firm are:
✓ To achieve the Organizational Goal
✓To maximize the Output
✓To maximize the Sales
✓To maximize the Customer and Stakeholders Satisfaction
✓ To maximize Shareholder’s Return on Investment
✓To maximize the Growth of the Organization
 Definitions and Theories of Profit
❖Definitions of Profit

• Business Profit: is defined as the residual of sales total revenue minus

the explicit or accounting costs of production, or doing business.
• It is the amount available to fund equity capital after payment for all
other resources used by the firm. This definition of profit is accounting
profit, or business profit.

• Economic Profit: Total revenue minus the explicit and implicit costs of
production.
• In economic terms, profit is business profit minus the implicit
(noncash) costs of capital and other owner-provided inputs used by
the firm.
 Definitions-
• Opportunity Cost: Implicit value of a resource in its best
alternative use.

• Normal rate of return: it is risk-adjusted rate of return on capital and

is an average profit necessary to attract and retain investment.

• Profit margin, or net income divided by sales, and the return on

stockholders’ equity, or accounting net income divided by the book
value of total assets minus total liabilities, are practical indicators of
firm performance.
 Definitions-

• The concepts of business profit and economic profit can be used to

explain the role of profits in a free enterprise economy.

• Anormal rate of return, or normal profit, is necessary to induce

individuals to invest funds rather than spend them for current
consumption.

• Normal profit is simply a cost for capital.

 Theories of Profit
1. Frictional Theory of Profit
• One explanation of economic profits or losses is frictional profit
theory.
• It states that markets are sometimes in disequilibrium because
of unanticipated changes in demand or cost conditions.
• Unanticipated shocks produce positive or negative economic profits
for some firms.
➢For example, automated teller machines (ATMs) make it possible for
customers of financial institutions to easily obtain cash, enter deposits, and
make loan payments. ATMs render obsolete many of the functions that used
to be carried out at branch offices and foster ongoing consolidation in the
industry.
➢Over time, due to barriers to entry and exit, resources flow into or out of
financial institutions, thus driving rates of return back to normal levels.
➢During interim periods, profits might be above or below normal because of
frictional factors that prevent instantaneous adjustment to new market
conditions.
 Theories--
2. Monopoly Theory of Profit

oA further explanation of above-normal profits, monopoly profit theory,

is an extension of frictional profit theory.
oThis theory asserts that some firms are sheltered from competition by
high barriers to entry.

oEconomies of scale, high capital requirements, patents, or import

protection enable some firms to build monopoly positions that allow
above-normal profits for extended periods.

oMonopoly profits can even arise because of luck or happenstance

(being in the right industry at the right time) or from anticompetitive
behavior.
 Theories--
3. Innovation Theory of Profit
▪ An additional theory of economic profits, innovation profit theory,
describes the above-normal profits that arise following successful
invention or modernization.
✓For example, innovation profit theory suggests that Microsoft Corporation has
earned superior rates of return because it successfully developed, introduced,
and marketed the Graphical User Interface, a superior image based rather
than command-based approach to computer software instructions.
✓ Microsoft has continued to earn above-normal returns as other firms
scramble to offer a wide variety of “user friendly” software for personal and
business applications.
✓Only after competitors have introduced and successfully saturated the market
for user-friendly software will Microsoft profits be driven down to normal
levels.
▪ As in the case of frictional or disequilibrium profits, profits that are due
to
innovation are susceptible to the onslaught of competition from new and
established competitors.
 Theories--
4. Compensatory Theory of Economic Profits
▪ Compensatory profit theory describes above-normal rates of return
that reward firms for extraordinary success in meeting customer
needs, maintaining efficient operations, and so forth.
▪ If firms that operate at the industry’s average level of efficiency
receive
normal rates of return, it is reasonable to expect firms operating at
above-average levels of efficiency to earn above-normal rates of
return.
▪ Inefficient firms can be expected to earn unsatisfactory, below normal
rates of return.
▪ Compensatory profit theory also recognizes economic profit as an
important reward to the entrepreneurial function of owners and
managers.
▪ The opportunity for economic profits is an important motivation for
such entrepreneurial activity.
 Function of
Profit
• Profit is a signal that guides the allocation of society’s resources.

• Above-normal profits serve as a valuable signal that firm or industry

output should be increased.

• High profits in an industry are a signal that buyers want more of what
the industry produces.

• Below-normal profits provide a signal for contraction and exit.

•
• Low (or negative) profits in an industry are a signal that buyers
want less of what the industry produces.
 Numerical Example
Q3. A person managing a dry-cleaning store for $ 30,000 per year
decides to open a new one. The revenues of the store during the first
year of operation are $ 100,000 and the expenses are $ 10,000 for
supplies, $ 35,000 for salaries, $ 8,000 for rent, and $ 2,000 for utilities.
The person also used $5,000 for interest on a bank loan. Assume that
income and business taxes are zero and the repayment of the principal
of the loan does not start before three years (suppose r=10%). Calculate
(a) the explicit cost
(b) the implicit costs (c)
the business profit, (d)
the Economic profit
(e) normal return on investment and also
(f) indicate whether the person should open the dry-cleaning store.
 Solution
(a) Expenses is the explicit costs- the expenses are $ 10,000 for supplies, $ 35,000 for salaries, $
8,000 for rent, and $ 2,000 for utilities as well as interest $ 5,000 – total amout is $ 60,000.

(b) The Implicit costs are the entrepreneeur’s foregone salary- $ 30,000.

(c) the business profit= total revenues - the explicit costs = $ 100,000 - $ 60,000= $ 40,000

(d) the Economic profit= total revenues – (the explicit costs + Implicit costs) = 100,000 – ($
60,000 + $ 30,000) = $ 10,000

(e) normal return on investment = The Implicit costs =$ 30,000.

(f)

PV=10,000/1+0.10)....

So, roughly we can say that the person would earn economic profit $ 10,000 per year,
therefore, the person should open the store..
 Basic Economic Relations
▪ Managers have to make tough choices that involve benefits and costs.
▪ Basic economic relations form the basis for describing all
demand, cost, and profit relations.
▪ Once the basics of economic relations are understood, the tools
and techniques of optimization can be applied to find the best course
of action.
❖Functional relations, TR = PQ
-Total, average, and marginal relations are very useful in optimization
analysis.
❖Especially, marginal analysis (marginal concepts are commonly used in
resource allocations)
❖The most common use of marginal analysis is to find the profit-maximizing
activity level.
- marginal revenue (the change in total revenue associated with a one-unit
change in output);
- marginal cost (the change in total cost following a one-unit change in output);
- marginal profit (the change in total profit due to a one-unit change in output).
✓ If MR = MC (Mπ = 0), profit-maximizing output level
✓ If TR = TC (π = 0), Break even point/out put
 Numerical example on profit maximization
▪ Given the following economic relationships on monthly demand, total
revenue, and marginal revenue relations for manufacturing company X:
P = $7,500 – $3.75Q
TR = $7,500Q – $3.75Q2
MR = ∆TR/∆Q = $7,500 – $7.5Q
, where P is price and Q is output.
▪ In addition, company’s accounting department has estimated monthly total
cost and marginal cost relations of:
TC = $1,012,500 + $1,500Q + $1.25Q2
MC = ∆TC/∆Q = $1,500 + $2.5Q
Calculate the profit maximizing out put and price, and the maximum profit

▪ Q* = 600 units, P* = $5250, $787, 500; how???

▪ To maximize short-run profits, the company should expand from its current
level to 600 units per month.

▪ Any deviation from an output of 600 units and price of $5,250 per unit
would
lower company's short-run profits.