FUNDAMENTALS OF 6 Basic Principles in Becoming an

MANAGERIAL ECONOMICS Effective Manager

Manager 1. Identify goals and constraints
 A person who directs resources to  the first step in making sound
achieve a stated goal decisions varies on the underlying
 To DIRECT the efforts of others goals of the manager
 To PURCHASE inputs used in  achieving different goals entails
the production of the firm’s output making different decision
 To DIRECT the product price or  different departments within a
quality decisions company may have different goals
 Generally responsible for their  Constraints make it difficult for
own actions & for the other inputs managers to achieve such goals
of the company/firm under their (i.e., maximizing
control profits/increasing market share)
 Tasked to maximize the profits of  Examples of constraints: available
the firm technology, availability of capital,
labor and the price of inputs used
ECONOMICS
in production
 The science of making decisions
2. Recognize the nature and
in the presence of scarce resources
importance of profits
 To allocate resources efficiently
 Accounting Profit = Total amount
Resources – anything used to produce
of money taken in from sales (total
a good or service (*to achieve a goal)
revenue) minus cost of producing
Decisions – are important because
goods or services
scarcity implies trade-offs (every
 FORMULA: AP = TR – Explicit
decision has an opportunity cost)
Costs
FACTORS OF PRODUCTION  Economic Profit = Difference
1. Land between total revenue and
2. Entrepreneur opportunity cost
3. Labor  Opportunity Cost = the explicit
4. Capital cost of a resource + the implicit
cost of giving up its best
MANAGERIAL ECONOMICS
alternative
 The study of how to direct scarce
 Explicit Cost = wages, rent, and
resources efficiently to achieve a
cost of materials
managerial goal
 Implicit Cost = forgone salary or
 Economics applied in decision
forgone rent
making
 FORMULA: EP = TR –
 A combination of economic theory
Opportunity Costs
and decision science methodology
  If substitute products are
ECONOMICS OF EFFECTIVE available, buyer power is high
MANAGEMENT
(FIVE FORCES FRAMEWORK) 4. INDUSTRY RIVALRY
 Sustainable industry profits
1. ENTRY depend on the nature and
 Heightens competition and intensity of rivalry among firms
reduces the margins of existing  Rivalry tends to be less intense
firms in a wide variety of in industries that have fewer
industry settings firms; will be most likely to
 Economic factors affect the highly sustain profits
ability of entrants to erode 5. THREATS OF SUBSTITUTES
existing industry profits AND COMPLEMENTS
 Examples: Entry costs, sunk  The level and sustainability of
costs, economies of scale, industry profits also depend on
network effects, reputation, the price and value of products
switching costs and government and services
restraints  The framework emphasizes that
2. POWER OF INPUT SUPPLIES the presence of close substitutes
 Low industry profits = suppliers erodes industry profitability
have the power to negotiate  Availability of a substitute good
favorable terms for their inputs effects the profitability of an
 Low supplier power when: industry because consumers will
i. Inputs are relatively choose the one with the lower
standardized price instead of the industry’s
ii. Input markets are not highly product
concentrated
iii. Alternative inputs are 3. Understand incentives
available  Incentives affect how resources
3. POWER OF BUYERS are used and how hard workers
 When customers or buyers have work
the power to negotiate favorable  Example: Money, Free
terms = industry profits are Holiday/Vacation days, time-off
lower 4. Understand markets
 Buyer is price sensitive and well  Bargaining position of
educated about the product = consumers and producers is
buyer power is high limited by three rivalries in
 If customer purchases large economic transactions:
volumes of products = high i. Consumer-producer rivalry
bargaining power - Consumers attempt to
negotiate or locate low prices
 vs. producers negotiate high FV
PV = n
prices (1+i)
- Consumers and producers try WHERE:
to “rip off” each other PV = Present Value
ii. Consumer-consumer rivalry FV = Future Value
- Arises because of the i = interest rate
economic doctrine of scarcity N = Nos. of years
- When only limited quantities 2. Present value of a stream of
of goods are available, future values
consumers will compete with - The cumulative present value
one another for the right to of future cash flows can be
purchase the available goods. calculated by summing the
iii. Producer-producer rivalry contributions of FV t , the value
 Firms that offer the best- of cash flow at time t:
quality product at the lowest FV 1 FV 2 FV n
price earns the right to serve to PV = 1
+ 2
+…+ n
(1+i) (1+i) (1+i)
customers *Remember to ask why hindi
 Government and the Market: nagrround up ng values
agents may frequently attempt 3. Future value and the
to induce the government to opportunity cost of waiting
intervene on their behalf; plays - the present value of the
a key role in disciplining the income stream generated by
market process the project minus the current
5. Recognize the time value of cost of the project:
money NPV =PV −OCW
 The timing of a decision If:
involves a gap between the +NPV = Profitable
time when costs are borne, and -NPV = Not Profitable/ Should
benefits received be rejected
 Managers can use present o because a negative NPV
value analysis to properly
would mean the cost of the
account for the timing of
project would exceed the
receipts and expenditures
present value of the
income stream that project
1. Present value of a single
is generating
future value
4. Present Value of Indefinitely
- The amount that would have
Lived Assets
to be invested today at the
- Some decisions generate
prevailing interest rate to
cash flows that continue
generate the given future
indefinitely
value:
 - An asset that generates a  one of the most important
cash flow from one to three managerial tools
years for an indefinite period  marginal analysis states optimal
- the asset generates a managerial decisions involve
perpetual stream of identical comparing the marginal benefits
cash flows at the end of each and marginal costs
period  control variable Q, of a
CF managerial objective
PV Perpetuity =
i i. total benefit as B(Q)
WHERE: ii. total cost as C(Q)
CF = cash flow  Manager’s objective is to
i = interest rate maximize net benefits
5. i. Present value of a Firm  N(Q) = B(Q) – C(Q)
 Present Value Analysis is useful in Marginal Principle
determining the value of a firm  To maximize net benefits, the
since the value of a firm is PV of manager should increase the
the cash flow generated by the managerial control variable
firm’s physical, human, and  Until marginal benefits = marginal
intangible asset costs
 The value of the firm today is the  Marginal benefit: MB(Q)
present value of its current and  The change in total benefits
future profits arising from a change in the
 The present value of the firm takes managerial control variable, (Q)
the long-term impact of  Marginal cost: MC(Q)
managerial decisions on profits  The change in total costs arising

( )
PV =Value of the firm
1+i
i−g
from a change in the managerial
control variable, Q
o The profits of the firm have not  Marginal net benefits: MNB(Q)
yet been paid out to stockholders  MNB(Q) = MB(Q) – MC(Q)
as dividends
WHERE:
PV = present value
i = interest rate
g = growth rate
ii. Profit Maximization
PV firm ex÷.=Valueof the Firm – Dividend
o Value of the firm after it pays out
the dividends to their stockholders
Marginal Value Curves are the Slopes of
^^
Total Value Curves
6. Use marginal analysis
 A Calculus Alternative
  Slope of a continuous function is purchase increases as the price
the derivative/marginal value of falls
that function:  The quantity of a good that
dB(Q) consumers are willing and able to
MB=
d (Q) purchase decreases as the price
dC (Q) rises
MC=
dQ  Price and quantity demanded are
dN (Q) inversely related
MNB=
dQ
Marginal Analysis Solving Steps:
1. State estimated benefit and cost
structure (given)
2
B (Q )=250 Q−4 Q
2
C ( Q ) =Q
 Power rule
2. Find MB(Q) and MC(Q)
Shift in Quantity Demanded vs. Shift in
250−8 Q=2 Q−8 Q−2Q=−250
Demand
−10Q −250 Shift in Quantity Demanded
= Q=25
−10 −10
 Changing ONLY PRICE
3. Q  refers to the value
 Graphically represented by a
MARKET FORCES: DEMAND movement along a given demand
AND SUPPY curve, holding other factors that
Demand – refers to the quantity of goods impact demand constant
that buyers are willing or able to buy at a Shift/Change in Demand
given price during specified time  Changing FACTORS OTHER
THAN PRICE
Market demand curve  Graphically represented by a shift
 Illustrates the relationship between of the entire demand curve
the total quantity and price per Demand Shifters
unit of a good all consumers are  Income (direct relationship with
willing and able to purchase demand)
holding other variables constant o Normal Goods – goods that
 Maximum price : 0 quantity experience an increase in
demanded demand due to an increase in a
 Decreased price : Increased consumer’s income
quantity demanded o Inferior Good – goods that
Law of Demand experience a decrease in
 The quantity of a good that demand due to an increase in a
consumers are willing and able to consumer’s income
 Prices of related goods
 o Substitute Goods – similar o Q x d – is the number of units of
products that a customer may good X demanded
use for the same purpose, if o P x– is the price of good X
one good increases price it o P y – price of a related good Y
increases the demand for the o M - income
OTHER o H – value of any other variable
o Complement Goods – if the
affecting demand
price for one good increase the
demand for the other good o The signs and magnitude of the a
decrease
coefficients determine the impact
 Advertising and Consumer Tastes –
of each variable on the number of
demand shifts to the right as it
units of X demanded
influences the consumers to buy d
Q x =a0 +a x P x + a y P y +a M M
this product
o For example:
 Consumer Expectations – when
consumers expect that a price of a a x <0 by thelaw of demand
good will increase, they will buy a y > 0 if good Y is a substitute for good X
more of this good a m <0 if good X is an inferior good

Inverse Demand Function

 Other Factors – the size of the
market and seasonal variation
 Movement along the same d
Q x =a0 +a x P x + a y P y +a M M
demand curve between points o Used to construct a market
A and B = change in quantity demand curve
Consumer surplus
demanded
o Extra value that consumers
 Going from one demand curve

derive from a good but do

to another = change in demand

not pay extra for

 Up and down = change in

Total Consumer Value =

quantity demanded

Consumer Surplus +
 Left and right = change in

Expenditures
demand
The Demand Function

Supply – total amount of a given

o A mathematical representation

product or service a supplier

describing how many units will be

offers to consumers
purchased at different prices for X,

Market Supply Curve

the price of related good Y,

o Indicates the total quantity

income and other factors that

of a good that all

affect the demand for good X

producers in a competitive
Linear Demand Function

market would produce at

d
Q x =a0 +a x P x + a y P y +a M M + aH H

each price, holding input

Where:
 prices, technology, and government guidelines and
other variables affecting regulations
supply constant Number Of Firms
Law of Supply o Entry – as firms enter the


As the price of a good supply increases

rises, the quantity supplied o Exit - as firms exit supply
o

of the good rises decreases

As the price of a good falls, Substitutes In Production –
the quantity supplied of Taxes
o 

the good falls, holding o Excise Tax – tax on each



other factors affecting unit of output sold; tax

supply constant revenue is collected from
Direct relationship the supplier
o Ad valorem tax –
o

Changes In Quantity Supplied vs. percentage tax

Changes In Supply Producer Expectations
Changes In Quantity Supplied


o changing only price

o graphically represented by Supply Function
a movement along a given - A mathematical
supply curve, holding other representation describing
factors that impact supply how many units will be
constant produced at alternative
Changes In Supply prices for X, alternative
o changing factors other input price W, and
than price graphically alternative values of other
represented by a shift of variables that affect the
the entire supply curve supply for good X
Supply Shifters
 Input Prices – as the price Linear Supply Function
of input increase the
s
Q x =β 0 + β x P x + β W W + β r P r + β H H
producers are willing to WHERE:
produce less product at a  Q x s= is the number of
given price (left shift in units of good X produced
supply curve)  P x= price of good X
 Technology Or Government  W = is the price of an
Regulation – left shift in the input
supply curve because of
lack in technology and
 = price of no pressure on prices or
quantities to change
 Pr
technologically related
goods - The equilibrium price is
 H = value of any other the price that equates
variable affecting supply quantity demanded with
The signs and magnitude of 𝜷 quantity supplied
coefficients determine the
impact of each variable on the A market with demand and
number of units of X produced. supply functions
d s
s
Q x =β 0 + β x P x + β W W + β r P r Q =10−2 P∧Q =2+2 P
For example:
 β x > 0 by the law of supply A Competitive market
 β W < 0 increasing input equilibrium exists at a price Pe ,
price such that
 β r >0 technology lowers the
d e s e
Q =( P )=Q (P )
cost of producing good X
Market Equilibrium
Inverse Supply Function - Supply = demand
Producer Surplus - No surplus nor shortage
- The amount producers - Price is stable
receive more than the
amount necessary to
induce them to produce
the good

Excess Supply
- Price is too high
Market Equilibrium
- Demand is lower than
Competitive Market Equilibrium
expected
- Determined by the
- Therefore, there is excess
intersection of the market
supply aka surplus
demand and market supply
curves
- A price and quantity such
that there is no shortage or
surplus in the market
- Forces that drive market
demand and market supply
are balanced, and there is Excess Demand
 - Price is set relatively low
- Demand for a product is
- Increase equilibrium price

higher than expected

- Increase equilibrium quantity
o Decrease in Demand ONLY
- Shortage is created - Decrease equilibrium price
- Decrease equilibrium quantity

Changes in Supply
o Increase In Supply ONLY
- Decrease equilibrium price

Price Restrictions and Market

- Increase equilibrium quantity

Equilibrium
o Decrease In Supply ONLY

- Price and quantity freely adjust to

- Increase equilibrium price
- Decrease equilibrium quantity

- Sometime government restricts

the forces of demand and supply

how much prices are permitted to LINEAR DEMAND, ELASTICITY,

rise or fall AND REVENUE
o Price ceiling – highest point
at which goods and services Total Revenue Test
can be sold; below the  Elastic – price increase (decrease)
equilibrium point leads to a decrease (increase) in total
o Price floor – lowest point at revenue; inversely related
which goods and services  Inelastic – price increase (decrease)
can be sold; above the leads to an increase (decrease) in
equilibrium point total revenue; directly related
*insert formula for price ceiling and price  Unitary Elastic – total revenue is
floor* maximized

Comparative Statics Perfectly Inelastic Demand

Comparative Static Analysis  If demand curve is a vertical
- The study of the movement from straight line
one equilibrium to another  Quantity is constant
- Competitive markets, operating  Price keeps on changing
free of price restraints, will be  The consumers do not respond to
analyzed when the changes in the price
o Demand changes
o Supply changes Perfectly Elastic Demand
o Demand and supply  If demand curve is a horizontal
simultaneously change straight line
Changes in Demand  Price is constant
o Increase in Demand ONLY  Quantity keeps on changing
  Measures responsiveness of a
Factors Affecting Price Elasticity percent change in demand for
 Availability of consumption good X due to a percent change in
substitutes – if consumers have the price of good Y.
d
many substitutes of product A, the  EQ x , P = % ∆ Qx
d

demand for product A will become % ∆ P} rsub {Y}¿ ¿

Y

ELASTIC; If product A is the only  Important for firms selling

product in the market (has no multiple products
 Price changes for one product
substitute), the demand for product
impact demand for other products
A will be INELASTIC
 Assessing the overall change in
 Time/Duration of purchase
revenue from a price change for
horizon – if consumers have one good when firm sells two
enough time, they can seek other goods is:
alternatives; but if consumers have 
only little time, consumers will
have to buy the product
[ d
x ]
∆ R= R x ( 1+ EQx , P ) + R Y EQyd , Px × % ∆ Px

 Expenditure share of consumers’ Quantitative Demand Analysis

budgets – if consumers spend small d
Qx =a 0 +a x P x + aY P y + am M + a H P H
share in the budget, then it is more
inelastic Px
 Own Price Elasticity - ax
Qxd
Marginal Revenue and the own Price Py
 Cross Price Elasticity - ay
Elasticity of Demand Qxd
 Marginal revenue - measures the M
 Income Elasticity - aM
additional revenue due to a change Qxd
in output Application:
 MR=P ( )
1+ E
E
The daily demand for Invigorated PED
shoes is estimated to be:
d
∞ < E<−1then , MR >O Qx =100−3 P x +4 P y −0.01 M + 2 P Ax
When E = -1 then, MR = 0 Suppose good X sells at $25 a pair,
−1< E< 0 then, MR<O good Y sells at $35, the company
utilizes 50 units of advertising, and
average consumer income is $20,000.
Calculate the own price, cross-price,
and income elasticities of demand.

Solution:
Qx d=100−3 ( 25 ) +4 (35 )−0.01 ( 20,000 ) +2 ( 50 )
¿ 65 units

Own Price Elasticity:

Px 25
ax =(−3 ) =−1.15
Cross-Price Elasticity Qxd 65
 Since -1.15 is > 1, demand for good X Application:
is elastic. An analyst for a major apparel
company estimates that the demand for
Cross Price Elasticity: its raincoats is given by:
Py 35
ay =( 4 ) =2.15 d
Qxd 65 Qx =10−1.2∈P x + 3 InR−2∈ A y
Since 2.15 is > 0, good y is a substitute Where:
for good x/invigorated PED shoes. R = Daily amount of Rainfall
Ay = Level of advertising on good Y
Income Elasticity:
M 20000 What would the impact of a 10% increase
aM =(−0.01 ) =−3.08 in the daily amount of rainfall?
Qxd 65
Since -3.08 is negative, good x is an
Solution:
inferior good.
EQxd , R=β R =3 (Coefficient of R )
d
% ∆ Qx
EQxd , R= →3
%∆R
DEMAND ELASTICITY d

INDICATORS ( 3 ) % ∆ Qx → 30 %
10
A 10% increase in rainfall will lead to a
OWN PRICE ELASTICITY
30% increase in the demand for raincoats.
 Elastic – greater than 1
What would be the impact of the demand
 Inelastic – less than 1
of a 10% decrease in the amount of
 Unitary Elastic – equals to 1 advertising directed toward good Y?
CROSS PRICE ELASTICITY

 If EQ x , P > 0, then X and Y are

d
Y

substitutes

 If EQ x , P < 0, then X and Y are

d
Y Solution:
complements EQxd , Ay=β A =−2 (Coefficient of Ay )
d
INCOME ELASTICITY % ∆ Qx
EQxd , Ay= →−2
% ∆ Ay
 Negative - good x is an inferior d
(−2 ) % ∆ Qx → 20 %
good −10
 Positive – good x is a normal A 10% decrease in the amount of
good advertising directed toward good Y will
have a 20% increase in the demand for
Elasticities for Nonlinear Demand raincoats.
Functions
d
Qx =β 0 + β x ∈ Px + β Y ∈ P y + β m InM + β H ∈P H Regression Analysis

 Own Price Elasticity - β x Ways to obtain information on the

 Cross Price Elasticity - β Y demand function:
 Income Elasticity - β m  Publishes studies
 - tb=
 Hire a consultant ^ a^
2σ b^
 t-statistics rule of thumb
 Regression Analysis using data on
quantity, price, income, and other
variables - When |t| ≥ 2, we are 95%
 Y = a + bX + e confident the true
Regression Line and Least Squares parameter in the regression
Regression is not zero (0)

True (population) regression model:

When t-stat is large we are confident that it
Y =a+bX + e is not zero thus the standard error is small
relative to the absolute value of the
 a = unknown population intercept
parameter estimate
parameter
 b = unknown slope parameter  ta^ =¿|6.69| > 2
 e = random error term with mean the intercept is statistically different
zero and standard deviation σ from zero
^ |-4.89| < 2
 tb=¿
Least Squares Regression Line
the slope is statistically different
Y = a^ + b^ X from zero

 a^ – least squares estimate of the  P values (Example: P value = 0.0012)

unknown parameter a - Only 12 in 10,000 chance that
 b^ – least squares estimate of the we’ll get an estimate at least as
unknown parameter b big as -2.6 in absolute value if
 a^ ∧b^ – represent the values of a the true coefficient is zero
- If the P value is .05 
and b = smallest sum of squared
estimated coefficient is
errors between a line and the
statistically significant at the
actual data 5% level
Evaluating Statistical Significance Evaluating the Overall Fit of the
Regression Line
 Standard Error – measures of
how much each estimated estimate  R-Square
varies in regressions based on the - Aka coefficient of determination
same true demand model using - Fraction of the total variation in
different data the dependent variable that is
 95% Confidence interval rule of explained by the regression
thumb -
- a^ ± 2 σ a^ 2 Explained Variation SSRegression
R= =
- b^ ± 2 σ b^ Total Variation SSTotal
 T-statistic  Adjusted R−square

- ta^ =
a^ - R-square that
2 σ a^ penalize
researchers for
 Interpretation (to check if the
model is statistically
having few degrees

significant)
of freedom

1. Look at the F – statistic

2 2 n−1
- R =1−(1−R )
and P-value of the output
n−k

1.1 the higher the f-

 n=total observations

statistic the better the

 k = number of estimated

overall regression fit

coefficients

2. the lower the p-value, the

 n-k = the degrees of

better overall regression

freedom for the

fit (p-value should be <

regression

0.05)
 F-statistic

3. Since a regression
- Measure of the total variation

relationship has been

to the total unexplained

confirmed, next to
variation (explained by the

determine is to what
regression relative)
extent the independent
- The greater the F-statistic, the
variables (x) can
better the overall regression fit
contribute to predict the
- Lower P-values are associated
future values of the
with better overall regression
dependent variable (y)
fit
Regression for Nonlinear Functions 4. Look at the Coefficients
and Multiple Regression
 Nonlinear Functional Relationships
 Nonlinear regression example
- InQ=β 0+ β P InP +e
- Q=β 0 + β P P+ e

 Functional relationships with multiple

variables
 Multiple regression example
- Qx d=a 0 +a x P x + am M + a H P H + e
-
d
Qx =β 0 + β x ∈ Px + β m InM + β H ∈P H +e

Step by Step Excel Application

1. Data > Data Analysis >
Regression > OK.
2. Select Y range
3. Select X ranges together
(must be placed side-by-
side: x1 x2 x3 … )