MANAGERIAL

ECONOMICS
By
Dr.P.S.Valarmathy
Managerial Economics
Dr.P.S.Valarmathy
 SYLLABUS
 Meaning & Definition of Managerial
Economics
 Nature & Scope
 Role & Responsibilities of a Business
Economist
 Inter disciplinary Approach to
Managerial Economics
 Circular Flow of Economics Activity
 Goals of Business Firm
 ECONOMICS OVERVIEW
 Definitions to Economics
 Wealth Definition
 Welfare Definition
 Scarcity definition
 Growth Definition
 WEALTH DEFINITION
Economics is the Science of Wealth
The main purpose of all economic activity is to
acquire as much wealth as possible.
Production & Expansion of wealth is the
subject matter of economics.
 Adam Smith (1723 -1790)
 Severely criticized
 Father of Economics
 Pig Science / Dark &
 Classical School of Dismal Science
Economics
 Neglect immaterial wealth
 First Academic Economist ( Services)
 Book – An inquiry into  Narrowed down the
Nature & Causes of the scope of Economics
Wealth of Nations
 WELFARE DEFINITION
Economics is the Science of Welfare
Economics is the study of mankind in the ordinary
business of life; it explains that part of individual and
social action which is most closely connected with the
attainment & with the use of material requisites of
well being
 Wealth is not an end in
 Alfred Marshal
itself. Means to an End
 Neo Classical School of
 Enlarged the scope of
Economics
Economics
 Book – Principles of
 Criticsms – Included only
Economics (1890)
material welfare.
 Emphasis on man and
Excluded non material
welfare
welfare.
 SCARCITY DEFINITION
Economics is the Science of Scarcity or Choice
Economics is the science which studies human
behaviour as a relationship between ends and scarce
means which have alternative uses.

 Lionell Robbins  Unlimited Wants

 Pre Keynesian Stage  Limited means
 Book – An essay on then  Alternative uses of
Nature & Significance of limited means
Science  Criticism – Economic
 Highlights – fundamental Problems arise not
features of Human always on scarcity. Arise
Existence from abundance also.
 GROWTH DEFINITION
Economics is the study of how men and society end
up choosing with or without the use of money to
employ scarce productive resources that could have
alternative uses to produce various commodities and
distribute them for consumption now or in future
among various people and grouos in society.

 Paul A.Samuelson  Human Behaviour

 Book – Economics  Behaviour of Individuals
 Behaviour of Firms
 Three Fundamentals
 Behaviour of Government
 Human Behaviour
 Allocation of Resources  Scarcity of Resources lead to
allocation
 Alternative uses of resources
 MANAGERIAL ECONOMICS

OTHER NAMES
BUSINESS ECONOMICS
APPLIED (MICRO ECONOMICS)
ECONOMICS OF FIRMS
THORY OF THE FIRM
ECONMICS OF ENTERPRISES
ECONOMICS OF BUSINESS MANAGEMENT
ECONOMICS FOR MANAGERS
 MANAGERIAL ECONOMICS
MANAGEMENT OF A BUSINESS FIRM –
SIGNIFICANT FUNCTIONS
• DECISION MAKING
PROCESS OF SELECTING A PARTICULAR
COURSE OF ACTION AMONG THE VARIOUS
ALTERNATIVES AVAILABLE TO A BUSINESS FIRM TO
ACHIEVE ITS PREDETERMINED OBJECTIVE

•FORWARD PLANNING
FORMULATION OF FUTURE PLANSAND
POLICIES FOR THE BUSINESS FIRM
 MANAGERIAL ECONOMICS
• BRIDGES GAB BETWEEN ECONOMICS THEORY
& MANAGERIAL PRACTICE
• MANGEMENT – SET OF PRINCIPLES THAT HELP
IN DECISION MAKING UNDER UNCERTAINTY
• ECONOMICS – SET OF PROPOSITIONS THAT
HELP IN OPTIMAL ALLOCATION OF SCARCE
RESOURCES
• MANAGERIAL ECONOMICS – ECONOMICS
APPLIED IN BUSINESS DECISION MAKING
 MANAGERIAL ECONOMICS
• DEFINITION
• INTEGRATION OF ECONOMIC THEORY WITH
BUSINESS PRACTICE FOR THE PURPOSE OF
FACILITATING DECISION MAKING AND
FORWARD PLANNING BY MANAGEMENT –
Milton H Spencer & Louis Siegelman
• SCIENCE WHICH STUDIES THE ASPECT OF
MANAGERIAL BEHAVIOUR WHICH IS
CONCERNED WITH THE ECONOMIC
RATIONALE OF DECISION MAKING
 NATURE OF MANAGERIAL ECONOMICS
 PRAGMATIC & REALISTIC
 MICRO ECONOMIC IN CHARACTER
 MACRO ECONOMIC IN CHARACTER
 NORMATIVE RATHER THAN POSITIVE
 NOT PART OF ECONOMICS – A FUNDAMENTAL
DISCIPLINE
 BOTH CONCEPTUAL & METRICAL
 GOAL ORIENTED
 APPLICATION ORIENTED SCIENCE
 USES ECONOMICS OF THE FIRM
 TOOL IN THE STUDY OF BUSINESS
ADMINISTRATION
 NATURE OF MANAGERIAL ECONOMICS
 PRAGMATIC & REALISTIC – it involves
complications ignored in economic theory
 Pragmatism: "A reasonable and logical way of doing
things or of thinking about problems that is based on
dealing with specific situations instead of on ideas
and theories“
 NATURE OF MANAGERIAL ECONOMICS
THEORY OF THE FIRM / ECONOMICS OF THE
FIRM
 Neo classical theory
 Transactions Cost theory
 Principal – Agent Theory
 Evolutionary theory
 SCOPE
 Demand Analysis & Forecasting
 Cost Analysis
 Production & Supply Analysis
 Pricing Decisions, Policies & Practices
 Profit Management
 Investment Analysis / Capital Management
 Managerial Techniques
 DIFFERENCE BETWEEN MANAGERIAL
ECONOMICS & ECONOMICS

MANAGERIAL ECONOMICS ECONOMICS

 Application of economic  Deals with the body of
principles to the problems of Principles itself
firms
 Deals with firm only  Deals with firm & individual
 Mainly Profit theory is used.  Deals with all Distribution
Other Distribution theories theories – wages, interest &
are not used much profit
 Adopts, modifies &  Hypothesizes economic
reformulate economic relationships & build models
models
 Introduces feed backs
 Makes certain assumptions
 FACTORS INFLUENCING BUSINESS
DECISIONS
 EXTERNAL FACTORS – OUTSIDE THE
CONTROL OF MANAGEMENT .
 NATIONAL INCOME
 PRICES
 OUTPUT
 VOLUME OF TRADE
 CONSTITUTE BUSINESS ENVIRONMENT
 FACTORS INFLUENCING BUSINESS
DECISIONS
 INTERNAL FACTORS – LIE WITHIN THE
SCOPE & OPERATION OF A FIRM
 WITHIN THE CONTROL OF MANAGEMENT
 WHAT TO INVEST
 HOW MUCH LABOUR TO EMPLOY

 HOW TO PRICE ITS PRODUCTS

 KNOWN AS BUSINESS OPERATIONS

 ROLE OF A MANAGERIAL ECONOMIST
 STUDY ECONOMIC TRENDS AT MACRO LEVEL &
INTERPRET THEIR RELEVANCE TO PARTICULAR
INDUSTRY

 ACT AS A BRIDGE BETWEEN GOVERNMENT &

INDUSTRY

 MACRO FORECASTING FOR DEMAND & SUPPLY

 NATIONAL & INTERNATIONAL DEVELOPMENTS ON

ECONOMIC & INDUSTRIAL MATTERS

 ENVIRONMENTAL FORECASTING
 ROLE OF A MANAGERIAL ECONOMIST
 HELP MANAGEMENT IN TAKING DECISIONS ON
INTERNAL OPERATIONS OF A FIRM –

 SALES FORECASTING

 INDUSTRIAL MARKET RESEARCH

 PRODUCTION PLANNING

 CAPACITY PLANNING

 PRODUCT MIX DETERMINATION

 ECONOMIC FEASIBILITY OF NEW PRODUCTION

LINES
ROLE OF A MANAGERIAL ECONOMIST
 ASSISTANCE IN PREPARATION OF OVERALL
DEVELOPMENT PLANS

 PREPARATION OF PERIODICAL ECONOMIC REPORTS

 ECONOMIC ANALYSIS OF COMPETING COMPANIES

 INVESTMENT ANALYSIS & FORECASTS

 ADVICE ON TRADE & PUBLIC RELATIONS

 ADVICE ON FOREIGN EXCHANGE

ROLE OF A MANAGERIAL ECONOMIST
 ECONOMIC INTELLIGENCE – SUPPLYING
MANAGEMENT WITH ECONOMIC
INFORMATION SUCH AS COMPETITORS
PRICE & PRODUCTS

 PARTICIPATING IN PUBLIC DEBATES

 RESPONSIBILITIES OF MANAGERIAL ECONOMIST

 FAMILIAR WITH DAY TO AFFAIRS OF A FIRM

 MAKE SUCCESSFUL FORECASTS

 SYNTHESIS OF POLICIES PERTAINING TO

PRODUCTION, INVESTMENT, INVENTORIES & PRICE

 ALERT MANAGEMENT EARLY ON ANY ERROR IN

FORECAST

 CONTACTS WITH ASSOCIATES OF THE FRIM

 EXPRESS IDEAS IN SIMPLE & UNDERSTANDABLE

LANGUAGE
 RESPONSIBILITIES OF MANAGERIAL ECONOMIST
 AWARE OF CHANGING BUSINESS & ECONOMIC TRENDS

 KEEP A WATCH ON CHANGING TECHNOLOGICAL

DEVELOPMENT

 IDENTIFY, ANALYSE, DISCUSS, CRITICISE AND

INTERPRET & SUGGEST SUITABLE MEASURES FOR
MANAGERIAL PROBLEMS
 INTER DISCIPLINARY APPROACH
 MICRO ECONOMIC THEORY –
 Concepts –
 Elasticity of demand
 Marginal cost

 Marginal revenue

 Short run cost

 Long run cost

 Market structures

 Models –
 Models in Price theory – kinked demand
model, price discrimination model
 INTER DISCIPLINARY APPROACH

 Macro Economic Theory – Study of aggregate or the

behaviour of the economy as a whole
 Helps in the area of forecasting

 Keynesian theory of employment & income

 GNP model

 Theory of decision making

 New discipline
 Based on multiplicity of goals
 Pervasiveness of uncertainty in real world
 Process by which expectations under conditions of
uncertainty are formed
 Considers psychological & sociological influences on
human behaviour
 INTER DISCIPLINARY APPROACH

 Operations Research
 Application of mathematical economics to solve
the business problem

 Concerned with model building

 Concerned with optimisation

 Example – linear programing model

 Economic problems solved with OR – allocation

problems, waiting line problems, inventory
problems, competitive problems
 INTER DISCIPLINARY APPROACH

 Statistics
 Provides the basis for empirical testing of
theory

 Marshalling of quantitative data & provides

measure of suitable functional relationship –
eg. Demand & cost function to base pricing
decision

 Theory of probability provides logic for dealing

with uncertainty
 INTER DISCIPLINARY APPROACH

 Mathematics
 Managerial economics is metrical – estimating
various relationships, predicting economic
quantities is needed for decision making &
forward planning.

 Knowledge of mathemetical tools

 Geometry, trignometry, algebra, calculas, differential,
integral
 INTER DISCIPLINARY APPROACH

 Accounting
 Principal source of data for managers – accounting
information eg. Profit & loss account

 Careful interpretation, recasting & adjustments

needed before using accounting data

 Growing link between managerial economics &

management accounting
 INTER DISCIPLINARY APPROACH

 Marketing
 Four P’s of marketing – product, price, place &
promotion

 Analysis of production techniques & product mix

problems

 Evaluation of distribution policies & promotional

activites
 INTER DISCIPLINARY APPROACH

 Psychology & Sociology

 Provides basis of behavioural theory of the firm

 Study of individual & group behaviour is essential for

decision making (eg) installing a electronic data
processing machine
 IMPORTANCE OF MANAGERIAL ECONOMICS

 Helps Management & Business executives in making

decisions concerning –
 product mix
 Production technique
 Price
 Level of output
 Input mix etc.
 Basic economic concepts – elasticity of demand,
cost concepts etc help the executives for
identifying, analysing business problems & finding
solutions to the problems
 IMPORTANCE OF MANAGERIAL ECONOMICS

 Helps Management in predicting future business in

terms of cost, production, sales, profit price, demand
and capital

 Reconciles basic models, tools & theories with actual

business practices & environment

 Assists management to identify & understand both

external & internal factors that influence the business.

 Estimates the relationship between various business

factors eg. Cost volume profit analysis, elasticity of
demand etc.
 CIRCULAR FLOW OF ECONOMIC ACTIVITY

 Scarcity – pervasive economic problem

 Decision making agents of economy
 Households – individuals or group of individuals
(family)
 Firms
 Three basic economic activity
Production


 Consumption

 Exchange of goods & services

Decision-makers act and react in such a manner that all

economic activities move in a circular flow.
 CIRCULAR FLOW OF ECONOMIC ACTIVITY
 Households – Households are consumers.

 Single-individuals or group of consumers (families)

 Aim is to satisfy the wants of their members with

their limited budgets.

 Owners of factors of production—land, labour,

capital and entrepreneurial ability

 Sell the services of these factors and receive

income in return in the form of rent, wages, and
interest and profit.
 CIRCULAR FLOW OF ECONOMIC ACTIVITY
 Firms – producer in economics.
 Decision to manufacture goods and services is
taken by a firm.
 Employs factors of production and makes
payments to their owners.
 Firms produce goods and services to make a
profit.
 Includes joint stock companies, public
enterprises, partnership concerns, cooperative
societies, and even small and big trading shops
which do not manufacture the commodities
they sell.
 CIRCULAR FLOW OF ECONOMIC ACTIVITY
 Government - Plays a key role in all types of economic
systems—capitalist, socialist and mixed.
 In a capitalist economy –
 government does not interfere
 establishes and protects property rights
 sets standards for weights and measures
 sets standards for the monetary system
 In a socialist economy –
 Playa an extensive role
 owns and regulates the entire production and consumption processes of
the economy
 fixes prices of goods and services
 In a mixed economy –
 government strengthens the market system
 Regulates the activities of the private sector
 Provides incentives
 CIRCULAR FLOW OF ECONOMIC ACTIVITY
 Economic Activities –
 Production
 Consumption and
 Exchange
 Consumption and production are flows which
operate simultaneously and are interrelated and
interdependent. Production leads to consumption
and consumption necessitates production.
 Production is a means (beginning) and
consumption is the end of all economic activities.
 Both production and consumption, in turn, depend
upon exchange.
CIRCULAR FLOW OF ECONOMIC ACTIVITY-
TWO SECTOR
CIRCULAR FLOW OF ECONOMIC ACTIVITY(THREE SECTOR)
 GOALS OF BUSINESS FIRMS
 BUSINESS FIRM – DEFINITION
 An economic unit engaged in production and
distribution or sale of goods and services with
a view to earn maximum profits
 OBJECTIVES OF BUSINESS FIRM:
 Profit maximization

 Sales revenue maximization

 Growth maximization

 Utility maximization

 Satisfying behaviour

 Long run survival

 Welfare Objectives
 GOALS OF BUSINESS FIRMS
PROFIT MAXIMIZATION
 Profit -
 Sole objective of a business firm - Theory of
business firm
 Real indicator of success of any business
enterprise
 Common man’s language - Profit means the
excess of income over costs
 Economics and Managerial economics - Profits
refer to rewards for entrepreneurial skills .
 A remuneration for the entrepreneur or a reward
for his entrepreneurial skills.
 Linked with risk and uncertainty.
 Profits fluctuate - either positive or negative.
 GOALS OF BUSINESS FIRMS
PROFIT MAXIMIZATION
 Profit emerge because of –
 Risk taking
 Coverable Risks – Insurance
 Uncoverable risks - Business Risk
 Innovation
 Advantageous condition – Imperfect market condition,
product differentiation, monopoly
 windfall
 How to measure profit?
 Accounting Approach
 Profit = Revenue – Expenses (Explicit cost)
 Economics Approach
 Profit = Revenue – Expenses (Explicit cost & Implicit cost)
Total profit is maximised at an output level
when marginal revenue = marginal cost
PROFIT MAXIMISING GRAPH
OBJECTIVES OF FIRM
 SALES REVENUE MAXIMIZATION L

 Alternative model for profit maximization

 Developed by Prof. Boumol, an American economist

 Greater significance in the context of the growth of

Oligopolistic firms.

 Goal of the firm is maximization of sales revenue

subject to a minimum profit constraint

 The minimum profit constraint is determined by the

expectations of the share holders
 SALES REVENUE MAXIMIZATION
 Does not mean maximization of physical sales but
maximization of total sales revenue

 when sales are maximized automatically profits of the

company would also go up.

 Maximizing sales revenue occurs when the marginal

revenue, MR, from selling an extra unit is zero.

 Most real world firms probably do try to maximize sales

rather than profit.

 Firms operating in competitive markets - relative fixed

prices and relatively constant average cost - then
increasing sales is bound to increase profits, too.
 SALES REVENUE MAXIMIZATION
Rationalization of Baumol’s Sales Revenue Maximization
Model
 Salaries and other earnings of top managers –
correlated with sales than with profits.
 Banks and other financial institutions – willing to
finance firms with large and growing sales.
 Higher earnings and better terms of work for personnel

 Large sales, growing over time, give prestige to the

managers
 Managers, prefer a steady performance with satisfactory
profits to spectacular profit maximization projects
 Large growing sales strengthen the power to adopt
competitive tactics
 SALES REVENUE MAXIMIZATION
Arguments in defense of the model:

 Increase in sales and market share

 is a sign of healthy growth of a company

 increases the competitive ability of the firm

 Linked to the amount of slack earnings and salaries of the top

managers

 enhance the prestige and reputation of top management

 distribute more dividends to share holders and

 increase the wages of workers and keep them happy.

 indication of financial health of a firm.

 a policy of steady performance with satisfactory levels of profits

rather than spectacular profit maximization over a period of time.
SALES REVENUE MAXIMIZATION
 MAXIMISATION OF FIRM’S GROWTH RATE
 Robin Morris

 Managers try to maximise the firm’s Balanced Growth

Rate subject to managerial and financial constraints.
 Defined organization’s balanced growth rate as:
 G = GD = GC
Where GD = Growth rate of demand for organization’s
product
GC = Growth rate of capital supply to the
organization
 The equation implies that an organization’s growth rate i
balanced when demand for its product and supply of
capital to
the organization increase at the same rate.
 MAXIMISATION OF FIRM’S GROWTH RATE
 The two growth rates are translated two utility
functions : (i) Manager’s Utility Function and
(ii) Owner’s Utility Function.
 The Manager’s Utility Function and The Owner’s Utility
Function can be specified as follows:
 Manager’s Utility Function includes variables such as
salary, power, job security, prestige & status. The utility
function of managers can be written as
Um = f(salary, power, job security, prestige, status
 Owner’s Utility Function
 Uo = ƒ(output, capital, market share, profit and public
esteem)
Managers try to achieve both the above objectives so as
to maximize firms Balanced Growth Rate.
 MAXIMISATION OF FIRM’S GROWTH RATE
 By maximizing these variables, managers maximize
their as well as owner’s utility functions.

 Most of the variables in the utility functions of owners

and managers are positively related with the size of the
organization.

 Maximization of the size of the organization depends

upon the maximization of the growth rate.

 Thus, managers seek to maximize the growth rate.

 Maximization of Managerial Utility Function
 Williamson

 Managers are very careful in pursuing the objectives

other than profit maximization

 maximize their own utility function subject to a

minimum level of profit.

 Managers’ utility function (U) is expressed below:

 U = f(S, M, ID)

 where, S = additional expenditure on staff

 M = Managerial emoluments
 Maximization of Managerial Utility Function
 According to Williamson’s hypothesis, managers
maximize their utility function subject to a satisfactory
profit.

 A minimum profit is necessary to satisfy the

shareholders and also to secure the job of managers.
The utility functions which managers seek to maximize
include both quantifiable variables like salary and slack
earnings anti non-quantitative variable such as prestige
power, status, job security, professional excellence, etc.
 HYPOTHESIS OF SATISFYING BEHAVIOR
 Cyert-March
 Extension of Simon’s hypothesis of firms’ satisfying
behavior -
 Real business world is full of uncertainties.
 Accurate and adequate data are not readily available.
 If data are available, managers have little time and ability to
process them.
 Managers also work under a number of constraints.
 Under such conditions it is not possible for the firms to act in
terms of consistency assumed under
profit maximization hypothesis.
 Nor do the firms seek to maximize sales and growth.
 Instead they seek to achieve a satisfactory profit or a
satisfactory growth and so on.
 This behavior of business firms is termed as
satisfaction behavior
 HYPOTHESIS OF SATISFYING BEHAVIOR
 Cyert and March added apart from dealing with uncertainty –
 managers need to satisfy a variety of groups of people such as
managerial staff, labor, shareholders, customers, financiers,
input suppliers, accountants, lawyers, etc.
 All these groups have conflicting interests in the business firms.

 The manager’s responsibility is to satisfy all of them.

 “firm’s behavior is satisfying behavior which implies satisfying

various interest groups by sacrificing firm’s interest or
objectives.”
 In order to clear up the conflicting interests and goals,
managers form an objective level of the firm by taking into
consideration goals such as production, sales and market,
inventory and profit.
 Goals and objective level are set on the basis of the managers
past experience and their assessment of the future market
conditions.
 The objective level is also modified and revised on the basis of
achievements and changing business environment.
 LONG RUN SURVIVAL
 K.W.Rothschild
 Survival is the central motive of the firm
 Struggle for survival in the long run
 Set of survival objectives based on five survival
functions:
 Earn minimum amount of profit for its future survival
 Short run – accept less than the minimum profit; Long run
– aim to earn higher profit though not maximum
 Not prefer maximum profit which affect future growth

 Reasonable & fair profit margin is appropriate for future

growth
 Earn & maintain goodwill by improving quality of goods &
services
 With reputation firm can command higher market share &
survive for long period
 ENTRY PREVENTION & RISK AVOIDANCE
 Some economists have suggested that an objective of
organizations is to prevent the entry of new organizations in
the industry.
 The goals behind entry prevention are as follows:
 a. Attaining profit maximization in the long run
 b. Securing a stable market share
 c. Avoiding risks caused by unpredictable behavior of new
organizations