MANAGERIAL

ECONOMICS
Theory of the Firm

In this lesson we will be able to:

1. Reason for the Existence of Firms and its Functions
2. The Objective and Value of the Firm
3. Constraints on the Operation of the Firm
4. Limitations of the Theory of the Firm
The Economic Way of Thinking
Economics is concerned with the efficient and effective allocation of recsources.
Efficiency means attaining maximum output with the least possible input. Effectiveness
can be attained by getting the desired outcome. Economists can either allocate
efficiently or effectively.

There are many ways to depict how economists think, here are 3 applicable ways:
1. decision-making during scarcity
2. rational behavior
3. marginal analysis
The Economic Way of Thinking
1. In a world of scarcity, most of the things we do would require us
to make choices.
Because resources are limited, decision makers should decide
what to have and what to forgo. This is the reason why we hear an
economist say, “There is no such thing as free lunch.” The idea is
simple: you may get treated to lunch by a person, so it is “free” for
you, but it will be a cost to someone else-up to the extent that it
could also affect the society.
The Economic Way of Thinking
1. In a world of scarcity, most of the things we do would require us
to make choices. Ex. Government suggested on increasing the fare
from P15 to P60.

Hypothetical Computation of Government Subsidy in One Year

Subsidy per individual Average number of Average amount of Average amont of
people taking the LRT subsidy every day subsidy every year
every day
45 500,000 22,500,000 8,212,500,000
The Economic Way of Thinking
To maintain the cheap train fare, the government has to get a share of the
national budget so it can respond to this need. This is one of the reasons why a
fare hike has been proposed 2012: both LRT and MRT only benefit the people
residing in Metro Manila, and yet the said utility is getting a portion of what is
due for the other parts of the nation. This means that other people in the
country are sacrificing a portion of their income to maintain the cheap fare.
This is why the government wants to balance the situation, but others do not
approve of such contention because it would hurt heir daily expenses.

Economists call these sacrifices opportunity cost. Opportunity cost is the cost
we forgo to getting something else. The cost of that which you get is the value
of which is sacrificed to obtain it.
The Economic Way of Thinking
2. Rational Behavior

In economics, one of the assumptions we always acknowledge is that human

behavior reflects “rational self-interest.” Individuals would always find a way to
increase their utility. Utility in economics is an individual’s pleasure, happiness
or satisfaction. These are the things where we have allocated our time, money,
energy, and other resources to maximize our well-being. Whatever makes a
person happy and satisfied gives him/her a specific utility.
The Economic Way of Thinking
3. Marginal Analysis

In essence, before we choose a certain alternative, we often ask ourselves if

this will be “beneficial or not” or shold we pursue this action or not” In the
economic perspective, these questions are also asked, but they are often
answered in a unique way by using an approach we call marginal analysis or
comparing the marginal cost and marginal benefits. The word marginal means
additional, change in or add in. This mbefore a certain action is made,
economists would look at how it may affect the firm at the margin.
The Economic Way of Thinking
3. Marginal Analysis
To understand this further, let us look at the table below.
Number of employees Number of output Marginal productivity
produced
1 50 0
2 60 10
3 71 11
4 76 5
5 77 1

Here we can see that when the number of employees changed from one to two, the addtional benefit of
the firm is 10. It increase by 11 when the employees are already three, but slowly declines as it reaches
four to five. This means that this hypothetical firm’s gain was high when it hired its second and third
employees, but gained a litttle on the fourth and fifth one. Sometimes we do not recognize that an
additional unit of something could do too much of a good things.
What is a Firm?
A firm is a for-profit business organization—such as a corporation,
limited liability company (LLC), or partnership—that provides
professional services. Most firms have just one location. However, a
business firm consists of one or more physical establishments, in which
all fall under the same ownership and use the same employer
identification number (EIN).
What is the Theory of the Firm

In neoclassical economics—an approach to economics focusing on the

determination of goods, outputs, and income distributions in markets
through supply and demand—the theory of the firm is a microeconomic
concept that states that a firm exists and make decisions to maximize
profits.
A firm maximizes profits by creating a gap between revenue and costs.
Theory of the Firm
Neoclassical economics dominates mainstream economics today, so the theory of the firm
(and other theories associated with neoclassicism) influences decision-making in a variety of
areas, including resource allocation, production techniques, pricing adjustments, and the
volume of production.
While early economic analysis focused on broad industries, as the 19th century progressed,
more economists began to ask basic questions about why companies produce what they
produce and what motivates their choices when allocating capital and labor.
Theory of the Firm
In microeconomics, the theory of the firm attempts to explain why firms exist, why they
operate and produce as they do, and how they are structured. The theory of the firm asserts
that firms exist to maximize profits; however, this theory changes as the economic
marketplace changes. More modern theories would distinguish between firms that work
toward long-term sustainability and those that aim to produce high levels of profit in a short
time.
 Theory of the Firm
 The theory has been debated and expanded to consider whether a company's goal is to maximize

profits in the short-term or long-term. Modern takes on the theory of the firm sometimes distinguish

between long-run motivations, such as sustainability, and short-run motivations, such as profit

maximization.
 If a company's goal is to maximize short-term profits, it might find ways to boost revenue and reduce

costs. However, companies that utilize fixed assets, like equipment, would ultimately need to make

capital investments to ensure the company is profitable in the long-term. The use of cash to invest in

assets would undoubtedly hurt short-term profits but would help with the long-term viability of the

company.
WHAT ECONOMICS IS AND WHY YOU SHOULD CARE

"Economics is the study of man's actions in the ordinary business of life:

it enquires how he gets his income and how he uses it." - Dr. Alfred
Marshall

Economics as "the science, which studies human behavior as a

relationship between ends and scarce means which have alternative
uses." - Prof Lionel Robbins
 THE MANAGER
The manager is a person who directs resources to achieve a
stated goal. This definition includes all individuals who (1)
direct the efforts of others, including those who delegate
tasks within an organization such as a firm, a family or a club;
(2) purchase inputs to be used in the production of goods and
services such as the outut of a firm, food for the needy, or
shelter for the homeless; or (3) are in charge of making other
decisions such as product price.
 THE MANAGER
A manager generally has responsibility for his or her own
actions as well as for the actions of individuals, machines and
other inputs under the manager's control. This control may
involve responsibilities for the resources of a multinational
corporation or for those of a single household. In each
instance, however, a manager must direct resources and the
behaviour of individuals for the purpose of accomplishing
some task.
 ECONOMICS
Economics is the science of making decisions in the presence
of scare resources. Resources are simply anything used to
produce a good or service or, more generally, to achieve a
goal.

Decisions are important because scarcity implies that by

making one choice, you give up another.
 ECONOMICS
A computer firm that spends more resources on advertising
has fewer resources to invest in research and development.

A food bank that spends more on soup has less to spend on

fruit. Economic decision thus involve the allocation of scarce
resources, and a manager's task is to allocate resources so as
to best meet the manager's goals.
 MANAGERIAL
ECONOMICS
is the study of how to direct scarce resources in
the way that most efficiently achieves a
managerial goal. It is a very broad discipline in
that it describes methods useful for directing
everything from the resources of a household to
maximize welfare to the resources of a firm to
maximize profits.
 EXAMPLES OF DECISIONS
MANAGERS MAKE
• Should you purchase components such as disk drives
and chips from other manufacturers or produce them
within your own firm?
• Should you specialize in making one type of computer
or produce several different types?
• How many computers should your produce, and at
what price should you sell them?
 EXAMPLES OF DECISIONS
MANAGERS MAKE

The key to making sound decisions is to know what

information is needed to make an informed decision and
then to collect and process the data.
THE ECONOMICS OF EFFECTIVE
MANAGEMENT

The nature of sound managerial decisions varies

depending on the underlying goals of the managers.
Since this course is designed primarily for managers
of firms.
 THE ECONOMICS OF EFFECTIVE
MANAGEMENT
Overview of the basic principles that comprise effective management. In
particular, an effective manager must:

• Identify goals and constraints;

• Recognize the nature and importance of profits;
• understand incentives;
• Understand markets;
• Recognize the time value of money; and
• Use marginal analysis
 IDENTIFY GOALS AND CONSTRAINTS

Overview of the basic principles that comprise effective management. In

particular, an effective manager must:

• Identify goals and constraints;

• Recognize the nature and importance of profits;
• understand incentives;
• Understand markets;
• Recognize the time value of money; and
• Use marginal analysis
 IDENTIFY GOALS AND
CONSTRAINTS

The first step in making sound decisions is to have well- Notice that in both instances, the
defined goals because achieving different goals entails making decision maker faces constraints
different decisions. If your goal is to maximize your grade in that affect the ability to achieve a
this course rather than maximize your overall grade point goal. Contraints are an artifact of
average, your study habits will differ accordingly. Similarly, if scarcity.
the goal of a food bank is to distribute food to needy people
in rural areas, its decisions and optimal distribution network
will differ from those it would use to distribute food to needy
innder-city residents.
 IDENTIFY GOALS AND
CONSTRAINTS

The goal of maximizing profits

requires the manager to decide the
Different units within a firm may be given different goals; optimal price to charge for a
those in a firm's marketing department might be instructed product, how much to produce,
to use their resources to maximize sales or market share,
which technology to use, how
while those in the firm's financial group might focus on
earnings growth or risk-reduction strategies. much of each input to use, how to
react to decisions made by
competitors and so on.
 SIGNIFICANCE OF
MANAGERIAL ECONOMICS

The goal of maximizing profits

requires the manager to decide the
Different units within a firm may be given different goals;
optimal price to charge for a
those in a firm's marketing department might be instructed
to use their resources to maximize sales or market share, product, how much to produce,
while those in the firm's financial group might focus on which technology to use, how
earnings growth or risk-reduction strategies. much of each input to use, how to
react to decisions made by
competitors and so on.
 There are different projections of the subject matter on managerial economics by
different authorities, but the following features seem common to these viewpoints.

1. Concerned with decision-making of economic nature.

This implies that managerial economics deals with identification of
economic choices and allocation.
 There are different projections of the subject matter on managerial economics by
different authorities, but the following features seem common to these viewpoints.

2. Micro-economic in character, where the unit of study is a firm. It concentrates on the study of the
firm and not on the working of the economy.

The chief source of concepts and analytical tools for managerial economics is micro-economic theory,
also known as price theory, some of the popular micro- economic concepts are the elasticity of demand,
marginal cost, the long-run economies and diseconomies of scale, opportunity cost, present value and
market structures. Managerial economics also uses some of the well-accepted models in price theory,
such as model for monopoly price, kinked demand model, the model of price discrimination and the
behavioral and managerial models.
 There are different projections of the subject matter on managerial economics by
different authorities, but the following features seem common to these viewpoints.

3. Concerned with normative micro-economics, where the economist says what he

thinks should happen rather than what does happen to the firm. When applies that
the decisions of the firm are made almost always within the broad framework of
economic environment within which thee firm operates, known as maco-economic
conditions. With regards to these conditions, we may stress these points.
 There are different projections of the subject matter on managerial economics by
different authorities, but the following features seem common to these viewpoints.

4. Takes the help of macro-economics to understand and adjust to the

environment in which the firm operates.
We know that the decisions of the firm are made almost always within the broad
framework of economic environment within which firm operates, known as micro-
economic conditions.
 There are different projections of the subject matter on managerial economics by
different authorities, but the following features seem common to these viewpoints.

5. Goal-oriented and prescriptive

It deals with how decisions should be mad e by managers to achieve the

organizational goals. Knowledge of managerial economics helps in making wise
choices—as managers continue to face the problem of scarcity of resources and
making suitable choices to allocate them appropriately in order to achieve
organizational goals.
Circular Flow of Economic Activity
 Circular Flow of Economic Activity
Production (transformation of productive resources into goods and services
occurring at the firm)

Society’s real income is the goods the economic system produces.

Production is the process that transforms productive resources such as capital and
labor into useful goods and services. It is these goods and services that constitute
society’s real income. The more resources and the more productive are those
resources, the more goods and services that are produced.
 Circular Flow of Economic Activity

Income (flows from Firms to Households in payment for productive resources)

Income is the reward the productive resources receive for participating in this production
process. Income and production are similar to two sides of the same coin. Income is the
reward for the resources or inputs and production is the measure of the output resulting
from the combination and transformation of those inputs or resources. Some households
have this income reduced by paying taxes. Others experience transfer payments such as
family income allowances and have a disposable income that is higher than what they have
earned as productive resources.
 Circular Flow of Economic Activity
The Firm (answers the question where — as in where production occurs)

The firm is a place where production occurs. It can be a private sector firm such as Wal-Mart or a government
owned firm such as port authority. Absent productive resources, nothing happens at the firm such as when a
strike or lockout occurs. The owners are not the firm. In the private sector, the owners are the equity
capitalists who are productive resources just as is labor. Profits are the reward to the equity capitalists and in
economic analysis, are a cost to the firm. Private sector firms can be organized as a corporation in which the
equity capitalists are the owners as well as a productive resource or in a non-corporate form such as a
partnership or proprietorship. In this latter case, the proprietors and partners are the equity capitalists but
also productive resources employed by the firm they own. The entrepreneurs are the productive resource
that make the decisions for the firm. Entrepreneurs may or may not also be equity capitalists or labor
supplying more than one type of productive resource to the firm in the transformation process called
production.
 Circular Flow of Economic Activity
The Household (dual role of supplying productive resources and demanding goods and services —consumer)

In free market capitalism, all resources are owned by the households and supplied to the firm in the
transformation process called production. Conventionally, they are divided into four categories, labor, debt
and equity capital, entrepreneurship, and land. As an economy develops, labor is increasingly embodied
human capital, resulting from education, training and experience. Capital can be provided by creditors in
which case it is debt capital or by the owners in which case it is equity capital. Entrepreneurship is the
decision making resource that determines what is produced by the firm and the way in which it will be
produced. They also determine the prices to be charged buyers and the prices to be paid for resources. Land
includes all natural resources and location or space. The rewards from each of the resources are
compensation to employees for labor, profits for equity capitalists, interest for debt capitalists, etc.