Managerial economics notes.pdf for mba students

Steevan Robert Tellis
Assit.Prof-Dept.Of MBA Page1
Shri Madhwa Vadiraja Institute of Technology and Managment
Managerial Economics: Meaning, Nature, Scope & Significance, Uses of Managerial Economics, Role and
Responsibilities of Managerial Economist. Theory of the Firm: Firm and Industry, Objectives of the firm,
alternate objectives of firm.
Managerial theories: Baumol‟s Model, Marris‟s Hypothesis, Williamson‟s Model.
MODULE-1INTRODUCTION
Economics is a social science concerned with the production, distribution, and consumption of goods
and services.
Economics studies how individuals, businesses, governments, and nations make choices about how to
allocate resources. Economics focuses on the actions of human beings, based on assumptions that
humans act with rational behavior, seeking the most optimal level of benefit or utility.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior
of the economy as a whole (analyzes the decisions made by countries and governments), and
microeconomics, which focuses on individual people and businesses (allocation of resources, and
prices of goods and services, taxes, regulations and government legislation.).
MANAGERIAL ECONOMICS: MEANING & DEFINITION
• “Managerial economics is concerned with the application of economic concepts and economic analysis
to the problems of formulating rational managerial decisions.
• Branch of Economics: „Managerial Economics is the study of Economic Theories, Principles and
Concepts which is used in Managerial Decision Making.‟
• „Managerial Economics is the Application of various Theories, Concepts and Principles of Economics
in the Business Decisions.‟
• It also includes „The Application of Mathematical and Statistical tools in Management decisions.‟
Definition:
1. “Managerial economics is the study of allocation of resources available to a firm among the activities
of that unit” - Hynes.
2. “The integration of economic theory and business practice for the purpose of facilitating decision
making and forward planning by management. – Spencer and Seligman.
3. “Managerial economics is the application of economic principles and methodologies to the decision-

Assistant Prof-Dept.Of MBA Page2
Making process within the firm or organization.”-Douglas.
4. “Managerial economics applies economic theory and methods to business and administrative decision-
making.”- Pappas & Hirschey.
MACROECONOMICS:
⚫ The study of economic activity by looking at the economy as a whole.
⚫ Macroeconomics analyzes overall economic issues such as employment, inflation, productivity,
interest rates, the foreign trade deficit, and the federal budget deficit....
⚫ An example of macroeconomics is the study of U.S. employment.
MICROECONOMICS:
⚫ Microeconomics is the social science that studies the implications of incentives and decisions,
specifically about how those affect the utilization and distribution of resources.
⚫ Microeconomics shows how and why different goods have different values, how individuals and
businesses conduct and benefit from efficient production and exchange, and how individual‟s best
coordinate and cooperate with one another.
⚫ Generally speaking, microeconomics provides a more complete and detailed understanding than
Macroeconomics.

NATURE OF MANAGERIAL ECONOMICS:
1. Art and Science: Management theory requires a lot of critical and logical thinking and analytical skills
to make decisions or solve problems. Many economists also find it a source of research, saying it
includes applying different economic concepts, techniques and methods to solve business problems.
2. Micro Economics: In managerial economics, managers typically deal with the problems relevant to a
single entity rather than the economy as a whole. It is therefore considered an integral part of
microeconomics.
3. Uses Macro Economics: A corporation works in an external world, i.e.it serves the consumer, which
is an important part of the economy. For this purpose, it is important that managers evaluate the various
macroeconomic factors such as market dynamics, economic changes, government policies, etc., and
their effect on the company.
Multi disciplinary: It uses many tools and principles that belong to different disciplines, such as
accounting, finance, statistics, mathematics, production, operational research, human resources,
marketing, etc.
4. Prescriptive/Normative Discipline: By introducing corrective steps it aims at achieving the objective
and solves specific issues or problems.
5. Management oriented: This serves as an instrument in managers‟ hands to deal effectively with
business - related problems and uncertainties. This also allows for setting priorities, formulating
policies, and taking successful decision-making.
6. Pragmatic: The solution to day-to-day business challenges is realistic and rational.
7. It is concerned with the application of theories and principles of economics.
SCOPE OF MANAGERIAL ECONOMICS:
Managerial economics is concerned with the application of economic concepts and analysis to the
problem of formulating rational managerial decisions. There are four groups of problem in both
decision making and forward planning.

1. Demand Analysis and Forecasting:
 A firm relies on converting inputs into outputs and generates revenue from them. A clear and accurate
estimation of demand ensures a continuous efficiency of the firm. Several external factors like price,
income, affect the demand that need to be analyzed.
 Upon analyzing these factors affecting the demand for a product, managers can decide on the
production. After estimating the current demands, manager‟s move ahead to predict future demands for
the product. This is referred to as demand forecasting.
2. Cost and Production Analysis:
 Cost Analysis is yet another function of Managerial economics.
 A company makes a profit in two ways: by increasing the demand or by reducing the cost.
 The determinants of assessing costs, the connection between cost and yield, the gauge of cost and
benefit are indispensable to a firm.
3. Pricing Decisions, Policies, and Practices:
⚫ Among the 4Ps of marketing, Price finds an important place. For any firm, Pricing is a very important
aspect of Managerial Economics as a firm's revenue earnings largely depend on its pricing policy.
However, it is a bit challenging as other players are competing in the same price segment.
⚫ When pricing a product is done, the costs of production are also taken into account. Managerial

Economics helps the management to go through all the analyses and then price a product. In an
oligopoly market condition, the knowledge of pricing a product is essential.
4. Capital Management:
⚫ Every asset a business owns is known as its capital. Capital management thus becomes an important
practice.
⚫ Planning and control of capital expenditures is a basic executive function. It involves the Equi-
marginal principle.
⚫ The prime objective is to ensure the sustainable use of capital. This means that funds should be kept at
a bay when the managerial returns are less than in other uses.
5. Profit Management:
⚫ A business firm is an organization designed with an intention to make profits and profits reflect the
success of a company. After all the analyses, it all rolls down to profits.
⚫ To maximize profits a firm needs to manage certain things like pricing, cost aspects, resource
allocation, and long-run decisions. This would mean that the firm should work from the very
beginning, evaluate its investment decisions and frame the best capital budgeting policies. Profit
management is considered as a difficult area of managerial economics.
OTHER:
⚫ Resource allocation: Scarce resources have to be used with utmost efficiency to get optimal results.
These include production programming, problem of transportation, etc.
⚫ Inventory and queuing problem: Inventory problems involve decisions about holding of optimal
levels of stocks of raw materials and finished goods over a period. These decisions are taken by
considering demand and supply conditions. Queuing problems involve decisions about installation of
additional machines or hiring of extra labour in order to balance the business lost by not undertaking
these activities.
⚫ Pricing problems: Fixing prices for the products of the firm is an important part of the decision
Making process. Pricing problems involve decisions regarding various methods of pricing to be adopted.

⚫ Investment problems: Forward planning involves investment problems. These are problems of
allocating scarce resources overtime. For example, investing in new plants, how much to invest, sources
of funds, etc.
Study of managerial economics essentially involves the analysis of certain major subjects like:
 Demand analysis and methods of forecasting
 Cost analysis
 Pricing theory and policies
 Profit analysis with special reference to break-even point
 Capital budgeting for investment decisions
 The business firm and objectives
 Competition.
 Inflation and economic conditions.
SIGNIFICANCE OF MANAGERIAL ECONOMICS:
 Business Planning: Managerial economics assists business organizations in formulating plans
and better decision making. It helps in analyzing the demand and forecasting future business
activities.
 Cost Control: Controlling the cost is another important role played by managerial economics. It
properly analyses and decides production activities and the cost associated with them.
Managerial economics ensure that all resources are efficiently utilized which reduces the overall
cost.
 Price Determination: Setting the right price is one of the key decisions to be taken by every
business organization. Managerial economics supplies all relevant data to managers for deciding
the right prices for products.
 Business Prediction: Managerial economics through the application of various economic tools
and theories helps managers in predicting various future uncertainties. Timely detection of
uncertainties helps in taking all possible steps to avoid them.

 Profit Planning and Control: Managerial economics enables in planning and managing the
profit of the business. It makes an accurate estimate of all cost and revenue which helps in
earning the desired profit.
 Inventory Management: Proper management of inventory is a must for ensuring the continuity
of business activities. It helps in analyzing the demand and accordingly, production activities are
performed. Managers can arrange and ensure that the proper quantity of inventory is always
available within the business organization.
 Manages Capital: Managerial economics helps in taking all decisions relating to the firm‟s
capital. It properly analyses investment avenues before investing any amount into it to ensure the
profitability of an investment.
 Assist in Decision Making
 Optimization of Resources
USES OF MANAGERIAL ECONOMICS:
1. Production Decisions: Production theory explains the principles in which the business has to take
decisions on how much of each commodity it sells and how much it produces and also how much of
raw material ie., fixed capital and labour it employs and how much it will use.
2. Inventory Decisions: Inventory decisions have a direct impact on production. For example, a decision
to increase safety stock means that the production rate must increase until the desired level of safety
stock is achieved
3. Cost Decisions: Its goal is to advise management on the most appropriate course of action based on the
cost efficiency and capability. Cost accounting provides the detailed cost information that management
needs to control current operations and plan for the future.
4. Marketing Decisions: Marketing decisions are those decisions that are taken by a marketing manager
to achieve the ultimate marketing objectives of the organization.
5. Investment Decisions: Investment decision refers to selecting and acquiring the long-term and short-
term assets in which funds will be invested by the business.
6. Personnel Decisions: Personnel decisions are decisions made in organizations that affect people's
work lives, such as selection, placement, and discharge. • All business organizations must make
personnel decisions about their employees. Some organizations useless formal and scientifically based
methods than others.

MANAGERIAL ECONOMIST:
⚫ A Managerial Economist is also termed as an economic advisor or business economist.
⚫ He is responsible for analyzing various internal and external environmental forces that influence the
functioning of business organizations.
⚫ Managerial economist makes several successful business forecasts and updates the management team
regarding the economic trends from time to time
ROLES AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST:
A managerial economist helps the management by using his analytical skills and highly developed
techniques in solving complex issues of successful decision-making and future advanced planning and
assists the business planning process of a firm.
⚫ Studies Business Environment
The managerial economist is responsible for analyzing the environment in which business
operates. Proper study of all external factors that affect the functioning of organization is must for
proper functioning. He studies various actors like growth of national income,
Competition level, price trends, phases of the business cycle and economy and updates the
management regarding it from time to time.
⚫ Analyses Operations Of Business
He analyses the internal operation of business and helps management in making better decisions
in regard to internal workings. Managerial economist through his analytical and forecasting skills
provides advice to managers for formulating policies regarding internal operations of the business.
⚫ Demand Forecasting and Estimation
Proper estimation and forecasting of future trends helps the business in achieving desired
profitability and growth. Managerial economist through proper study of all internal and external forces
makes successful forecasting of future uncertainties or trends.
⚫ Production Planning
Managerial economist is responsible for scheduling all production activities of business. He
evaluates the capital budgets of organizations and accordingly helps in deciding timing and locating of
various actions.

⚫ Economic Intelligence
He provides economic intelligence services by communicating all economic information to
management. Managerial economist keeps management always updated of all prevailing economic
trends so that they can confidently talk in seminars and conferences.
⚫ Performing Investment Analysis
A managerial economist analyzes various investment avenues and chooses the most appropriate
one. He studies and discovers new possible fields of business for earning better returns.
⚫ Focuses On Earning Reasonable Profit
He assists management in earning a reasonable rate of profit on capital employed in the business.
Managerial economist monitors activities of organizations to check whether all operations are running
efficiently as per the plans and policies.
⚫ Maintaining Better Relations
A managerial economist maintains better relations with all internal and external individuals
connected with the business. It is his duty to develop a peaceful and cooperative environment within
the organization and aims to reduce any opposition taking place.
THEORY OF THE FIRM:
The theory of the firm is the microeconomic concept founded in neoclassical economics that states that
a firm exists and makes decisions to maximize profits. The theory holds that the overall nature of
companies is to maximize profits meaning to create as much of a gap between revenue and costs. The
firm's goal is to determine pricing and demand within the market and allocate resources to maximize
net profits.
Theory of the firm is related to comprehending how firms come into being, what are their objectives,
how they behave and improve their performance and how they establish their credentials and standing
in society or an economy and so on.
The theory of the firm aims at answering the following questions:
• Existence – why do firms emerge and exist, why are not all transactions in the economy mediated over
the market?
• Which of their transactions are performed internally and which are negotiated in the market?

• Organization–why are firms structured in such a specific way? What is the interplay of formal and
informal relationships?
• Heterogeneity of firm actions/performances–what drives different actions and performances of firms?
FIRM AND INDUSTRY
A Firm is a commercial enterprise, a company that buys and sells goods and services to consumers
with the aim of making a profit. A business entity such as a corporation, limited liability company,
public limited company, sole proprietorship, or partnership that has goods or services for sale is
categorized as a firm.
An Industry is an economic activity concerned with the processing of raw materials and manufacture
of goods. It can also be said as a sector that produces goods or related services within an economy.
OBJECTIVES OF THE FIRM
1. Profit maximization
2. Sales maximization
3. Utility maximization
4. Increase market share/market dominance
5. Social/environmental concerns
6. Profit Satisficing
7. Co-operatives
1. Profit maximization: Considering any business that exists, they are usually concerned with
maximizing profit. Higher profit means:
 Higher dividends for shareholders.
 More profit can be used to finance research and development.
 Higher profit makes the firm less vulnerable to takeover.
 Higher profit enables higher salaries for workers.
2. Sales Maximization: Firms often seek to increase their market share, even if it means less profit. This
could occur for various reasons:
Increased market share increases monopoly power and may enable the firm to put up prices and make

more profit in the long run.
Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
Increasing market share may force rivals out of business. E.g. the growth of supermarkets has led to the
demise of many local shops. Some firms may actually engage in predatory pricing which involves
making a loss to force a rival out of business.
3. Utility maximization: It means “that managers get satisfaction from using some of the firm's potential
profits for unnecessary spending on items from which they personally benefit.”To pursue his goal of
utility maximization, the manager directs the firm's resources many ways.
4. Increase Market Share/ Market Dominance: This is similar to sales maximization and may involve
mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in
order to increase in size and gain more market share. More market share increases its monopoly power
and ability to be a price setter.
5. Social Concern: A firm may incur extra expense to choose products which don‟t harm the environment
or products not tested on animals. Alternatively, firms may be concerned about local community /
charitable concerns.
 Some firms may adopt social/environmental concerns as part of their branding. This can ultimately
help profitability as the brand becomes more attractive to consumers.
 Some firms may adopt social/environmental concerns on principal alone – even if it does little to
improve sales/brand image.
6. Profit Satisficing: Profit satisficing is a situation where there is a separation of ownership and control.
As a result, the owners are likely to have different objectives to the managers and workers.
7. Co-operatives: Co-operatives may have completely different objectives to a typical business. A co-
operative is run to maximize the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.

ALTERNATE OBJECTIVES OF THE FIRM:
• Economic objectives:
• Maximize growth rate
• Desire for liquidity
• Non-economic objectives:
• Survival
• Retention of Customers
• Innovation
• Recognition
• Optimum Utilization of Resources
• Supplying desired goods at reasonable prices
• Social welfare
• Building up public confidence for the public
MANAGERIAL THEORIES OF THE FIRM:
Managerial theories of the firm place emphasis on various incentive mechanisms in explaining the
behavior of managers and the implications of this conduct for their companies and the wider economy.
According to traditional theories, the firm is controlled by its owners and thus wishes to maximize
short run profits. The more contemporary managerial theories of the firm examine the possibility that
the firm is controlled not by its owners, but by its managers, and therefore does not aim to maximize
profits. Although profit plays an important role in these theories as well, it is no longer seen as the sole
or dominating goal of the firm. The other possible aims might be sale revenue maximization or growth.
MANAGERIAL THEORIES OF THE FIRM
• Baumol's Theory of Sales Revenue Maximization
• Marris Growth Maximization Model
• Williamson‟s Managerial Discretionary Theory

1. BAUMOL'S THEORY OF SALES REVENUE MAXIMISATION:
Baumol‟s Model: Baumol's theory of sales revenue maximization was created by American economist
William Jack Baumol. It's based on the theory that, once a company has reached an acceptable level of
profit for a good or service, the aim should shift away from increasing profit to focus on increasing
revenue from sales.
W.J.Baumol suggested Sales Revenue maximization as an alternative goal to profit maximization.
Managers only ensure acceptable level of profit, pursuing a goal which enhances their own utility.
Assumption of theTheory:
1. There is a single period time horizon of the firm.
2. The firm aims at maximizing its total sales revenue in the long run subject to a profit constraint.
3. The firm‟s minimum profit constraint is set competitively in terms of the current market value of its
shares.
4. The firm is oligopolistic whose cost curves are U-shaped and the demand curve is downward sloping.
Its total cost and revenue curves are also of the conventional type.

From the above graph considering Output in X axis and TR/TC/profit in Y axis, where TC is the total
cost curve, TR the total revenue curve, TP the total profit curve and MP the minimum profit or profit
constraint line. The firm maximizes its profits at OQ level of output corresponding to the highest point
В on the TP curve. But the aim of the firm is to maximize its sales rather than profits. The sales
maximization output is OK where the total revenue KL is the maximum at the sales maximization
output OK is higher than the profit maximization output OQ. But sales maximization is subject to
minimum profit constraint highest point of TR. This sales maximization output OK is higher than the
profit maximization output OQ. But sales maximization is subject to minimum profit constraint. The
output OK will not maximize sales as the minimum profits OM are not being covered by total profits
KS hence total revenue gets decrease from L to E showing the quantity level showing the quantity of
output „OD‟. By the above Baumol justified that sales revenue has to be optimally increased.
ARGUMENTS IN FAVOUR OF MAXIMISATION OF SALES GOAL:
Baumol‟s argument to justify sales revenue importance.
1. If the sales of a firm are declining then the banks, creditors and the capital market are not prepared to
provide finance to the firm anymore.
2. Its own distributors and dealers might stop showing interest on the firm‟s product in future.
3. Consumers might not buy its product because of its unpopularity and there is a more chance of
competitors acquiring the consumers.
4. Firm reduces its managerial and other staff with fall in sales.
5. But if firm‟s sales are large, there are economies of scale and the firm expands and earns large profits.
6. Salaries of workers and management also depend to a large extent on more sales and the firm gives
them bonus and other facilities.
Conclusion: This theory states that the sales maximization is to increase the total revenue by money
where, Sales can increase up to the point of profit maximization where the marginal cost equals
marginal revenue. If sales are increased beyond this point money sales may increase at the expense of

profits. If sales are increased beyond this point money sales may increase at the expense of profits.

2. MARRIS’S GROWTH MAXIMIZATION MODEL:
Robin Marris in his book The Economic Theory of „Managerial‟ Capitalism (1964) has developed a
dynamic balanced growth maximizing theory of the firm. He concentrates on the proposition that
modern big firms are managed by managers and the shareholders are the owners who decide about the
management of the firms.
The managers aim at the maximization of the growth rate of the firm and the shareholders aim at the
maximization of their dividends and share prices. To establish a link between such a growth rate and
the share prices of the firm, Marris develops a balanced growth model in which the manager chooses a
constant growth rate at which the firm‟s sales, profits, assets, etc., grow.
“In Corporate firms, there is structural division of ownership and management which allows managers
to set goals which do not necessarily conform to those of the owners.
The shareholders are the owners. Their utility function includes variables such as
 Profits,
 Size of output,
 Size of capital,
 Market share and
 Public image.
The Managers have other ideas. Their utility functions are:
 Salaries,
 Job security,
 Power and status
The Marris’s model is based on the following assumptions:
 It assumes a given price structure.
 Production costs are given.
 There is no oligopolistic interdependence.
 Factor prices are constant.
 Firms are assumed to grow through diversification.
 All major variables such as profits, sales and costs are assumed to increase at the same rate.
 The objective of the firm is to maximize its balanced growth rate.

The Growth itself depends on two factors: First, the rate of growth of demand for the firm‟s product-
GD; and second, the rate of growth of capital supply – GS.
All major variables such as profits, sales and costs are assumed to increase at the same rate.
• According to Marris, there are two different utility functions for the manager and the owner of the firm.
The utility function of the manager consists of his emoluments, status, power, job security, etc. On the
other hand, the utility function of the owner includes profits, capital, output, market share, etc.
• The firm may grow in size through the creation of new products which create new demands. Marris
calls it differentiated diversification. The introduction of new products depends upon the rate of
diversification, advertising expenses, R&D expenditures, etc.
• Marris establishes the relationship between growth and profits on the demand side through
diversification into new products. The links between growth and profits are different at different levels
of growth. In this growth-profits relationship, growth determines profits. When the rate of growth of
the firm is low, the relationship is a positive one.
• As new products are introduced, the firm expands(grows) and profits increase. With the further
increase in the growth rate due to greater diversification into new products, the growth-profits
relationship becomes negative. This is because there is the managerial constraint which sets a limit on
the rate of managerial growth that restricts the growth of the firm.

The firms‟ managerial ability to cope with a great number of changes at once is limited. It is not
possible to develop a larger management team for the development and marketing of new products.
• The higher rate of diversification requires higher expenditures on advertising and R&D. As a result,
beyond a certain growth rate, the higher growth rate leads to a lower rate of profit. This is illustrated in
Figure 4 where the GD curve first rises, reaches the highest point M and then starts falling.
• The growth-supply curve will be very steep as shown by GS1 curve .The firm‟s equilibrium will be at
point L where the GS1 curve intersects the GD curve. This is again not the optimal equilibrium point
of the firm because here the growth rate is low and profits are below the maximum level.
• Larger retained profits are required by managers to invest larger funds for the growth of the firm. These
raise the retention ratio which, in turn, leads to higher profits and higher growth rates until point M of
maximum profits is reached.
• This is again not the optimum equilibrium point of the firm because the managers feel that this
combination of higher growth rate and higher profits is approved by the shareholders and there is no
threat to their job security. They will, therefore, be encouraged to raise the retention ratio further, invest
more funds, expand and increase the growth rate of the firm.
• As a result, the growth-supply curve will become flatter and take the shape of GS3 curve as in the
figure where it intersects the DS curve at point E. At this point, distributed profits to shareholders fall.
But they are adequate to satisfy the shareholders so that there is no fear of fall in the prices of shares
and of the threat of take-overs. There is also job security for managers.
• Thus point E is the optimal equilibrium point of the firm. If the managers adopt a higher retention ratio
than this, the distributed profits will fall further and the shareholders will not be satisfied which will
endanger the job security of managers. The existing shareholders may decide to replace the managers.
If the distribution of low profits to shareholders brings a fall in the market prices of shares, it may lead
to take-over of the firm.
Criticism:
⚫ Marris assumes a given price structure for the firms. He, therefore, does not explain how prices of
products are determined in the market. This is a serious weakness of his model.
⚫ Another defect of this model is that it ignores the problem of oligopolistic interdependence of firms in
non- collusive market.
⚫ The assumption that all major variables such as profits, sales and costs increase at the same rate is
highly unrealistic.

⚫ It is also doubtful that a firm would continue to grow at a constant rate, as assumed by Marris. The firm
might grow faster now and slowly later on.
⚫ Marris lumps together advertising and R&D expenses in his model. This is a serious shortcoming of
the model because the effectiveness of these two variables is not the same in any given period.
Conclusion:
• Thus the manager of a firm aims at maximizing his utility,and his utility depends upon the rate of
growth of the firm. Though promoting the growth of the firm is the main aim of the manager, yet he is
also motivated by his job security. The manager‟s job security depends upon the satisfaction of
shareholders who are concerned to keep the firm‟s share prices and dividends as high as possible.
• Thus the manager aims at maximizing the rate of growth of the firm and the shareholders (owners) aim
at maximizing their profits in the form of dividends and share prices. Marris analyses the means by
which the firm tries to achieve its growth-maximization goal.
3. WILLIAMSON’S MANAGERIAL DISCRETIONARY THEORY:
 Oliver E. Williamson found (1964) that profit maximization would not be the objective of the
managers of a company.
 This theory assumes that utility maximization is a manager‟s sole objective. However it is only in a
corporate form of business organization that a self-interest seeking manager Maximize his/her own
utility, since there exists a separation of ownership and control.
 The managers can use their „discretion‟ to frame and execute policies which would maximize their own
utilities rather than maximizing the shareholders‟ utilities.
 This is essentially the principal–agent problem. This could however threaten their job security, if a
minimum level of profit is not attained by the firm to distribute among the shareholders.
 Utility function or "expense preference"[8]
of a manager can be given by:
U=U(S,M,Id)
U denotes the Utility function,
S denotes the “monetary expenditure on the staff” (not only the manager's salary and other forms of
monetary compensation received by him from the business firm)

M stands for "Management Slack“(non-essential management perquisites such as entertainment
expenses, lavishly furnished offices, luxurious cars, large expense accounts, etc. which are above
minimum to retain the managers in the firm) and
ID stands for amount of "Discretionary Investment". (The amount of resources left at a manager's
disposal, to be able to spend at his own discretion. For example, spending on latest equipment,
furniture, decoration material, etc.)
Managerial utility function:
The managerial utility function includes variables such as salary, job security, power, status, dominance,
prestige and professional excellence of managers.
The basic assumptions of the model are:
• Imperfect competition in the markets.
• Divorce of ownership and management.
• A minimum profit constraint exists for the firms to be able to pay dividends to their shareholders.
• Fig 1. Shows the various levels of utility (U1, U2, U3) derived by the manager by combining different
amounts of discretionary profits and staff expenditure. Higher the indifference curve, higher is the level
of utility derived by the manager. Hence the manager would try to be on the highest level of
indifference curve possible given the constraints. Staff expenditure is plotted on the x-axis and
discretionary profits on the y- axis.

• The discretionary profit in this simplified model is equal to the discretionary investment. The
indifference curves are downward sloping and convex to the origin. This shows diminishing marginal
rate of substitution of staff expenditure for discretionary profits. The curves are asymptotic in nature
which implies that at any point of time and under any given circumstance the manager will choose
positive amounts of both discretionary profits and staff expenditure
⚫ Assuming that the firm is producing an optimum level of output and the market environment is given,
the discretionary profits curve is generated, shown in Fig 2. It gives the relationship between staff
expenditure and discretionary profits.
⚫ It can be seen from the figure that profit will be positive in the region between the points B and
⚫ Initially with increase in profits, the staff expenditure the discretionary profits also increase, but this is
only till the point Πmax that is, till S level of staff expenditure. Beyond this if staffexpenditure is
increased due to increase in output, and then a fall in the discretionary profits is noticed.
⚫ Staff expenditure of less than B and more than C is not feasible as it wouldn't satisfy the
minimum profit constraint and would in turn threaten the job security of managers.

• To find the equilibrium in the model,Fig1.is superimposed on Fig2.
• The equilibrium point is the point where the discretionary profit curve is tangent to the highest possible
indifference curve of the manager, which is point E in Fig 3. Staying at the highestprofit point would
require the manager to beat a lower indifference curve U2.
• In this case the highest attainable level of utility is U3. At equilibrium, the level of profits would be
lower but staff expenditure S*is higher than the staff expenditure made at the maximum profit point.
• As indifference curve is downward sloping, the equilibrium point would always be on the right of the
maximum profit point. Thus the model shows the higher preference of managers for staff
expenditure as compared to the discretionary investments
Arguments:
⚫ In the Williamson theory or model argues that managers have discretion in pursuing policies which
maximize their own utility rather than attempting the maximization of profits which maximizes the
utility of owner and shareholders.

⚫ Profit acts as a constraint to this managerial behavior in that the financial market and the shareholders
require a minimum profit to be paid out in the form of dividends; otherwise the job Security of managers
is endangered.
⚫ In this theory Williamson considered the two important factors namely, staff expenditures on
emoluments (slack payments), and funds available for discretionary investment give to managers a
positive satisfaction (utility) because these expenditures are a source of security and reflect the power,
status, prestige and professional achievement of managers.
⚫ Being the head of a large staff is a symbol of power, status and prestige, as well as a measure of
professional success, because a progressive and increasing staff implies successful expansion of the
particular activity for which a manager is responsible within a firm.
Criticism:
⚫ This model does not clarify the basis of the derivation of his feasibility curve. In particular, he fails to
indicate the constraint in the profit-staff relation, as shown by the shape of the feasibility curve.
⚫ It lumps together staff and manager‟s emoluments in the utility curve. This mixing up of
non-Pecuniary and pecuniary benefits of the manager make the utility function ambiguous.
⚫ This model does not deal with oligopolistic interdependence and of oligopolistic rivalry.
QUESTIONBANK:
1. Define managerial economics. 3m
2. What is Managerial Revenue and ManagerialCost? 3m
3. Explain the concepts of Micro and Macroeconomics.7m
4. Discuss the scope of managerial economics.7m/10m
5. Explain the significance and uses of managerial economics.10m
6. Who is Managerial Economist? Elaborate the roles and responsibilities of managerial economist.10m
7. Discuss the objectives of the firm.7m
8. Explain the Baumol‟s sales revenue maximization model, with a suitable graph.10m
9. Elaborate the Marris‟s model? Explain with graph 10m
10. Enumerate the Williamson‟s Discretionary model with a graph? 10 M

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Managerial economics notes.pdf for mba students