Ch 1: Summary

Definition of Managerial Economics: The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently. The meaning of this definition can be best examined with aid of figure below:

Managerial #ecision $roblems

%conomic theory Microeconomics Macroeconomics

#ecision &ciences Mathematical %conomics %conometrics

M'(')%*+', %-.(.M+-& 'pplication of economic theory and decision science tools to solve managerial decision problems

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Managerial Decision Problems: Managerial decision problems arise in any organization (i.e. non-profit organization such as a hospital or a university or government agency . !hen they see" to achieve some goal or objective subject to limitations on the availability of essential inputs and in the face of legal constraints.

o Case of Hospital: ' hospital may see" to treat as patients as possible at an ade1uate medical standard with its limited physical resources (i.e. physicians2 technicians2 nurses2 e1uipment2 beds etc. and budget. o Case of University: The goal a state university may provide an ade1uate education to as student as possible subject to the physical and financial constraints it faces. o Case of government agency &imilarly2 a government agency may investigate to provide a particular service to as many people as possible the lowest feasible cost. +n all these cases2 the relevant organizations face management decision problems as it see" to accomplish their own goals or objective subject to the constraint they face. +t is important to note that the goals and constraints may differ from case to case2 however the basic decision-ma"ing process is the same. Economic Theory: The organization can solve its management decision problems by application of economic theory and the tools of decision science. %conomic theory refers to microeconomics and macroeconomics. %conomic theories see" to predict and explain economic behaviour based on a model. o Microeconomics: This subject is the study of the economic behaviour of individuals decision-ma"ing units such as individual consumers2 resources owners and business firm in the free enterprise system. o Macroeconomics: .n the other hand2 this subject is the study of the total or aggregate level of output2 income2 employment2 consumption2 investment and prices for the economy viewed as a whole. 3

o 'lthough the microeconomic theory of firm is the single most important element in the managerial economics2 the general macroeconomic conditions of the economy (i.e. the level of aggregate demand2 rate of inflation2 and interest rate in which the firm operates are also very important. o The theory of firm assumes that the firm see"s to maximize profits and minimize cost and on the basis of that it predicts how much of a particular commodity the firm should produce under different forms of mar"et structure or organization. Decision Sciences: Managerial economics is very closely related to the decision sciences. These use the tools of mathematical economics and econometrics to construct and estimate decision models aimed at determining the optimal behavior of the firm (i.e. how the firm can achieve its goals most efficiently . o Mathematical Economics: This subject especially is used to formalize (i.e. express in e1uational form the economic model postulated by economic theory. o Econometrics: This subject applies statistical tools (i.e. regression analysis to real world data to estimate the models postulated by economic theory and for forecasting. pplication of economic theory an! !ecision science tools to solve managerial !ecision problems

E"ample: %conomic theory postulates that the 1uantity demanded (4 of a commodity is a function of the price the commodity ($ 2 the income of consumers (5 2 and the price of related (i.e. complementary and substitute commodities ($ - and $& respectively. &o we may postulate the following formal model: #$ f %P&'& PC& PS(

!e can estimate this empirical relationship by collecting data on the variables mentioned in the e1uation above. This will permit the firm to determine how much 4 would change in $2 52 $- and $& and to forecast the future demand for the commodity. This information is essential in order for management to achieve the goal or objective of the firm (profit maximization most efficiently.
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Theory of the firm firm is an organi0ation that o Combines and organizes resources for the purpose of producing goods and/or services for sale. 7or instance8 there are millions of firms in the /nited &tates. These include proprietorship (i.e. firms owned by one individual 2 partnership and corporations (i.e. owned by stoc"holders . 7irms produce more than 9: percent of all good and services consumed in the /.&.'. The remainder is produced by the government and non profit organizations such as private college2 hospitals2 museums and foundations. o Internalizes transactions, reducing transactions costs. 7irms exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with wor"ers and owners of capital2 land and the other resources for each separate step of production and distribution process. +nstead2 entrepreneurs enter into long term and broader contracts with labor to perform a number of tas"s for a specific wages and fringe benefit. This "ind of contract is much less costly than numerous specific contracts and is highly advantageous both to entrepreneurs and to the wor"ers and the other resource owners. The firm exists in order to save on such transaction costs. 0y performing many functions within the firm2 the firm also saves on sales taxes and avoids price controls and other government regulations that apply only to transactions among firms. This is called internalizing transactions. o Primary goal is to maximize the wealth or value of the firm. ;

The theory of the firm was based on the assumption that the goal or objective of the firm was to maximize current or short-term profits. 7irms2 however2 are often observed to sacrifice short-term profit for the sa"e of increasing future or long-term profits. &ome examples of this are expenditures on research and development2 new capital e1uipment so on. &ince both short-term as well as long-term profits are clearly important the theory of firm now postulates that the primary goal or objective of the firm is to maximize the wealth or value of the firm. This definition can be formulated in the following e1uation: The present value of all e"pecte! future profits:

P# =

= 3 n + + L + (= + r = (= + r 3 (= + r
n

t t == (= + r
n

t #alue of %irm = t == (= + r
lternative Theories

T$t TCt (= + r t t ==
n

The theory of firm has also been criticized as being much narrow and unrealistic. 7or this reason2 broader theories of the firm have been proposed. The most prominent among these are models that postulate that the primary objective of the firm is the maximization of sales2 the maximization of management utility and satisficing behavior. ales maximization

'ccording to this model2 managers of modern corporations see" to maximize sales after an ade!uate rate of profit has been earned to satisfy stoc"holder. "anagement utility maximization

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This model postulates that with the advent of the modern corporation and resulting separation of management from ownership. Managers are more interested in maximizing their utility measured in terms of their compensation (i.e. salaries2 stoc" options etc. 2 the size of their staff2 extent of control over the corporation2 lavish offices etc. than maximizing corporate profits. This referred to as the Principle&agent problem. atisficing behavior

This stems from the great complexity of running the large modern corporation- a tas" often complicated by uncertainty and a lac" of ade1uate data. Manager are not able to maximize profits but can only strive for some satisfactory goal in terms of sales2 profit2 growth2 mar"et share and so on. This situation is called satisficing behaivour. Definitions of Profit

/usiness Profit: Total revenue minus the explicit or accounting costs of production.

The explicit or accounting costs' are the actual out of poc"et expenditures of the firm to purchase or hire inputs it re1uires in production. (i.e. wages to hire labour2 interest on borrowed capital2 rent on land and buildings and the expenditure on raw materials .

Economic Profit: Total revenue minus the explicit and implicit costs of production.

Implicit costs' refers to the value of the inputs owned and used by the firm in its own production processes.

)pportunity Cost: +mplicit value of a resource in its best alternative use.

Theories of Profit

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*is"-0earing Theories of $rofit 7rictional Theory of $rofit Monopoly Theory of $rofit +nnovation Theory of $rofit Managerial %fficiency Theory of $rofit

1unction of Profit

$rofit is a signal that guides the allocation of society?s resources. @igh profits in an industry are a signal that buyers want more of what the

industry produces. ,ow (or negative profits in an industry are a signal that buyers want less

of what the industry produces. /usiness Ethics

+dentifies types of behavior that businesses and their employees should not

engage in. &ource of guidance that goes beyond enforceable laws.

 The Changing Environment of Managerial Economics

)lobalization of %conomic 'ctivity

)oods and &ervices -apital Technology &"illed ,abor

Technological -hange

Telecommunications 'dvances The +nternet and the !orld !ide !eb