Economics 340H - Managerial Economics

Lecture 1 – Scope and Nature of Managerial Economics

1.1 - Defining Managerial Economics

Refers to the use of economic theory (micro and macro) and the tools
of analysis of decision science (mathematical economics and
econometrics) to examine how an organization can achieve its aims
and objectives most efficiently.
Microeconomics – Is the study of decisions of individual people and
businesses and the interaction of these decisions:
• Price & quantities of individual goods and services.
• Effects of government regulation & taxation on prices
and quantities of goods and services produced.
Macroeconomics - Is the study of the national economy and the global
economy.
• Effects of taxation and government spending on the
economy and is measured through jobs, labour, output,
income etc…
• Effects of money and interest rates.
Mathematical Economics – Is used to formalize the economic models
postulated by economic theory.
Econometrics – applies statistical tools (regression analysis) to real
world data to estimate models postulated by economic theory and
forecasting.
Managerial economics combines or applies economic tools and
techniques to business and administrative decision making using
micro, macro, mathematical and econometric models.
Prescribes rules for improving managerial decisions and public policy.
Integrates and applies microeconomic theory and methods to decision
making problems faced by private, public, and not-for-profit
organizations.
Managerial economics deals with microeconomic reasoning on real
world problems such as pricing decisions selecting the best strategy in
different competitive environments.

Christopher Michael, Department of Economics - Trent University 1

 Economics 340H - Managerial Economics

1.2 - Relationship of Managerial Economics to other fields of study.

Managerial economics uses concepts and quantitative methods to

solve managerial problems.

Management Decision Problems

- Product selection, output and pricing
- Internet strategy
- Organizational design
- Product development and promotion
- HR – hiring and training
- Investment and financing

Economic Concepts Quantitative Methods

- Marginal analysis - Numerical analysis
- Theory of consumer demand - Statistical estimation
- Theory of the firm - Forecasting procedures
- Industrial organization - Game theory
and firm behaviour - Optimization techniques
- Public choice theory - Information systems

Managerial Economics = Optimal Solutions to Management Decisions

To make good economic decisions, managers need to be able to

forecast & estimate relationships.

Christopher Michael, Department of Economics - Trent University 2

 Economics 340H - Managerial Economics

Seven steps in the decision making process.

1.3 - Theory of the firm

A firm may seek to maximize profits subject to limitations on the

availability of essential inputs (skilled labour, land, capital and raw
materials) and legal constraints (minimum wage laws, health and
safety, and pollution).

Value of the firm = Present value of expected future profits

PV  1 /(1  r )1   2 /(1  r ) 2  ....  3 /(1  r ) 3 or

Such that:
PV  i 1  t /(1  r ) t
n

PV = Present value of all expected future profits of the firm.

  Expected profits in each of the n years considered.
r = discount rate.

Christopher Michael, Department of Economics - Trent University 3

 Economics 340H - Managerial Economics

Example 1:

The owner of a small business expects to generate a profit of $100,000

per year for 2 years and is going to sell the firm at the end of the second
year for $800,000. The owner believes that the appropriate discount rate
for the firm is 10 percent per year. What is the value of the small
business based on the assumptions that the owner has set?

PV  $100,000 /(1  .1)1  $100,000 /(1  .1) 2  $800,000 /(1  .1) 2

PV  $100,000 /(1.1)  $100,000 /(1.21)  $800,000 /(1.21)
PV  $90909.1  $82,644.6  $661,157.0
PV  $834,710.7

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

 Public Goods are goods that can be consumed or used by more than
one person at the same time with no extra cost.
 Instead of profit, NFP organizations may have as their goals:

1. Maximization of output, subject to a budget constraint.

2. Maximization of the utility of NFP administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP
organization.

• Which goal a NFP manager selects affects decisions made.

» A food bank manager may maximize the utility of clients by selecting
only "healthy foods"
• Public sector managers are performance monitored.
» Hospital administrators are rewarded for reducing the cost per bed
over a year. Hence, they become efficient with respect to costs.
» The "friendliness" of the hospital staff is harder to measure, so
friendliness will tend not be a high priority of the public sector manager.

Christopher Michael, Department of Economics - Trent University 4

 Economics 340H - Managerial Economics

Examples of NFPs

Not for profit organizations (NFP)

 Hospitals
 Universities / Colleges
 Museums
NFPs seek to reach some goal or objective subject to a constraint.
What are the objectives of NFPs?
 Hospital – objective (patients)
 University / college (students)
 Museum (customers)
What are the constraints NPOs face?
 Hospital (doctors, nurses, beds, facilities, equipment
etc…)
 University / college (Faculty, staff, funding sources,
facilities, etc….)
 Museum (funding, space etc…)

1.4 – Nature and Function of Profits

Economic Profit

Economic profit = Total Revenue – Economic Costs

Total Revenue = Price * Quantity
Economic costs include:
o Explicit costs
 Are the actual out-of-pocket expenditures of the firm to
hire labour, borrow capital, rent land and buildings and
purchase raw materials.
o Implicit costs
 Are the money value of inputs owned and used by the
firm in its own production processes.
Economic profit = Total Revenue – explicit costs - implicit costs
Accounting profit = Total Revenue – explicit costs
Economic profit = Accounting profit – implicit costs

Christopher Michael, Department of Economics - Trent University 5

 Economics 340H - Managerial Economics

Normal profit = implicit costs = opportunity cost of owner-supplied

resources
Economic profit = Accounting profit – normal profit

Example 2:

The costs for a typical full-time student attending Trent University for
their first yr of study in 2006-07 is $4,372 for tuition fees, $1,184 for
compulsory and student fees, $8,500 for a residence room and a meal
plan, and $650 for textbooks. As an alternative to attending University
that same student could have earned $28,000 by getting a job in the
labour market. In addition, they could have earned 4.5% interest by
investing the money not spent on attending Trent University.

Calculate explicit costs, implicit costs and economic costs.

a) Explicit costs

EC = $4,372 + $1,184 + $8,500 + $650

EC = $14,706

b) Implicit costs

IC = Income Earned + Investing University Costs @ rate of return of 4.5%

IC = $28,000 + ($14,706 * .045)
IC = $28,000 + $661.77
IC = $28,661.77

c) Total economic cost that the student faces for that one year?

Economic Costs = Explicit costs + Implicit Costs

Economic Costs = $14,706 + $28,661.77
Economic Costs = $43,367.77

Christopher Michael, Department of Economics - Trent University 6

 Economics 340H - Managerial Economics

Profit Maximization

Profit maximization and value maximization are equivalent in the

long run
If costs and revenue are independent of decisions made in other
periods, short-run profit-maximization is equivalent to value
maximization

Incentives

Separation of ownership and control

Principal-agent problem
– Shareholders (principals) want profit
– Managers (agents) want leisure & security
Moral hazard problem
Incentive compatibility
– Equity ownership
– Outside directors
Tie CEO pay to value of the firm
Debt finance
 Adds risk of bankruptcy and loss of job for managers
 Loans must be repaid
 Lenders provide monitoring

Market structure and decisions

Economic theory postulates that the quantity demanded of a

product (Q) is a function of, or depends upon, the price (P), the
income of consumers (Y), and the prices of related commodities
(complementary and substitutes).

Such that: Q  f ( P, Y , Pc , Ps )

Control over price varies by market structure

o Price-setting firms
o Price-taking firms

Christopher Michael, Department of Economics - Trent University 7

 Economics 340H - Managerial Economics

Market = any arrangement through which buyers and sellers

exchange goods or services
Transactions costs affect market outcomes and price dispersion

Alternative market structures

# of and size of firms

Degree of product differentiation
Likelihood of entry of new firms in response to economic profits

Perfect competition

Large number of firms

Homogeneous product
No barriers to either entry or exit

Monopoly

Single seller
No close substitutes
Barriers to entry
– Economies of scale
– Exclusive ownership of raw material
– Licensing, patents, copyrights, legal franchise
Local monopolies may exist

Monopolistic competition

Many firms
Differentiated product
Free entry and exit

Oligopoly

Few firms produce most output

Homogeneous or differentiated product
Barriers to entry

Christopher Michael, Department of Economics - Trent University 8

 Economics 340H - Managerial Economics

Recognized mutual interdependence

Globalization
Increased global integration
Growth of imports and exports in all industrialized economies
Reduction in trade barriers
Internet and reduced transaction costs
NAFTA, FTAA, EU, EMU

Michael Porter - The 5 forces that determine competitive advantage are:

 Substitutes
 Potential Entrants

 Buyer Power

 Supplier Power

 Intensity of Rivalry

Christopher Michael, Department of Economics - Trent University 9