Managerial Economics- An Introduction

By Prof. Neha Patel

(c) Prof. Neha Patel

What is Economics?

Human wants are unlimited

Resources available to satisfy these wants are scare / limited People wants to maximize their gains Economic agents / society have some economic problems because of scarcity of resources They need to choose scare resources among alternatives (scare resources) based on choice and valuation of alternatives

Managerial Economics
1. Describes the economic forces that shape the internal and external environments of a business firm. 2. Prescribes rules for managerial decisionmaking that furthers the objective of the firm.

(c) Prof. Neha Patel

A Decision-Making Model
Objectives

Define the problem

Alternative Solutions Organizational and input constraints

Social constraints

Evaluation

Implement and monitor the decision

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What is Microeconomics?

Study of economic phenomena at micro level i.e. individual and firm level When it establishes cause and effect relationship between two or more economic events at micro level and provide basis if analysis it is positive science When it gives value judgment on what is good and what is bad for society it is a normative science

Uses of Microeconomics

Explains economic behaviour of individual decision makers consumers firms industries Predicts the future course of economic events by establishing cause and effect relationships Contributes in formulating economic policies and examining appropriateness of policies Price theory is being used in business decision making Formulates propositions which maximize social welfare

Limitations of Microeconomic Theories

Assume given level of aggregate data at national level Assume free enterprise system in an economy absence of Government intervention Scope of limited in the sense that it concerns with individual items

Model of an Economy: Real Flows and Money Flows (opposite direction to each other) Factor market (sale & purchase of input) Product market (sale & purchase of goods / services)
Factor Market Determination of Factor Price

Wages & Salaries

Payments for Purchases

Households
Taxes & Fees Transfer Payments

Government Sector
Taxes & Fees Transfer Payments

Business Firms

Product Market Determination of Product Price (c) Prof. Neha Patel

Objective of the Firm

Not market share Not growth Not revenue Not empire building Not name recognition Not state-of-the-art technology

(c) Prof. Neha Patel

Whats the objective of the firm?

The objective of the firm is to maximize the value of the firm. Value of the firm is the true measure of business success (of course, from a for-profit perspective.) Questions? 1. How is the value of the firm defined and measured? 2. How do managers go about adding value to the firm?
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Managerial Economics
Q1- Whats the value of the firm?
The present value of the firms future net earnings.
1 2 n V = [--------] + [ --------] + . . . + [ -------- ] (1+r)1 (1+r)2 (1+r)n t = [ ------- ] , (1+r)t

t = 1, 2, ... , N

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Managerial Economics
Q2 - How should a manager go about adding value?
A good map or a travel guide to the curious land of the Econ should help.

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Managerial Economics
A Useful Map
Profit = Total Rev - Total Cost = P . Qd - AC . Qs

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Theories of Profits
(Why are profits necessary?)

Risk-Bearing Theory of Profit - Profits (normal profits) are necessary to compensate for the risk that entrepreneurs take with their capital and efforts Dynamic Equilibrium (Frictional) Theory Profits, especially extraordinary profits, are the result of our economic systems inability to adjust instantaneously to unanticipated changes in market conditions.

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Theories of Profits

Monopoly Theory - Profits are the result of some firms ability to dominate the market Innovation Theory - Extraordinary profits are the rewards for successful innovations Managerial Efficiency Theory Extraordinary profits can result from exceptionally managerial skills of wellmanaged firms.

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Managerial Actions

Controllable factors (internal environment):

Productions Technology Marketing Mix Employment Policies Investment Strategies Capital structure

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Managerial Actions
Non-Controllable factors(external environment):

Level of Economic activities Economic Regulations Unions Global Business conditions Exchange rate changes

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Terminology Issues

The Marginality analysis Economic Profits Accounting Profits Cash flows

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Concept of Marginalism

Change occurred due to a single unit is know is marginalism or by using additional unit and getting expected additional output It should not be confused with average. Average means say for exp. Average product of labour = total product / total labour Marginal product of labour = change in product to one unit change in labour Marginalism is used to maximize the satisfaction of net gain or satisfaction must balance sacrifice
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Concept of Marginalism
1. 2. 3.

Examples of marginalism are: Marginal labour unit Marginal output of labour Marginal revenue Additional unit sold Marginal cost of production Additional unit produced Nature of relationship between the variables is to be clearly stated The independent variable is to be changed by just one unit at a time to work out the impact The absolute activity level is when marginal benefit = marginal cost (Baumol Principle) The desired activity level is when marginal benefit > marginal cost 20 (c) Prof. Neha Patel

The Principle of Marginality

$

$1,000

MC MB 1 2 3 4

Hospital Days
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(c) Prof. Neha Patel

Example of Marginalism
No. of TV Spots A: Total Benefit (Sales) Marginal Benefit (Sales) B: Total Cost Marginal Cost A-B: Net Benefit

1
2

20000
34000

14000

4000
8000

4000

16000
26000

3
4

42000
46000

8000
4000

12000
16000

4000
4000

30000 (desired activity level)

30000 (absolute activity level)

5
6

48000
49000

2000
1000

20000
24000
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4000
4000

28000
25000
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The Principle of Opportunity Cost

Costs are opportunities sacrificed. To be precise, the opportunity cost of a choice or decision is measured by the highest valued alternative that will be given up. Cost is not always the monetary expense Cost is often implicit rather than explicit

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Significance of the Opportunity Cost Concept

Accounting profits = Net revenue Accounting costs (dollar costs of goods and services) Reported on the firms income statement Economic profits = Net revenue Opportunities Costs Economic profits and opportunity costs are critical to decision making
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More examples of useful concepts

The principal-agent or the agency problems: Moral hazard

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Whats Managerial Economics?

Managerial economics is not a separate management discipline

Rather, it is a logical and useful tool for framing and solving management problems.

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Outline for this Course

Microeconomics Way of Thinking

Consumers, Value and Demand

Sellers, Production, Costs

Markets and Pricing

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What will we learn?

Useful economic principles for sound economic decision-making in a management context. The basics of the demand side of the market and which factors influence the buyers behavior. The fundamentals of the markets supply side laws of production and how these laws impact a firms costs. How firms costs and buyers demand together determine the firms price and net profit.
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Thank You!!

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