Introduction

Economics

Macro Economics
The study of the economic system as a whole

Micro Economics
The study of the behaviour of the individual/s and firm/s and their interaction in the market. Applied micro economic is Managerial Economics.

Managerial Economics

Focuses on the topics like:- Demand, production, cost, pricing, market structure and govt. regulation etc.
The better understanding of the economic behaviour of the firms and individuals results in better managerial talent, decisions, higher profits, allocation efficiency and an increase in the value of the firm etc. Development of Managerial Economic skill attributed to the followings 1. Circular flow of Economic Activities. 2. Nature and Objective of the Firm

3.Importance of Profit: Accounting & Economic Profit

4. Principal-Agent Problems 5. role of Economics in Decision Making

1. Circular flow of Economic Activities. Interrelationship among consumers, firms and resource owners in a market economy-

Circular flow of income, output, resources and factor paymentInterdependent relationship between product and factor markets.

Goods & services

Product Market

Goods & services

Household

Firms

Economic Resources Income

Economic Resources

Factor Market

Factor payments

Fig. Circular flow of income, output, resources & factor payment.

2. Nature and objective of the Firm

The very nature of the firm is to organize the factors of production to produce goods and services that will meet the demands of individual consumers and other firms in such a way that profit can be earned. Thus, the concept of firm and the theory of firms plays central role in Managerial Economics.
Rationale for the firm 1. Dichotomy:- Dichotomy in organizing production in a market economy i.e. Absence of external (govt./other) central control/ direction but existence of internal control and direction (performed by managers). In a free market economy, the organization and interaction of producers (i.e. firms) and customers is accomplished through the price system. But due to the dichotomous relation as mentioned above, the price system guides the decentralized interaction among consumers and firms, whereas central planning and control tend to guide the interaction within the firms.

This raises the question, why is the production system not guided by price signals ? That is, why do firms exist in a market economy? Essentially firms exist as organisations because the total cost of producing any rate of output is lower than if the firm did not exist. There are several reasons why these cost are low as follows :1- saving of transaction cost (associated with obtaining information, negotiation and contracts. ) 2- Saving cost (transaction cost while transacting among firms) by internalising certain things in production process. Given that production cost are reduced by organising production factors into firms, why wouldnt the process continue until there is just one large firm, such a giant that produces all goods and services for the entire economy? There are at least two reasons.

1- Higher Transaction cost

The larger the size of firm the Higher the transaction cost.
2- Limited managerial ability :The larger the size of firm the limited the managerial ability. Thus it leads to allocative inefficiency & hence production costs per unit of output will tend to rise as firm goes larger. This can be termed as diminishing returns to management. To overcome this problems many large firms are organised in to groups of divisions (i.e. decentralised by establishing a number of separate divisions) referred to as profit centers that act as individual firms. The management of each of these seeks to maximise divisions profit.

The objective of the firm

to maximise the present value of all future profits, subject to various constraints like moral, contractual, financial and technological constraints etc..

Traditionally, economists have assumed that the objective at the firm is to maximise profit. But profit in which period? This year? The next five year? Often, managers are observed making decisions that reduce current year profits in an effort to increase profits in future years. Expenditure for R&d, New capital equipment, and major marketing programmes are a few examples of activities that reduce profits initially but will significantly increase profits in later years. As both current and future profits are important it is assumed that the goal is to maximise the present or discounted value of all future profits.

Symbolically.
Maximise PV ( ) = 1 + 2 + -------- + n 1+r (1+r)2 (1+r)n Where, PV= present value, -profit, r = discount rate, t = time period or max. PV ( ) = n t (1 + r)t i=1

Example : An Annuity of three, Rs. 100- payments at the end of each of the next three years at 10% interest rate. PV = 100 [ PVAF10%, 3years ] = 100 [2.4868]= 248.68 or, PV = 100 [ 3 1 ] = 100 (2.4868) = 248.68 (1+r)3 i=1 Or, PV = 100 1 + 100 1 + 100 1 1.10 (1.10)2 (1.10)3

= 100 (PV1F 10% ,1) + 100 (PV1F 10%, 2) + 100 (PV1F 10%, 3)
= 100 (0.9091 + 0.8264 + 0.7513) = 100 (2.4868) = 248.68 = 100 (PVAF 10%, 3yrs) = 100 (2.4868) = 248.68

PVAF = Present Value Annuity Factor.

PVIF = Present Value Interest Factor

Principal Agent Problem

The principal (owner or, stockholders) Agent (Manager) problem refers to the possibility that owners and their managers may have different objectives. These interests can be aligned through the use of managerial compensation arrangements that tie individual compensation to the overall performance of the firm.
Example : smith is hired as the president of a firm at an annual salary of Rs. 5,00,000 plus a five year option to by 1,00, 000 shares of stock at the current market price of Rs. 50% per share. Assume that within five years the price of the stock has increased to Rs. 75 per share. Smith exercises the option by buying 1,00,000 share for Rs. 50,00,000 which have a market value of Rs. 75,00,000. In the year the option are exercised, smith has a gain (i.e. additional compensation) of Rs. 25,00,000. However if the price of stock had remained unchanged or had declined, this option would have no value and smith would have received no additional compensation.

The Present Value of all future profits can also be interpreted as the value of the firm, that is, what a willing buyer would pay for the business. Thus, to maximise the discounted value at all future profits is equivalent to maximising the value of the firm. Examples of PV method. PV of an Amount :- (S = Amount).

PV = S [

(1+i)n

] = S [PVIF i, n]

Where, PVIF i, n = Present value Interest Factor at i rate in n period present value of Rs. 1 in n period if the interest rate is i . Example:- 1)What is the PV of Rs. 1080 in 1 year if the interest rate is 8% per year. 2) What is the PV of Rs.1,00,000 to be received at the end of 10 years if the interest rate is 10 % ?.

Ans:- 1)

PV = 1080 [

1+0.08

] = 1080 [

1.08

] = Rs. 1000

Or, PV = 1080 [0.9259] = Rs. 1000 ( Where, PVIF 8%, 1 yr. = 0.9259 as given in PVIF Table) 2) PV = 100, 000 [
1

(1+0.10)10

] = 100,000 [

(1.10)10

] = 38,550.
10 yrs =

Or PV = 100,000 [0.3855] = 38,550 [ PVIF 10%, PV of an Annuity

1 1 1

0.3855 ]

PV = A

(1+i)

+ A

+ (1+i)2
1

-------- + A

(1+i)n

Or, PV = A[ n i=1

(1+i)t

] = A [ PVAF i, n ]

Concept of Economic Profit

Economic profit refers to Revenues minus all relevant costs, both explicit and implicit. Thus, the Accounting profit differs from economic profit by the magnitude of implicit costs.
The implicit cost is opportunity cost. Opportunity cost is the income foregone which a business man could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Further, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, using productive assests (land & building) in his own business, he sacrifices his market rent. These foregone incomes - interest, salary and rent etc. are called opportunity cost or, transfer cost. Accounting profit does not take into account the opportunity cost.

Example:-

Consider an individual who has an MBA degree and is considering investing Rs. 2,00,000 in a retail store that he would manage. Further, the best alternative use for this money (i.e. Rs. 2,00,000) might be in a bank account paying a 5% interest rate per annum. Also it is learnt that the annual wage return on an MBA degree from a reasonably good business school may be Rs. 60,000 per year. Given this information stated above, the projected income statement for the year as prepared by an accountant is shown as follows. Find out the Economic profit and show how it is different from Accounting profit.
Sales 90,000 Less: Cost of goods sold 40,000 Gross profit -------------------------50,000

Less Advertising

10,000

Depreciation
Utilities Property tax Misc. expenses

10,000
3,000 2,000 5,000

30,000 ----------20,000

Net Accounting profit Less : implicit cost Return on 2,00,000 of invested capital 10,000 Foregone wages 60,000 ------------Net Economic Profit

70,000 ---------- 50,000

From, this broader perspective, the business is projected to lose Rs. 50,000 in the first year. The 20,000 accounting profits disappears when all relevant costs are included. Obviously with the financial information reported in this way, an entirely different decision might be made on whether to start this business. Another way of looking at the problem is to assume that Rs. 2,00,000 had to be borrowed at 5% interest per annum and an MBA graduate hired at Rs. 60,000 per year to run the store. In this case, Implicit costs become explicit and the accounting profit is the same as the economic profit (i.e. 50,000) because all costs both explicit and implicit, have been considered. PROBLEMS 1-1, A recent engineering graduate turns down a job offer at Rs. 3,00,000 per year to start his own business. He will invest Rs. 5,00,000 of his own money, which has been in a bank account earning 7% interest per year. He also plans to use a building he owns that has been rented for Rs. 15,000 per month.Revenue in the new business during the first year was Rs. 10,70,000 while other expenses were:-

Advertising Rent Taxes Employees' Salaries Supplies

Rs. 50,000 1,00,000 50,000 4,00,000 50,000

Prepare Two income statements, one using the traditional accounting approach and one using the opportunity cost approach to determine profit. Ans:Revenue Less: Explicit costs Advertising Rent Taxes Employees Salaries Supplies Rs. 10,70,000 50,000 1,00,000 50,000 4,00,000 50,000

65,0000

Accounting Profit
Less implicit Cost Return of Rs. 5,00,000 35,000

4,20,000

Invested Capital
Rent foregone Foregone Salary 1,80,000 3,00,000 5,15,000

Economic Profit

-95,000

The business is projected to lose 95,000 in the first year

1-3

Kishore, a college sophomore, generally spends his summers working on the college maintenance crew at a wage rate of Rs. 60 per hour for a 40 hr. week. Overtime work is always available at an hourly rate of 1.5 times the regular wage rate. For the coming summer, he has been offered the pizza stand concession at the student union building, which would have to be opened 10hrs per day, 6 days a week. He estimates that he can sell 100 pizzas a week at Rs.60 each. The production cost of each pizza is Rs.20 and the rent on the stand is Rs.1500 per week. Should Kishore take the pizza concession? Explain.