Managerial Economics Chapter 1

What is Economics? What is Micro and Macro economics? What is Managerial Economics?

Nature, scope and significance of Managerial Economics

How it is useful to a Manager? Functions of a Managerial Economist? What Role a managerial Economist plays in the Management Team

Managerial Economics
Def:- Economics is the Study of allocation of scarce resources, among alternative uses. 1. Resources are always scarce. 2. They are not only scarce, but also have alternative uses. 3. Optimum allocation is required Allocation problems are faced by individuals, Organizations (Both profit making and non- profit making) and Nations also. Economics deals with: 1. How an individual consumer allocates his scarce resources among alternative uses? - in such a way that he always tries to get maximum satisfaction. - Maximization of satisfaction / utility is the goal of an individual consumer. 2. Similarly, an individual producer aims at least cost combination of inputs to get a given quantities of output.

Managerial Economics

3. How an individual firm/Industry attains equilibrium.

A firm is said to be an equilibrium, if it attain profit maximizing level of out put.

It tries to maximize Revenue, or minimize Cost

4. How a country reach equilibrium: Allocating limited resources in such a way that the desired goals are reached. The goal may be over all welfare of its people. Individuals / organizations (profit/non profit)/nations attain their goals, by optimum use of limited resources.

Managerial Economics

What is Microeconomics and Macroeconomics ? Micro means Small and Macro means Large Microeconomics deals with the study of individual behaviour. It deals with the equilibrium of an individual consumer, producer, firm or industry.

Macroeconomics on the other hand, deals with economy wide aggregates.

Determination of National Income Output, Employment Changes in Aggregate economic activity, known as Business Cycles Changes in general price level , known as inflation, deflation Policy measures to correct disequilibrium in the economy, Monetary policy and Fiscal policy (Monetary policy is typically implemented by a central bank, while fiscal policy decisions are set by the national government. However, both monetary and fiscal policy may be used to influence the performance of the economy in the short run.)

Managerial Economics
What is Managerial Economics? Managerial Economics is economics applied in decision making. It is a special branch of economics bridging the gap between abstract theory and managerial practice Willian Warren Haynes, V.L. Mote, Samuel Paul Integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning - Milton H. Spencer Managerial economics is the study of the allocation of scarce resources available to a firm or other unit of management among the activities of that unit - Willian Warren Haynes, V.L. Mote, Samuel Paul

Managerial economics, used synonymously with business economics, is a branch of economics that deals with the application of microeconomic analysis to decision-making techniques of businesses and management units.

Economics role in decision making

Managerial Economics
BUSINESS ADMINISTRATION DECISION PROBLEMS

TRADITIONAL ECONOMICS : THEORY AND METHODOLOGY

DECISION SCIENCES : TOOLS AND TECHNICS

MANAGERIAL ECONOMICS : INTEGRATION OF ECONOMIC THEORY AND METHODOLOGY WITH TOOLS AND TECHNICS BORROWED FROM OTHER DECIPLINES

OPTIMAL SOLUTIONS TO BUSINESS PROBLEMS

Characteristics

Normative

It is concerned with varied corrective measures that

a management undertakes under various circumstances. It deals with goal determination, goal development and achievement of these goals. Future planning, policy-making, decision-making and optimal utilisation of available resources, come under the banner of managerial economics.

Pragmatic:
Managerial economics is pragmatic. In pure

micro-economic theory, analysis is performed, based on certain exceptions, which are far from reality. However, in managerial economics, managerial issues are resolved daily and difficult issues of economic theory are kept at bay.

Uses theory of firm

Managerial economics employs economic

concepts and principles, which are known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is narrower than that of pure economic theory.

 Takes the help of macroeconomics: Managerial

economics incorporates certain aspects of macroeconomic theory. These are essential to comprehending the circumstances and environments that envelop the working conditions of an individual firm or an industry.

 Prescriptive rather than descriptive: Managerial economics is a normative and applied

discipline. It suggests the application of economic principles with regard to policy formulation, decision-making and future planning. It not only describes the goals of an organisation but also prescribes the means of achieving these goals.

Scope
Theory of Demand: According to Spencer and

Siegelman, A business firm is an economic organisation which transforms productivity sources into goods that are to be sold in a market. Production function : Production function shows the relationship between the quantity of a good/service produced (output) and the factors or resources (inputs) used. The inputs employed for producing these goods and services are called factors of production.

 Theory of Exchange is popularly known as Price

Theory. Price determination under different types of market conditions comes under the wingspan of this theory.

 Theory of profit: Every business and industrial

enterprise aims at maximising profit. Profit is the difference between total revenue and total economic cost. Profitability of an organisation is greatly influenced by the following factors: Demand of the product Prices of the factors of production Nature and degree of competition in the market Price behaviour under changing conditions

 Theory of Capital and Investment: Theory of

Capital and Investment evinces the following important issues: Selection of a viable investment project Efficient allocation of capital Assessment of the efficiency of capital Minimising the possibility of under capitalisation or overcapitalisation

 Environmental issues: Managerial economics also encompasses

some aspects of macroeconomics. These relate to social and political environment in which a business and industrial firm has to operate.
This is governed by the following factors: The type of economic system of the country Business cycles Industrial policy of the country Trade and fiscal policy of the country Taxation policy of the country Price and labour policy

 General trends in economy concerning the

production, employment, income, prices, saving and investment etc. General trends in the working of financial institutions in the country General trends in foreign trade of the country Social factors like value system of the society General attitude and significance of social organisations

Managerial Economics
Functions of a Managerial Economists: The main function of a manager is decision making and managerial Economics helps in taking rational decisions. The need for decision making arises only when there are more alternatives courses of action. Steps in decision making : Defining the problem

Identifying alternative courses of action

Collection of data and analyzing the data Evaluation of alternatives Selecting the best alternative Implementing the decision Follow up of the action

Demand
Quantity demanded (Qd)
Amount of a good or service consumers are willing

& able to purchase during a given period of time

2-20

General Demand Function

Six variables that influence Qd

(P) Incomes of consumers (M)

Price of good or service Prices of related goods & services

(PR)

Taste patterns of consumers ( ) Expected future price of product (Pe) Number of consumers in market (N)

General demand function

Qd f ( P, M , PR , , Pe , N )
2-21

General Demand Function

Qd a bP cM dPR e fPe gN
b, c, d, e, f, & g are slope parameters
Measure effect on

Qd of changing one of the

variables while holding the others constant

Sign of parameter shows how variable is

related to Qd
Positive sign indicates direct relationship Negative sign indicates inverse relationship

2-22

General Demand Function

Variable Relation to Qd
Inverse
Direct for normal goods Inverse for inferior goods

Sign of Slope Parameter

P M PR

b = is negative c = is positive c = is negative

Direct for substitutes Inverse for complements

Direct Direct Direct

d = is positive d = is negative
e=
is positive

Pe N

f = is positive g = is positive
2-23

Direct Demand Function

The direct demand function, or simply

demand, shows how quantity demanded, Qd , is related to product price, P, when all other variables are held constant
Qd = f(P)

Law of Demand Qd increases when P falls & Qd decreases when P rises, all else constant

2-24

Inverse Demand Function

Traditionally, price (P) is plotted on the vertical

axis & quantity demanded (Qd) is plotted on the horizontal axis

The equation plotted is the inverse demand

function, P = f(Qd)

2-25

Graphing Demand Curves

A point on a direct demand curve shows either:
Maximum amount of a good that will be purchased

for a given price Maximum price consumers will pay for a specific amount of the good

2-26

A Demand Curve (Figure 2.1)

2-27

Graphing Demand Curves

Change in quantity demanded
Occurs when price changes Movement along demand curve

Change in demand
Occurs when one of the other variables, or

determinants of demand, changes Demand curve shifts rightward or leftward

2-28

Supply
Quantity supplied (Qs)
Amount of a good or service offered for sale during a

given period of time

2-29

Supply
Six variables that influence Qs

Price of good or service (P) Input prices (PI ) Prices of goods related in production (Pr) Technological advances (T) Expected future price of product (Pe) Number of firms producing product (F)

General supply function

Qs f ( P, PI , Pr , T , Pe , F )
2-30

General Supply Function

Qs h kP lPI mPr nT rPe sF
k, l, m, n, r, & s are slope parameters
Measure effect on

Qs of changing one of the

variables while holding the others constant

Sign of parameter shows how variable is

related to Qs
Positive sign indicates direct relationship Negative sign indicates inverse relationship

2-31

General Supply Function

Variable Relation to Qs
Direct
Inverse

Sign of Slope Parameter

P PI Pr T Pe F

k = is positive l = is negative

Inverse for substitutes Direct for complements

Direct Inverse Direct

m = is negative m = is positive
n = is positive r = is negative s = is positive
2-32

Direct Supply Function

The direct supply function, or simply supply,

shows how quantity supplied, Qs , is related to product price, P, when all other variables are held constant

Qs = f(P)

2-33

Inverse Supply Function

Traditionally, price (P) is plotted on the vertical

axis & quantity supplied (Qs) is plotted on the horizontal axis

The equation plotted is the inverse supply function,

P = f(Qs)

2-34

Graphing Supply Curves

A point on a direct supply curve shows either:
Maximum amount of a good that will be offered for

sale at a given price Minimum price necessary to induce producers to voluntarily offer a particular quantity for sale

2-35

A Supply Curve

(Figure 2.3)

2-36

Graphing Supply Curves

Change in quantity supplied
Occurs when price changes Movement along supply curve

Change in supply
Occurs when one of the other variables, or

determinants of supply, changes Supply curve shifts rightward or leftward

2-37

Market Equilibrium
Equilibrium price & quantity are determined by the

intersection of demand & supply curves

At the point of intersection, Qd = Qs Consumers can purchase all they want & producers

can sell all they want at the market-clearing or price

2-38

Market Equilibrium

(Figure 2.5)

2-39

Market Equilibrium
Excess demand (shortage)
Exists when quantity demanded exceeds quantity

supplied
Excess supply (surplus)
Exists when quantity supplied exceeds quantity

demanded

2-40

Changes in Market Equilibrium

Qualitative forecast
Predicts only the direction in which an economic

variable will move

Quantitative forecast
Predicts both the direction and the magnitude of the

change in an economic variable

2-41

Demand Shifts (Supply Constant)

(Figure 2.7)

2-42

Supply Shifts (Demand Constant)

(Figure 2.8)

2-43

THE THEORY OF THE FIRM

Although managerial economics is not concerned solely with the management of business firms, this is its principal field of application. To apply managerial economics to business management, we need a theory of the firm, a theory indicating how firms behave and what their goals are.
Although managerial economics is not concerned solely with the management of business firms, this is its principal field of application. To apply managerial

economics to business management, we

need a theory of the firm, a theory indicating how firms behave and what their goals are.
47

THE THEORY OF THE FIRM

The Objective of the Firm
To be able to discuss efficient or optimal decision making requires that a goal or objective be established. That is, a management decision can only be evaluated against the goal that the firm is attempting to achieve. Originally, the theory of the firm was based on the assumption that the goal of the firm was to maximize current or short-run profits. Firms, however, are often observed to sacrifice short-term profits for the sake of increasing future or long-term profits. Since both short-term as well as long-term profits are clearly important, the theory of the firm now suggests that the primary goal of the firm is to maximize the wealth or value of the firm.
48

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Put briefly, a firms value will be defined here as the present value of its expected future cash follows. For present purpose, we can regard a firms cash flow as being the same as its profit. Thus, expressed as an equation, the value of the firm equals

Present value of = expected profits

+ ... +

(1)

Where is the expected profit in the year t, i is the appropriate discount rate used to find the present value of future profits, and t goes from 1 (next year) to n (the last year in the planning horizon).
49

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Because profit equals total revenue (TR) minus total cost (TC), this equation can also be expressed as

Present value of = expected profits

Where

(2)

is the firms total revenue in year t, and is its total cost in year t.

To repeat, managerial economists generally assume that firms want to maximize their value, as defined in equations (1) and (2). However, this does not mean that a firm has complete control over its value, and that it can set it at any level it chooses. On the contrary, firms must cope with the fact that there are many constraints on what they can achieve. 50

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
The constraints that limit the extent to which a firms value can be increased are of various kinds as given below:

i. Input Constraints: - The amount of certain types of inputs may be limited. In the relevant period of time, the firm may be unable to obtain more than a particular amount of specialized equipment, skilled labour, essential materials, or other inputs.
ii. Legal Constraints: - Another important type of constraint that limits what firms can do is legal in nature. A wide variety of laws (ranging from environmental laws to antitrust laws to tax laws) limit what firms can do, and the contracts and other legal agreement made by firms further constrain their actions. As indicated in figure given below, these constraints limit how much profit a firm can make, as well as the value of the firm itself.
51

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Value of Firm
Input, legal and other constraints

The value of i depends on: 1 Riskiness of firm 2 Conditions in capital market

The value of depends on: The value of depends on: 1 Production Techniques 1 Demand and forecasting 2 Cost of Production 2 Pricing 3 Process Development 3 New product development

52

THE THEORY OF THE FIRM

Limitations of the Theory of the Firm The theory of the firm, which postulates that the goal or objective of the firm is to maximize wealth or the value of the firm, has been criticized as being much narrow and unrealistic.

In its place, 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 sales, the maximization of management utility, and satisficing behaviour.

53

Decision Making Environments

Type 1: Decision Making under Certainty.

Decision maker know for sure (that is, with certainty) outcome or consequence of every decision alternative.
Type 2: Decision Making under Uncertainty.

Decision maker has no information at all about various outcomes or states of nature.
Type 3: Decision Making under Risk.

Decision maker has some knowledge regarding

probability of occurrence of each outcome or state of nature.

54 Reddy SK,Dept of Management ,WU 3/19/2014

Decision Making Under Uncertainty

If the decision maker does not know with certainty which state of nature will occur, then he/she is said to be making decision under uncertainty. The four commonly used criteria for decision making under uncertainty are:

1. the optimistic approach (Maximax) 2. the conservative approach (Maximin)

the minimax regret approach (Minimax regret) 4. Equally likely (Laplace criterion)
3.

55

Reddy SK,Dept of Management ,WU

3/19/2014

Example: Marketing Strategy

Consider the following problem with two decision alternatives (d1 & d2) and two states of nature S1 (Market Receptive) and S2 (Market Unfavorable) with the following payoff table representing profits ( $1000):

States of Nature s1

s2

d1
Decisions d2
56 Reddy SK,Dept of Management ,WU

20
25

6
3
3/19/2014

Example: Optimistic Approach

An optimistic decision maker would use the optimistic approach. All we really need to do is to choose the decision that has the largest single value in the payoff table. This largest value is 25, and hence the optimal decision is d2. Maximum Decision Payoff d1 20 choose d2 d2 25 maximum
57 Reddy SK,Dept of Management ,WU 3/19/2014

Example: Conservative Approach

A conservative decision maker would use the conservative approach. List the minimum payoff for each decision. Choose the decision with the maximum of these minimum payoffs. Minimum Decision Payoff choose d1 maximum d1 d2
58 Reddy SK,Dept of Management ,WU

6 3
3/19/2014

Example: Minimax Regret Approach

For the minimax regret approach, first compute a regret table by subtracting each payoff in a column from the largest payoff in that column. The resulting regret table is:

s1
d1 d2 5 0

s2
0 3

Maximum

5 3

minimum

Then, select the decision with minimum regret.

59 Reddy SK,Dept of Management ,WU 3/19/2014

Example: Equally Likely (Laplace) Criterion

Equally likely, also called Laplace, criterion finds decision alternative with highest average payoff. First calculate average payoff for every alternative. Then pick alternative with maximum average payoff.

Average for d1 = (20 + 6)/2 = 13 Average for d2 = (25 + 3)/2 = 14 Thus, d2 is selected
60 Reddy SK,Dept of Management ,WU 3/19/2014

Managerial Economics

Optimization Techniques and New Management Tools

OPTIMIZATION Managerial economics is concerned with the ways in which managers should make decisions in order to maximize the effectiveness or performance of the organizations they manage. To understand how this can be done we must understand the basic optimization techniques. Functional relationships: relationships can be expressed by graphs:
P

Quick Differentiation Review

Name Function Derivative
dY/dX = 0

Example
Y=5 dY/dX = 0 Y = 5X dY/dX = 5 Y = 5X2 dY/dX = 10X

Constant Y = c

Functions
A Line

Y=cX

dY/dX = c

Power Y = cXb dY/dX = bcX

b-1

Functions

Quick Differentiation Review

Sum of Y = G(X) + H(X)

dY/dX = dG/dX + dH/dX dY/dX = 5 + 10X

Functions example Y = 5X + 5X2

Product of

Y = G(X) H(X) dY/dX = (dG/dX)H + (dH/dX)G

Two Functions example

Y = (5X)(5X2 ) dY/dX = 5(5X2 ) + (10X)(5X) = 75X2

Quick Differentiation Review

Quotient of Two

Y = G(X) / H(X)

Functions

dY/dX = (dG/dX)H - (dH/dX)G H2 Y = (5X) / (5X2) dY/dX = 5(5X2) -(10X)(5X) (5X2)2 = -25X2 / 25X4 = - X-2
Chain Rule

Y = G [ H(X) ] dY/dX = (dG/dH)(dH/dX) Y = (5 + 5X)2 dY/dX = 2(5 + 5X)1(5) = 50 + 50X

 USING DERIVATIVES TO SOLVE MAXIMIZATION AND

MINIMIZATION PROBLEMS
Maximum or minimum points occur only if the slope of the

curve equals zero.

Look at the following graph

Max of x y Slope = 0

the function
value of x

Y = -50 + 100X - 5X2 i.e.,

dy/dx

10

20

Value of Dy/dx when y is max 0

dY = 100 - 10X dX dY = 0 if dX
X = 10 i.e., Y is maximized when the slope equals zero.

Value of dy/dx which Is the slope of y curve

10

20

Note that this is not sufficient for maximization or minimization problems.

Optimization Rules
Maximization conditions: 1-

2-

dY = 0 dX d 2Y = < 0 dX 2

Minimization conditions: 1-

2-

dY = 0 dX d 2Y = > 0 dX 2

Applications of Calculus in Managerial Economics

maximization problem:
A profit function might look like an arch, rising to a peak and then

declining at even larger outputs. A firm might sell huge amounts at very low prices, but discover that profits are low or negative. At the maximum, the slope of the profit function is zero. The first order condition for a maximum is that the derivative at that point is zero. If = 50Q - Q2, then d/dQ = 50 - 2Q, using the rules of differentiation. Hence, Q = 25 will maximize profits where 50 - 2Q = 0.

More Applications of Calculus

minimization problem: Cost minimization supposes that there is a least cost point to produce. An

average cost curve might have a U-shape. At the least cost point, the slope of the cost function is zero. The first order condition for a minimum is that the derivative at that point is zero.

If TC = 5Q2 60Q, then dC/dQ = 10Q - 60. Hence, Q = 6 will minimize cost Where: 10Q - 60 = 0.

More Examples
Competitive Firm: Maximize Profits
where = TR - TC = P Q - TC(Q) Use our first order condition:

d/dQ = P - dTC/dQ = 0.

a function of Q

Max = 100Q - Q2
First order = 100 -2Q = 0 implies Q = 50 and; = 2,500

Second Order Condition: one variable

If the second derivative is negative, then its a maximum If the second derivative is positive, then its a minimum

Problem 1

Problem 2

Max = 100Q - Q2
First derivative

Max= 50 + 5X2
First derivative

100 -2Q = 0 second derivative is: -2 implies Q =50 is a MAX

10X = 0 second derivative is: 10 implies Q = 10 is a MIN

Extra examples
e.g.; Y = -1 + 9X - 6X + X first condition
2 3

X=

(12) 122 4(9 3) 6

=2 1

therefore Y = 0 at X=3 the second condition or X = 1

dY dX

= 9 - 12X + 3X2 = 0

Quadratic Function Y = aX + bX + c
2

d 2Y dX 2
at X = 3

= -12 + 6X

X=

b b2 4ac 2a

d 2Y dX 2
at X = 1

= -12 + 6(3) = 6 >0 ( minimum point)

a=3 b = -12 c=9

d 2Y dX 2

= -12 + 6(1) = - 6 <0 (maximum point)

 Marginal Analysis for Optimal

Decisions
The most interesting and

challenging problems facing a manager involve trying either to maximize or to minimize particular objective functions. Regardless of whether the optimization involves maximization or minimization, or constrained or unconstrained choice variables, all optimization problems are solved by using marginal analysis. No other tool in managerial economics is more powerful than

The concept of marginal value is widely used in economic analysis, for example marginal utility, marginal cost and marginal revenue. Marginality concept assumes special significance where maximisation or maximization problem is involved e.g. maximization of consumers utility, maximisation of firms profit, minimization of cost etc. The term marginal refers to the change (increase or decrease) in the total of any quantity due to one unit change in its determinant e.g. the total cost of production of a commodity depends on the number of units produced. In this case marginal cost or (MC) can be defined as the change in total cost as result of producing one unit less of a commodity thus, Marginal Cost (MC) = TCn TCn 1 Where TCn = total cost of producing n

 the results fall neatly into two

categories: the solution to unconstrained and the solution to constrained optimization problems. When the values of the choice variables are not restricted by constraints such as limited income, limited expenditures, or limited time, the optimization problem is said to be unconstrained. Unconstrained maximization problems can be solved by following this simple rule: To maximize net benefit, increase or

MB=MC

 In many instances, managers

face limitations on the range of values that the choice variables can take. For example, budgets may limit the amount of labor and capital managers may purchase. Time constraints may limit the number of hours managers can allocate to certain activities. Such constraints are common and require modifying the solution to optimization problems. To maximize or minimize an objective function subject to a constraint, the ratios of the marginal benefit to price must be equal for all activities,