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Topic 1

The Nature & Scope


of
Economics

What is the Economic


Problem?
The ECONOMIC PROBLEM is the
problem of allocating resources
efficiently
to achieve objectives
while satisfying constraints, such
as
scarcity
requirement

Economics analyses and provides


answers to basic fundamental
question of scarcity
Scarcity arises out of two basic
fundamental facts of life
a) Wants unlimited
b) Economic Resources limited

Three questions
A) What to produce
B) How to produce
C) For whom to produce

Objectives of Economic
Agents
Different groups have different objectives
Firms maximize profits constrained by
demand (consumer preferences),
production (technological production
possibilities),
competition (competitive responses),
government (regulatory or fiscal measures)

Consumers maximize utility


prices and other characteristics of goods
income

Governments maximize social welfare

Managerial
Economics:

Introduction

Definition of Economics
ECONOMICS IS THE ART OF MAKING THE
MOST OF LIFE..GB Shaw
.THE STUDY OF MANKIND IN
THE EVERYDAY BUSINESS OF
LIFE..A Marshall
THE SCIENCE WHICH STUDIES
HUMAN BEHAVIOR AS A
RELATIONSHIP BETWEEN ENDS AND
SCAECE MEANS WHICH HAVE
ALTERNATIVE USES.. L Robbins

Managerial Economics
Defined
The application of economic
theory and the tools of decision
science to examine how an
organization can achieve its
aims or objectives most
efficiently.

Managerial Decision Problems


Economic theory
Microeconomics
Macroeconomics

Decision Sciences
Mathematical Economics
Econometrics

MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems
OPTIMAL SOLUTION TO
MANAGERIAL DECISION PROBLEMS

Relationship of Managerial Economics to


Business School Curriculum
Integrating Course that treats the firm as one
unit rather than as individual functional areas
such as
Operations
Finance
Marketing etc

Technique Course

What do you get out of the course?


Better
Decision-making skills
Understanding of the role of business
Understanding of economic analysis

Basic Assumptions in
Economics

Ceteris Paribus

A Latin Phrase which means with other things


being the same
Used in isolating description of a particular event
from other potential variables
Ex: price-demand relationship

Rationality
People act rationality (??!!)
Consumers and producers measure and compare
the costs and benefits of a decision before going
ahead

Basic Assumptions in
Economics
People Respond to Economic Incentives
Diesel & petrol cars

Optimal Decision is Made at the Margin


Most decision in life involve doing a little
more or little less
Economists use the word marginal to mean
an extra or additional benefit or cost of a
decision
Economists reason that the optimal is to
continue any activity up to the point where

THEORY OF THE FIRM


-What is a firm
-Types of Firms
-Reasons for Existence of a firm
-Value of the firm
-Constraints under which the
firm operates
-Limitations of the theory of the
firm

What is a FIRM:
Definition

FIRM is an organisation that


combines and organizes
resources for the purpose of
producing goods and/or
services for selling in the
market

Types of Firms
-Proprietorships
-Partnerships
-Corporations
In India the firms produce more than 70% of all goods
and services. Rest by GOs and NGOs

Forms of Ownership
Private Sector
Wholly owned by people, individually
or as a group

Public Sector
Owned, managed and controlled by
government

Joint Sector
Owned and managed jointly by
individuals and government

Private Sector
Sole Proprietorship: Ancient form of ownership in
which an individual invests own or borrowed
capital and solely responsible for the results of
operations
Partnership: Two or more individuals decide to
start a common business
Joint Stock Company: Most important type of
business organization. Owners capital here is
invested in the form of shares. The liability of
each shareholders is limited to the proportion of
share held by him(er)
Cooperative: A non-profit, non-political, nonreligious voluntary organization formed with an

Public Sector
Public Sector Units (PSUs):
Here, just like private sector, government invests
in production activities and enters the market.
These units play very significant role in aspects
like employment generation, equitable distribution
of national wealth and where private sector
doesnt want to enter

Corporation or Board
Does not aim for revenue generation but equitable
distribution of resources through government
intervention (FCI, KVIC etc)
Department
Run for a specific purpose like education, health,
civil administration etc

Theory of the Firm


What will be the consequences for the society if the firm did not exist?

Combines and organizes


resources for the purpose of
producing goods and/or
services for sale.
Internalizes transactions,
reducing transactions costs.
Primary goal is to maximize
the wealth or value of the firm.

Why FIRM exists?


Social role
Firms exist to allocate societys
resources efficiently and
equitably
- Case Application 1-2 p 12-3: The Objective
and Strategy of Firms in Cigarette Industry

Why FIRM exists?


Firms exist becoz otherwise itll be very
inefficient & costly for entrepreneurs to
enter into & enforce contracts with
workers, owners of capital, land & other
resources for separate step of production
& distribution process. e.g. Car, PC.
Firms do not continue to grow larger and
larger indefinitely because of limitations
on management ability to effectively
control and direct the operation of the
firm as it becomes larger and larger.
Interesting book on this issue by John Kennith Galbraith The New Industrial Estate

Present Value Analysis


Many transactions involve making or
receiving cash payments at future dates
Here concepts related to time value of
money are required to take sound
business decision
TVM refers to the fact that a rupee to be
received in the future is not worth a
rupee today
Hence measuring present value of

Value of the Firm


The present value of all expected future profits
n
n
t
1
2
PV

1
2
n
t
(1 r ) (1 r )
(1 r )
t 1 (1 r )

t
TRt TCt
Value of Firm

t
t
t 1 (1 r )
t 1 (1 r )
n

where:
TRt = Total Revenue

TCt = Total cost year

r = the interest rate,


t goes from 1 (next year) to n (the last year) in
the planning horizon

Present value (PV) of expected


future profits

t
TRt TCt
Value of Firm

t
t
t 1 (1 r )
t 1 (1 r )
n

where: TRt = the firms TR in year t


TCt = the firms TC in year t
r = the interest rate
and t goes from 1 (next year) to n (the last year in
the planning horizon)

Hershey Foods an example


Present
Value
of Re 1
at

Because the project has a negative net present


value, it does not contribute to the goal of
maximizing shareholder value. Therefore, it

Cost30crores
1. #years
Profit
inthefuture(Rs.crores)
1
8
2
10
3
12
4
14
5
15
6
16
7
17
8
15
9
13
10
10

Problem 1

1
Present
(1+r)t
value(PV)
.90909
7.27272
.82645
8.26450
.75131
9.01572
.68301
9.56214
.62092
9.31380
.56447
9.03152
.51316
8.72372
.46651
6.99765
.42410
5.51330
.38554
3.85540
Total77.55047
Thus,theanswerisRs.77.55047crores.

Costofthe30crores
1. #years
Profit
inthefuture(Rs.crores)
1
8
2
10
3
12
4
14
5
15
6
16
7
17
8
15
9
13
10
10

Problem 1

1
Present
(1+r)t
value(PV)
.90909
7.27272
.82645
8.26450
.75131
9.01572
.68301
9.56214
.62092
9.31380
.56447
9.03152
.51316
8.72372
.46651
6.99765
.42410
5.51330
.38554 3.85540
Total77.55047
Thus,theanswerisRs.77.5504730=47.55047crores.

Discounting Examples
n

V = (TRt-TCt)/(1+i)t Discount rate (i) = 0.06


t=0

Two courses of action: A and B


If A is chosen, outflow of Rs. 1 million this year (t=0) and
inflows of Rs300,000 for each of next 5 years.
V = -1,000,000 + 300,000 + 300,000 + 300,000 + 300,000 + 300,000 =

Rs263,709
1.060

1.06

1.062

1.063

1.064

1.065

If B is chosen, outflow of Rs 1 million this year (t=0) and


inflows of Rs. 260,000 for each of next 6 years.
V = -1,000,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000 + 260,000
1.060
1.06
1.062
1.063
1.064
1.065
1.066

=Rs. 278,504

Case Study of
- Indian Oil buying IB Petroleum
- Jet Sahara Deal Some Details of Case
- TATA - Jaguar Land Rover Deal
- TATA CORUS Deal
- TATA Tetley Tea
- Buying Equity Shares from Market
- M & A Deals
- Google Motorola buying & Selling it
later to Lenovo
- Microsoft buying Skype & earlier
Hotmail
- Vodafone buying Hutch The Tax
controversy apart

Jet Sahara Deal


Some Details of Case Jetlite Brand now
Kingfisher was ready to pay 500 crores
but Jet paid 1500 crores why?
1.Capital Cost
2.Interest Rate on capital cost
3.Staff cost
4.Type of Aircraft
5.International Rights what are the
rules?
6.Parking slots Regulatory domain

HomeAssignment1
1. #years
inthefuture
1
2
3
4
5
6
7
8
9
10

Profit
(Rs.crores)
18
15
12.9
14.5
15.5
11.6
19.7
18.5
15.3
100

Cost100crores
1
(1+r)t

Present
value(PV)

Find the PV 4, 5, 8 and 10 years


The discount rate is 5, 10, 15, 20 and 25 percent
TheanswerisRs.__________crores.

1. A firm is expected to earn Rs100,000 per year forever.


If the annual discount rate is 10%, what is the present
value of the firm?
2. The owner of a firm has decided that he wants to sell it
for Rs5,000,000 and he sets out to increase annual
profits up to the level required to attain this value. If the
annual discount rate is 10% and the level of profit can
be expected to continue indefinitely, how much annual
profit must the firm earn to attain the value that the
owner seeks?
3. Phil is considering the purchase of a 10-year lease that
will allow him to operate a concession stand at a local
sports stadium. If the lease will cost Rs100,000 and the
relevant discount rate is 15%, what is the minimum
annual profit necessary to justify the purchase?

Alternative Theories
Sales/Revenue maximization (W.Baumol, 1959)
Adequate rate of profit

Management utility maximization (Williamson,


1963)
Principle-agent problem - e.g. ESOPs

Satisficing behavior (Cyert & March)


Growth
Long Run Survival

Management utility maximization


Agency Costs
Stockholder and managers may have different
objectives
job security or personal wealth may be pursued by
managers rather than pursuing stockholder wealth
maximization
Stockholder lack knowledge of managers
Random events may obscure managerial effectiveness
and results

Agency costs
costs to provide incentive for managers to pursue
stockholder goals
monitoring cost

3 policies that create the right


monetary incentives for CEOs to
maximize the value of their
companies:
Boards can require that CEOs become
substantial owners of company stock ESOPs
Salaries, bonuses, and stock options can
be structured so as to provide big
rewards for superior performance
The threat of dismissal for poor
performance can be made real
Ha-Joon Chang Thing 14 : US Managers are

Executive pay
Jan 19th 2006 The Economist

America's chief executives earn


almost twice as much as their
European counterparts thanks
mainly to the greater use of
incentive schemes, such as stock
options. The typical chief executive
of a $500m company in America
earned $2.2m in 2005. Of this total,
only $600,000, or less than 30%,
came from a basic salary,
according to the latest study of
global executive pay by Towers
Perrin, a consultancy.

Opportunity Cost
When an activity is
chosen, the opportunity
cost is the benefit
expected from the best
alternative forgone
Example:
If you choose to attend B-School this year, your
opportunity cost is the salary you would have
received from the best available full-time job.

Opportunity Cost

I hunt and she gathersotherwise we


couldnt make ends meet.
Example: Neanderthals and Homo Sapiens
Source: Discovery Channel Documentary

Diamond water paradox

Definitions of Profit
Business Profit:
Total revenue minus the
explicit (or accounting) costs
of production[1].
[1] also called out-of-pocket expenses

Definitions of Profit
Business (or Accounting) Profit:
Total revenue minus the explicit (or
accounting) costs of production.

Mainly a concern of an Accountant


Controlling day to day operations
Detecting frauds/embezzlement
Satisfy tax and other laws
Produce records for various interest
groups - e.g. shareholders, tax authority,
regulators etc.

Definitions of Profit

Economic Profit:
Total revenue minus the explicit
and implicit costs* of production.
*refers to the value of the inputs owned and used by the firm in its own
production process e.g salary that entrepreneur could have earned for
someone else in a similar capacity, return the firm could have earned
from investing its capital, renting its land & other inputs to others .

Important for decision making


To choose rationally among the alternative
projects for investment/expansion

Opportunity Cost: Implicit value of a


resource in its best alternative use.

Jane has compiled the following list of expenses after


completing 1 year of college. Assume that Jane would be
living with her parents and working if she weren't
attending college. Use this information to calculate Jane's
economic cost of attending college for one year.
Tuition
Rs 8,000
Dormitory room
4,000
Books and supplies
1,000
Food plan
3,000
Foregone income
19,000
Entertainment expenses
1,000
Clothing
2,000
Health insurance
1,000
Sol: Economic cost = 8,000 + 4,000 +1,000 + 3,000 + 19,000
= Rs35,000

EXAMPLE
Violet purchased a tract of land for Rs1000,000.
She quit her Rs300,000 a year job as a postal
employee and opened a skeet shooting range on
her land. The range generates Rs300,000 in net
revenue after all day-to-day expenses have been
covered. Assume that the relevant discount rate is
10%. What is Violet's business profit? What is her
economic profit?
Solution: Business profit is Rs 300,000.
Economic Profit = Business Profit Economic Cost
Economic cost = 300,000 + (0.10)(1000,000) = Rs
400,000
so she has an economic loss of Rs100,000.

Theories of Profit
Risk-Bearing Theories of Profit
Frictional Theory of Profit
Monopoly Theory of Profit
Innovation Theory of Profit
Managerial Efficiency Theory of
Profit

Function of Profit
Profit is a signal that guides the
allocation of societys resources.
High profits in an industry are a signal
that buyers want more of what the
industry produces.
Low (or negative) profits in an industry
are a signal that buyers want less of
what the industry produces.
- Case Application 1-3 p 17: Profits in Personal
Computer Industry
Other Example: Biotechnology, Auto Components, BPO
etc.

NORMAL PROFIT
Normal profit or normal rate of return, is the level
of profit required to keep a firm engaged in a
particular activity.
Alternatively, normal profit represents the rate of
return on the next best alternative investment of
equivalent risk. It is the level of profit necessary to
keep people from pulling their investments in
search of higher rates of return.

Resources should be used as


efficiently as possible to
achieve societys goals
An economy is efficient if it takes all

opportunities to make some people


better off without making other people
worse off
Should economic policy makers always

strive to achieve economic efficiency?


Equity means that everyone gets his

or her fair share. Since people can


disagree about whats fair, equity
isnt as well-defined a concept as

Efficiency vs. Equity


Ex.:

Handicapped-designated
parking
spaces in a busy
parking lot
A conflict between:
equity, making life fairer for
handicapped
people, and
efficiency, making sure that all
opportunities to make people better off
have been fully
exploited by
never
letting parking spaces go unused.
How far should policy makers go in

promoting equity over efficiency?

Markets usually lead to


efficiency
The incentives built into a market

economy already ensure that resources


are usually put to good use
Opportunities to make people better

off are not wasted


Exceptions: market failure, the

individual pursuit of self-interest found


in markets makes society worse off
the market outcome is
inefficient.

Business Ethics
Identifies types of behavior that
businesses and their employees
should not engage in.
Source of guidance that goes beyond
enforceable laws.
Case Application: Business Ethics at Boeing
Case Application: Enron-Anderson & Other Financial
Disasters, Present financial crisis, Credit Rating
Agencies Watch Movie Inside Jobs SONY Pictures

Constraints on Operations
of the FIRM
Availability of essential
input/s
a) Skilled labour
b) Specific raw material
c) Credit availability etc.
d) Factory and warehouse
space

Constraints on Operations of
the FIRM (contd.)
Legal constraints: to ensure that
the firm behaviour is consistent
with social welfare objectives

Wage/labour laws
Health and safety standards
Pollutions emission norms
Unfair business practices etc.

Diamond Water
Paradox

The International
Framework of Managerial
Economics
Globalization of Economic Activity
Goods and Services (e.g. BPO, auto
components, electricity etc.)

Capital (FDI, FII)


Technology (Biotechnology, Computer
Software)

Skilled Labor (software professionals,


scientists, teachers)

Technological Change
Telecommunications Advances
The Internet and the World Wide Web

Any
Questions ???
All the best