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Managerial Economics

Definitions of Economics
According to Adam Smith (1723-1790), hailed as the Father of Economics, saw economics as .an enquiry into the nature and causes of the wealth of nations. According to Alfred Marshall (1842-1924) the study of mankind in the everyday business of life. According to Lionel Robbins (1898-1984) the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.
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Basic Assumptions
Ceteris Paribus (Latin Phrase) All other things being equal. The term is most often used in isolating description of a particular event from other potential environmental variables. Ex: Demand and price Rationality Consumers and Producers measure and compare the costs and benefits of a decision before going ahead. Ex: whether to train the existing workers or recruit new workers for the newly opened unit of the firm
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Types of Economic Analysis


Micro and Macro
Micro economics looks at the smaller picture of the economy and is the study of the behaviour of small economic units; Macro economics is that branch of economic analysis that deals with the study of aggregates;

Positive and normative


Positive economics speaks about what it is Normative economics speaks about what ought to be Ex: The distribution of income in India is unequal The distribution of income in India should be equal

Short run and long run Partial and general equilibrium


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Managerial Economics & Theory


Managerial economics applies microeconomic theory to business problems
How to use economic analysis to make decisions to achieve firms goal of profit maximization

Microeconomics
Study of behavior of individual economic agents
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Economic Cost of Resources


Opportunity cost of using any resource is:
What firm owners must give up to use the resource

Market-supplied resources
Owned by others & hired, rented, or leased

Owner-supplied resources
Owned & used by the firm
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Total Economic Cost


Total Economic Cost
Sum of opportunity costs of both market-supplied resources & ownersupplied resources

Explicit Costs
Monetary payments to owners of market-supplied resources

Implicit Costs
Nonmonetary opportunity costs of using owner-supplied resources
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Economic Cost of Using Resources (Figure 1.1)


Explicit Costs
of Market-Supplied Resources The monetary payments to resource owners

+
Impli it
f r- ppli r O The returns forgone by not taking the owners resources to market

=
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Total Economic Cost


The total opportunity costs of both kinds of resources

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Types of Implicit Costs


Opportunity cost of cash provided by owners
Equity capital

Opportunity cost of using land or capital owned by the firm Opportunity cost of owners time spent managing or working for the firm
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Economic Profit versus Accounting Profit


Economic profit = Total revenue Total economic cost = Total revenue Explicit costs Implicit costs Accounting profit = Total revenue Explicit costs

Accounting profit does not subtract implicit costs from total revenue Firm owners must cover all costs of all resources used by the firm
Objective is to maximize economic profit
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Maximizing the Value of a Firm


Value of a firm
Price for which it can be sold Equal to net present value of expected future profit

Risk premium
Accounts for risk of not knowing future profits The larger the rise, the higher the risk premium, & the lower the firms value
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Maximizing the Value of a Firm


Maximize firms value by maximizing profit in each time period
Cost & revenue conditions must be independent across time periods

Value of a firm = T Tt T1 T2 TT   ...  ! 2 T t (1  r ) (1  r ) (1  r ) t !1 (1  r )


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Separation of Ownership & Control


Principal-agent problem
Conflict that arises when goals of management (agent) do not match goals of owner (principal)

Moral Hazard
When either party to an agreement has incentive not to abide by all its provisions & one party cannot cost effectively monitor the agreement
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Corporate Control Mechanisms


Require managers to hold stipulated amount of firms equity Increase percentage of outsiders serving on board of directors Finance corporate investments with debt instead of equity

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Price-Takers vs. Price-Setters


Price-taking firm
Cannot set price of its product Price is determined strictly by market forces of demand & supply

Price-setting firm
Can set price of its product Has a degree of market power, which is ability to raise price without losing all sales
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What is a Market?
A market is any arrangement through which buyers & sellers exchange goods & services Markets reduce transaction costs
Costs of making a transaction other than the price of the good or service

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Market Structures
Market characteristics that determine the economic environment in which a firm operates
Number & size of firms in market Degree of product differentiation Likelihood of new firms entering market

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Perfect Competition
Large number of relatively small firms Undifferentiated product No barriers to entry

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Monopoly
Single firm Produces product with no close substitutes Protected by a barrier to entry

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Monopolistic Competition
Large number of relatively small firms Differentiated products No barriers to entry

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Oligopoly
Few firms produce all or most of market output Profits are interdependent
Actions by any one firm will affect sales & profits of the other firms

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Globalization of Markets
Economic integration of markets located in nations around the world
Provides opportunity to sell more goods & services to foreign buyers Presents threat of increased competition from foreign producers
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