managerial economics 00.0

Chapters

• Chapter No. 1 Introduction to Managerial Economics

• Chapter No. 2 Basic Training/Economic Optimization

• Chapter No. 3 Demand Theory and Analysis

Managerial Economics MBA

Javaid Dars (MBA, M.Phil) 1

• Reviewed & Compiled by Javaid Dars from the publications of Mark Hirschey and H. Craig Petersen



Introduction



Managerial Economics

Introduction of the subject


4Javaid Dars (MBA, M.Phil)

What is Economics?

• A social science that studies choice with scarcity of resources.

• Economics = Oikos + Nomos (Law of Households)

• Microeconomics:

1. Theory of Individual/Market Demand

2. Theory of Production and Cost

3. Theory of Markets and Price

4. Theory of Profit.



What is Economics?

• Macroeconomics:

Theory of total output and employment.

General Price level.

Theory of Inflation

Theory of trade cycles

Economic Growth



Economics v. Managerial Economics

• Comprehensive and wider scope.

• Micro and Macro in approach.

• Normative and Positive Science.

• Formulation of Theories and Principles.

• Narrow and limited scope.

• Essentially Micro in approach.

• Normative Science.• Application of

Theories and Principles.



Overview of Course outline

1. Objectives of Firm2. Theories of Profit3. Demand Analysis and Forecasting4. Production and Cost Analysis5. Pricing Decision.6. Profit Management7. Capital Management8. Market Structure9. Inflation and Economic Conditions



What is Managerial Economics?What is Managerial Economics?

• Managerial economics is concerned with the application Managerial economics is concerned with the application of economic concepts and economics tools and of economic concepts and economics tools and techniques to the problems of formulating rational techniques to the problems of formulating rational decision making – (decision making – (Mansfield)Mansfield)

• Managerial economics applies the principals and Managerial economics applies the principals and methods of economics to analyze problems faced by the methods of economics to analyze problems faced by the management of a business, or other types of management of a business, or other types of organizations and to help and to help find solutions that organizations and to help and to help find solutions that advance the best interests of such organizations – advance the best interests of such organizations – ((Davis & Chang)Davis & Chang)



Why do business manager need to Why do business manager need to know economics?know economics?

Business decisions are taken under uncertainty and risk Business decisions are taken under uncertainty and risk which arises due to following aspects:which arises due to following aspects:

1.1. Behavior of market forcesBehavior of market forces

2.2. Changing business environmentChanging business environment

3.3. Emergence of competitors with highly competitive Emergence of competitors with highly competitive productsproducts

4.4. Government PolicyGovernment Policy

5.5. External influence on domestic on domestic marketExternal influence on domestic on domestic market

6.6. Social and political changesSocial and political changes



Areas of decision makingAreas of decision making

• Production related issuesProduction related issues

• Sale prospects and problemsSale prospects and problems



Production related issuesProduction related issues

1.1. Available techniques of productionAvailable techniques of production

2.2. Cost of production associated with each production Cost of production associated with each production techniquetechnique

3.3. Supply position of inputs required to produce the Supply position of inputs required to produce the planned commodityplanned commodity

4.4. Price structure of InputsPrice structure of Inputs

5.5. Cost structure of competitive productsCost structure of competitive products

6.6. Availability of foreign exchange if inputs are tp be Availability of foreign exchange if inputs are tp be importedimported



Sale Prospects and problemsSale Prospects and problems

1.1. General market trendsGeneral market trends

2.2. Trends in the industry to which the planned products Trends in the industry to which the planned products belongbelong

3.3. Major existing and potential competitors and their Major existing and potential competitors and their respective market sharesrespective market shares

4.4. Prices of competing productsPrices of competing products

5.5. Pricing strategy of the prospective competitorsPricing strategy of the prospective competitors

6.6. Market structure and degree of competitionMarket structure and degree of competition

7.7. Supply position of complimentary goodsSupply position of complimentary goods



The Nature and Scopeof Managerial Economics

Chapter No. 1



Theory of the Firm1. Firm combines and organizes resources for the

purpose of producing goods and/or services for sale.

2. Internalizes transactions, reducing transactions costs/time.

3. Resource owners use the income generated from the sale of their services/resources, to purchase goods and services produced by firms. Circular flow of economic activity is thus completed.

4. Primary goal is to maximize the wealth or value of the firm.



Value of the Firm

1 21 2

1(1 ) (1 ) (1 ) (1 )

nn tn t

t

PVr r r r

1 1(1 ) (1 )

n nt t tt t

t t

TR TCValueof Firm

r r

•Managerial economics, begins by postulating a theory of the firm, which is then used to analyse managerial decision making. The theory of the firm is based on the assumption that the goal of the firm is to maximise profit. However, firms are observed to sacrifice short-term profits for long term profits. Hence, its is appropriate to postulate that the objective of the firm is to maximise the wealth of value of the firm.

• The value of the firm is, present value of all expected future profits:



Alternative Theories of the firm

• Sales maximization(William Baumol)– Adequate rate of profit to satisfy share holders; assuming

this, maximise sales, even by sacrificing some profits.• Management utility maximization (Oliver Williamson)

– Principle-agent problem: managers try to maximise their benefits like salaries, fringe benefits, stock options, staff size, lavish offices, etc. This can be resolved by linking managers’ rewards to firm’s performance compared to similar firms in the industry.

• Satisficing behavior( not maximising) with reference sales, profits, growth, mkt.. Share etc.



Different Concepts of Profit

• Business Profit: Total revenue minus the explicit or accounting costs of production.

• Economic Profit: Total revenue minus the explicit and implicit costs of production.

• Opportunity Cost: Implicit value of a resource in its best alternative use.



Theories of Profit

• Frictional Theory of Economic Profits: Abnormal profits observed following unanticipated

changes in demand or cost conditions.• Monopoly Theory of Economic Profits:Above normal profits caused by barriers to entry that limit

competition.• Innovation Profit Theory:Above normal profits that follow successful invention or

modernization.• Compensatory Profit Theory:Above normal rates of return that reward efficiency.



Function of Profit

• Profit is a measurement that guides the allocation of society’s resources.

• High profits in an industry are a measurement that buyers want more of what the industry produces.

• Low (or negative) profits in an industry are a measurement that buyers want less of what the industry produces.



The Changing Environment of Managerial Economics

• Globalization of Economic Activity– Goods and Services– Capital– Technology– Skilled Labor

• Technological Change– Telecommunications Advances– The Internet and the World Wide Web



Economic Optimization

Chapter No. 2



Chapter 2OVERVIEW

• Economic Optimization Process

• Expressing Economic Relations

• Marginals as the Derivatives of Functions

• Marginal Analysis in Decision Making

• Incremental Concept in Economic Analysis



Chapter 2KEY CONCEPTS

• optimal decision• table• spreadsheet• graph• equation• dependent variable• independent variable• marginal• marginal revenue• marginal cost• marginal profit

• derivative• inflection point• second derivative• profit maximization• breakeven point• revenue maximization• average cost minimization• multivariate optimization• constrained optimization• Lagrangian technique• Lagrangian multiplier, λ



Economic Optimization Process

• Optimal Decisions– Best decision helps achieve objectives most

efficiently.

• Maximizing the Value of the Firm– Value maximization requires serving

customers efficiently.• What do customers want?• How can customers best be served?



Expressing Economic Relations

• Tables and Equations– Simple graphs and tables are useful.– Complex relations require equations.

• Total, Average, and Marginal Relations– Total increases when marginal is positive.



Revenue per time period ($)$9 8 7 6 5 4

3 Total revenue = $1.50 ´ output 2 1

0 1 2 3 4 5 6 7 8 9 Output per time period (units)



Maximization occurs when marginal switches from positive to negative.

• If marginal is above average, average is rising.

• If marginal is below average, average is falling.

• Graphing Total, Marginal, and Average Relations– Deriving Totals from Marginal and Average

Curves– Total is sum of marginals.



Marginals as the Derivatives of Functions

• Concept of a Derivative– Derivative is a marginal relation.

• Derivatives and Slope– Derivative of total revenue is marginal

revenue.– Derivative of total cost is marginal cost.– Derivative of total profit is marginal profit.



Marginal Analysis in Decision Making

• Finding Maximums or Minimums– Maximum and minimum points occur where marginal

is zero.

• Distinguishing Maximums from Minimums– Maximum is where first derivative is zero, second

derivative is negative.– Minimum is where first derivative is zero, second

derivative is positive.

• Maximizing the Difference Between Two Functions– Maximum profit requires MR = MC.



Incremental Concept in Economic Analysis

• Marginal v. Incremental Concept– Marginal relates to one unit of output.– Incremental relates to one managerial

decision.• Multiple units of output is possible.

• Incremental Profits– Profits tied to a managerial decision.

• Incremental Concept Example



Concept of the Derivative

•The derivative of Y with respect to X is equal to the limit of the ratio Y/X as X approaches zero.

0limX

dY Y

dX X



Rules of Differentiation

1. Constant Function Rule: The derivative of a constant, Y = f(X) = a, is zero for all values of a (the constant).

( )Y f X a

0dY

dX




2. Power Function Rule: The derivative of a power function, where a and b are constants, is defined as follows.

( ) bY f X aX

1bdYb aX

dX




3. Sum-and-Differences Rule: The derivative of the sum or difference of two functions U and V, is defined as follows.

( )U g X ( )V h X

dY dU dV

dX dX dX

Y U V




4. Product Rule: The derivative of the product of two functions U and V, is defined as follows.

( )U g X ( )V h X

dY dV dUU V

dX dX dX

Y U V




5. Quotient Rule: The derivative of the ratio of two functions U and V, is defined as follows.

( )U g X ( )V h X UY

V

2

dU dVV UdY dX dXdX V




6. Chain Rule: The derivative of a function that is a function of X is defined as follows.

( )U g X( )Y f U

dY dY dU

dX dU dX



Optimization With CalculusFind X such that dY/dX = 0

•Second derivative rules:

1.If d2Y/dX2 > 0, then X is a minimum.

2.If d2Y/dX2 < 0, then X is a maximum.> In Cost functions, we attempt to find the minimum value.

> In Profit functions, we attempt to find the maximum value.

> Hence the objective is to minimize costs and maximize profits or optimize profit.



Demand and Supply

Chapter 3



Chapter 3OVERVIEW

• Basis for Demand• Market Demand Function• Demand Curve• Basis For Supply• Market Supply Function• Supply Curve• Market Equilibrium



Chapter 3KEY CONCEPTS

• demand• direct demand• utility• derived demand• demand function• demand curve• change in the quantity

demanded• shift in demand• Supply

• supply function• supply curve• change in the quantity

supplied• shift in supply• equilibrium• market equilibrium price• surplus• shortage• comparative statics

analysis



Basis for Demand

• Direct Demand– Demand is the quantity customers are willing

to buy under current market conditions.– Direct demand is demand for consumption.

• Derived Demand– Derived demand is input demand.– Firms demand inputs that can be profitably

employed.



Individual Consumer’s DemandQdX = f(PX, I, PY, T)

1. QdX = Quantity demanded of commodity X by an individual per time

period

2. PX = Price per unit of commodity X

3. I =Consumer’s income

4. PY = Price of related (substitute or complementary) commodity

5. T = Tastes of the consumerManagerial Economics MBA


Individual Consumer’s Demand

QdX/PX < 0____________

1.QdX/I > 0 if a good is normal

2.QdX/I < 0 if a good is inferior

3.QdX/PY > 0 if X and Y are substitutes

4.QdX/PY < 0 if X and Y are complements



Market Demand Function

• Determinants of Demand– Demand is determined by price, prices of

other goods, income, and so on.

• Industry Demand Versus Firm Demand– Industry demand is subject to general

economic conditions.– Firm demand is determined by economic

conditions and competition.



Market Demand FunctionQDX = f(PX, N, I, PY, T)

1. QDX = Quantity demanded of commodity X

2. PX = Price per unit of commodity X

3. N = Number of consumers on the market

4. I = Consumer income

5. PY= Price of related (substitute or complementary) commodity

6. T = Consumer tastes



Demand Curve

• Demand Curve Determination– Demand curve shows price and quantity

relation holding everything else constant.

• Change in Quantity Demanded– Quantity demanded falls if price rises.– Quantity demanded rises if price falls.

• Role of Non-Price Variables– Change in non-price variables will define a

new demand curve.



Relation Between the Demand Curve and Demand Function

• Movements Along Demand Curve– A rise in price causes upward movement

along a given demand curve.– A price decline causes downward movement

along a given demand curve.

• Demand Curve Shifts– Demand increases if a non-price change

allows more to be sold at every price.– Demand decreases if a non-price change

causes less to be sold at every price.



Basis For Supply

• Firms Offer Supply To Make Profits– When prices rise, firms boost the quantity

supplied.– When prices fall, firms cut the quantity

supplied.

• Everything That Affects Marginal Production Costs Affects Supply– If MC falls, supply rises.– If MC rises, supply falls.



Market Supply Function

• Determinants of Supply– Supply is determined by price, prices of

other goods, technology, and so on.

• Industry Supply Versus Firm Supply– Firm supply is determined by economic

conditions and competition.

– Industry supply is the sum of firm supply.



Supply Curve

• Supply Curve Determination– Supply curve shows price and quantity relation

holding everything else constant.

• The Price-quantity Supplied Relation– A rise in price will increase the quantity

supplied.– A fall in price will decrease the quantity

supplied.

• Along a supply curve, all non-price variables are held constant



Relation Between Supply Curve and Supply Function

• Movements Along Supply Curve– A rise in price causes upward movement along a

given supply curve.– A price decline causes downward movement along a

given supply curve.

• Supply Curve Shifts– Supply increases if a non-price change allows more to

profitably produced and sold.– Supply decreases if a non-price change causes less

to be profitably produced and sold.



Market Equilibrium

• Demand and Supply Balance– Equilibrium exists if perfect balance exists

in the quantities demanded and supplied.– Equilibrium reflects productive and

allocative efficiency.

• Surplus and Shortage– Surplus is excess supply.– Shortage is excess demand.



Comparative Statics

• Changes in Equilibrium– Equilibrium exists when there is no economic

incentive for change in demand or supply.– Changing demand or supply affects

equilibrium.

• Comparative Statics– Study of how equilibrium changes with

changing demand or supply.– Change continues until a new equilibrium is

established.



Price Elasticity of Demand

/

/P

Q Q Q PE

P P P Q

Linear Function of Elasticity of Demand

Point Elasticity of Demand

1P

PE a

Q

It is the % change in quantity demanded of a good due to a % change in price of a good.



Price Elasticity of Demand

Arc Elasticity of Demand 2 1 2 1

2 1 2 1P

Q Q P PE

P P Q Q

It gives elasticity over a range of observations (values) over the given time period. The measure of elasticity does not change over the range i.e. from point A to B, elasticity will be same from A to B or from B to A.



MR and Price Elasticity of Demand

PX

QX

MRX

1PE

1PE

1PE

On a straight line of demand curve, the price elasticity decreases along with the curve i.e. low price & high quantity; high price & low quantity.

(If Demand Curve is Linear)



Marginal Revenue, Total Revenue, and Price Elasticity

TR

QX

1PE MR<0MR>0

1PE

1PE MR=0

TR is maximum when Ep = 1 and MR is equal to 0.



Determinants of Price Elasticity of Demand

Demand for a commodity will be more elastic if:

1.It has many close substitutes

2.It is narrowly defined

3.More time is available to adjust to a price change



Determinants of Price Elasticity of Demand

Demand for a commodity will be less elastic if:

1.It has few substitutes

2.It is broadly defined

3.Less time is available to adjust to a price change



Income Elasticity of Demand

Linear Function of Point Income Elasticity of Demand

Point Income Elasticity of Demand /

/I

Q Q Q IE

I I I Q

3I

IE a

Q

It is the % change in quantity demanded of a good due to a % change in income of the consumer.



Income Elasticity of Demand

Arc Income Elasticity of Demand2 1 2 1

2 1 2 1I

Q Q I IE

I I Q Q

•Normal Good •Inferior Good

0IE 0IE



Cross-Price Elasticity of Demand

Linear Function of Cross Elasticity of Demand

Point Cross Elasticity of Demand /

/X X X Y

XYY Y Y X

Q Q Q PE

P P P Q

4Y

XYX

PE a

Q



Cross-Price Elasticity of Demand

Arc Cross Elasticity of Demand

Substitutes Complements

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PE

P P Q Q

0XYE 0XYE



Next Chapters

• Chapter No. 4 Regression Techniques and Demand Estimation

• Chapter No. 5 Business and Economic Forecasting

• Chapter No. 6 Production Theory and Analysis



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