mba wd me pdf 01

MBA 532 Managerial Economics Lecture 1

Nature and scope of Managerial Economics

Professor H.D. Karunaratne

2

Why We Study Managerial Economics?

Growing complexity of business decision-making process due to changing market conditions and business Environment

Increasing use of economic logic, concepts, theories, and tools of economic analysis in the process of business decision making

Rapid increase in demand for professionally trained managerial manpower

Professor H. D Karunaratne

3

Definition of Managerial Economics Managerial economics is the application of

microeconomic tools and techniques to the key decisions firms need to make; e.g. pricing, output, investment, and advertising.

Managerial economics is primarily concerned with the theory of the firm, although any study of decisions at the firm level requires an understanding of the structure of the industry within which the firm is located.


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Managerial economics is the study of economic theories, logic and tools of economic analysis that are used in the process of business decision making.

Economic theories and techniques of economic analysis are applied to analyze business problems, evaluate business options and opportunities with a view to arriving at an appropriate business decision.

Managerial economics is thus constituted of that part of economic knowledge, logic, theories and analytical tools that are used for rational business decision-making


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The Nature of Managerial Economics

Economic Theory Micro/Macro

Analytical Tools Mathematics/

Statistics

Management Problems

Economic Methodology Descriptive Models Prescriptive Models

Study of functional areas Acc/Fin/Mkt/Per/Pro

Optimal Decisions

Managerial Economics


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Managerial economics applies economic theory and methods to business and administrative decision making

The role of managerial economics in management decision making;

1. Management decision problems

2. Economic Concepts

3. Decision sciences: Tools & techniques

of analysis


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Manager: A person who directs resources to achieve a stated goal.

Basically managers are confronted with two types of problems (a) decision-making (b) forward planning

Economics: The science of making decisions in the presence of

scarce resources

Managerial Economics: The study of how to direct scarce resources in the way

that most efficiently achieves a managerial goal

Basic Concepts in Managerial Economics


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Various approaches to analyze management problems Descriptive approach Quantitative approach

Functions & constraint maximization Graphs & numerical values

Revenue of the firm Costs of the firm Profit Maximization


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Managerial Economics yManagerial Economics is the study of economic

theories, logic and tools of economic analysis, used in the process of business decision making

yWhy Managerial Economics? y The growing complexity of business decision-

making processes y Changing market conditions y Globalization of business transactions. y Rapid increase in demand for professionally

trained managerial manpower.


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Nature of Managerial Economics

Managerial Decision Problem

Product selection, pricing Organization design Product development & promotion Investments Advertising Make or buy


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Nature of Managerial Economics Economic Concepts

Marginal analysis Theory of Firm Consumer demand Public Choice theory


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Quantitative Methods

Numerical analysis Statistical estimations Forecasting procedures Game-theory concepts Optimization techniques Information systems

Nature of Managerial Economics


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Managerial Economics

Optimal Solution

Use of economic concepts and quantitative methods to solve management decision problems

Nature of Managerial Economics Managerial Decision

Problem Economic Concepts Quantitative Methods


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yManagerial Economics helps to identify yhow economic forces affect organizations yways to achieve goals efficiently and

effectively

yManagerial Economics is applicable for non-profit organization

e.g. Non-profit Hospital Management problem: providing best medical care

possible given limited medical staff, equipment etc.

Managerial economics help to determine the optimal allocation of these limited resources


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Theory of the Firm What is a firm?

Series of contractual relationships that connect suppliers, inventors, workers and management in a joint effort to serve customers

Firm

Society

Inventors Suppliers

Employees Management

Customers Professor H. D Karunaratne

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Theory of the Firm Theory of the firm is simply firm is thought to

have profit maximization as its primary goal Theory of the firm sometimes distinguish

between long-run motivations (sustainability) and short-run motivations (profit maximization)

Today the primary goal of the firm is long-term expected value maximization

16Professor H. D Karunaratne

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Value of a Firm Value of the Firm = Present Value of

Expected Future Profits

TR-Total Revenues TC- Total Costs i- Appropriate interest t -time

Profits = Total Revenues - Total Costs

Therefore, Value =


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Constraints & Theory of the Firm Goal of Theory of the Firm is profit maximization

But there are constraints Resources are limited(skilled labor, energy, space,

funds)

Decisions are constrained by contractual requirements(labour contracts limit flexibility of work)

Constrains on out put(quality level, minimum satisfaction level)

Legal restrictions(Environment, health & safety)


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Limitations of the Theory of Firm

Competition in the capital market forces to seek value maximization

Risk of the decisions to reach the goal Should consider all relevant costs and

benefits before making a decisions

Firms need to have Social responsible behavior as well


Profit Measurement

Free enterprise depend upon profits & Profit relevant motive

Efficient allocation of economic resources reflects from profit

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Business Vs. Economic Profit

Accounting Profit (Business Profit) = Residual of Sales Revenue The explicit costs of doing business This is the amount available to fund Equity Capital

after payment for all other resources used by the firm

As for the cost for resources such as labour, energy, there is a price for entrepreneurial effort of a firms owner / manager & for other resources that owners bring to the firm


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To compensate inputs provided by owners, including entrepreneurial effort & capital,

have to includes an Opportunity Cost to the Nominal Rate of Return on equity capital

This enables the concept of Economic Profit

Economic Profit = Business Profit Implicit (non-cash) costs of capital & other owner provided inputs used by the firm

Specially among small business opportunity costs for owner provided inputs are often a considerable part of business profits


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Economic profits: The difference between total revenue and total

opportunity cost

Opportunity cost: The cost of the explicit and implicit resources

that are forgone when a decision is made

Present value: The amount that would have to be invested

today at the prevailing interest rate to generate the given future value.


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Determinants of the Value of a Firm

Value of Firm Inputs, legal,

and other Constraints

n

ti

tt

iTCTR

1 1

The value of i depends on

1. Risk ness of firm

2. Conditions in capital markets

Values of TR depends on 1.Demand & Forecasting 2.Pricing 3.New product development

Value of TC depends on 1. Production Techniques 2. Cost functions 3. Process Development


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Scope of Managerial Economics

The following key business areas can be considered to be the scope of managerial economics

1. Demand Analysis and Demand Forecasting 2. Resource Allocation 3. Production and Cost analysis 4. Competitive analysis 5. Pricing 6. Strategic Planning Reference: Chapter 1 & 2 of Dwivedi, D. N. (2005) Managerial

Economics, Sixth Reprint , VIKAS Publishing House Professor H. D Karunaratne

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Variability of Business Profits

Normal rate of profit is typically assessed by Return on Stockholders Equity (ROE) ROE = Accounting net income/ Book value of the firm


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Lets have a look about Corporate Giants in 2007,

Company Name Return on Equity (ROE) %

Intel Corporation 13.7 HP Company 17.1 Johnson & Johnson 28.1

The Coca-Cola company 30.1

Microsoft Corporation 32.4 Proctor & Gamble 15.0 The Boeing Company 46.5


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The annual average ROE of 10% can be regarded as typical value in the market

Most of the companies shown in the chart have exceed this limit !!!

Also

Why do Profits vary among firms ?


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Explanation of economic profit or losses can be done using varies theories.

y Frictional Profit Theory Markets are sometimes in disequilibrium because of unanticipated changes in demand or cost conditions.

For example,

y New user friendly software increased demand for personal computers & boots returns for PC manufactures & software venders.

y ATMs & financial sector Professor H. D Karunaratne

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Monopoly Profit Theory some firms earn above normal profits because they are sheltered from competition by high barriers to entry

High capital requirements Intel Corporation Patents Microsoft Corporation Import protection & regulations US automobile

industry

Frictional Profit Theory & Monopoly Profit Theory commonly called as Disequilibrium Profit Theories


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Compensatory Profit Theories Innovative Profit Theory - Above normal profits

that arise following successful invention or modernization

For example, Microsoft Corporation Introduced & marked Graphical User Interface, while other competitors using command based approach

In general Compensatory Profit Theory describes above normal rates of return that reward firms for extraordinary success in meeting customer needs & maintaining efficient operations

Also recognizes economic profit as an important reward to the entrepreneurial function of owners & managers


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Role of Profits in the Economy

Each of preceding theories describes economic profits obtained for different reasons. Some cases combination of theories apply.

Economic profits play an important role in any market-based economy as indicator.

Above normal profits alarms that firm output should be increased. Expansion by established firms or entry by new competitors occurs quickly in high profit period.

Below normal profits alarms firm for contraction & exit. Such profits penalize stagnation & inefficiency.


1-33

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

1-34

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

1-35

Total Economic Cost

Total Economic Cost Sum of opportunity costs of both market-

supplied resources & owner-supplied resources

Explicit Costs Monetary payments to owners of market-

supplied resources

Implicit Costs Nonmonetary opportunity costs of using owner-

supplied resources

1-36

Economic Cost of Using Resources (Figure 1.1)

Explicit Costsof

Market-Supplied ResourcesThe monetary payments to

resource owners

Total Economic CostThe total opportunity costs of both kinds of resources

Implicit Costsof

Owner-Supplied ResourcesThe returns forgone by not takingthe owners resources to market

+

=

1-37

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

1-38

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

1-39

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

1-40

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 =

1 22

1

...(1 ) (1 ) (1 ) (1 )

TtT

T ttr r r r

SS S S

1-41

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

1-42

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

1-43

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

1-44

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

1-45

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

1-46

Perfect Competition

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

1-47

Monopoly

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

1-48

Monopolistic Competition

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

1-49

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

1-50

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

3-51

Optimization

An optimization problem involves the specification of three things: Objective function to be maximized or

minimized

Activities or choice variables that determine the value of the objective function

Any constraints that may restrict the values of the choice variables

3-52

Choice Variables

Choice variables determine the value of the objective function

Continuous variables Can choose from uninterrupted span of

variables

Discrete variables Must choose from a span of variables that is

interrupted by gaps

3-53

Net Benefit

Net Benefit (NB) Difference between total benefit (TB) and total

cost (TC) for the activity NB = TB TC

Optimal level of the activity (A*) is the level that maximizes net benefit

3-54 NB

TB

TC

Optimal Level of Activity (Figure 3.1)

1,000

Level of activity

2,000

4,000

3,000

A

0 1,000 600 200

T

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Panel A Total benefit and total cost curves

A

0 1,000 600 200 Level of activity

N

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(

d

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Panel B Net benefit curve

G

700

F

D

D

C

C

B

B

2,310

1,085

NB* = $1,225

f

350 = A*

350 = A*

M

1,225 c 1,000 d 600

3-55

Marginal Benefit & Marginal Cost

Marginal benefit (MB) Change in total benefit (TB) caused by an

incremental change in the level of the activity

Marginal cost (MC) Change in total cost (TC) caused by an

incremental change in the level of the activity

3-56

Marginal Benefit & Marginal Cost

TBMBA

' 'Change in total benefit

Change in activity

TCMCA

' 'Change in total costChange in activity

3-57

Relating Marginals to Totals

Marginal variables measure rates of change in corresponding total variables Marginal benefit & marginal cost are also

slopes of total benefit & total cost curves, respectively

3-58

MC (= slope of TC)

MB (= slope of TB)

TB

TC

Relating Marginals to Totals (Figure 3.2)

F

D D

C C

Level of activity

800

1,000

Level of activity

2,000

4,000

3,000

A

0 1,000 600 200

T

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Panel A Measuring slopes along TB and TC

A

0 1,000 600 200

M

a

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g

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Panel B Marginals give slopes of totals

800

2

4

6

8

350 = A*

100

520

100

520

350 = A*

B

B

b

G

g

100

320

100

820

d (600, $8.20)

d (600, $3.20)

100

640

100

340

c (200, $3.40)

c (200, $6.40)

5.20

3-59

Using Marginal Analysis to Find Optimal Activity Levels

If marginal benefit > marginal cost Activity should be increased to reach highest net

benefit

If marginal cost > marginal benefit Activity should be decreased to reach highest net

benefit

Optimal level of activity When no further increases in net benefit are

possible

Occurs when MB = MC

3-60

NB

Using Marginal Analysis to Find A* (Figure 3.3)

A 0 1,000 600 200

Level of activity

N

e

t

b

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n

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f

i

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(

d

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)

800

c

d

100

300 100

500

350 = A*

MB = MC

MB > MC MB < MC

M

3-61

Unconstrained Maximization with Discrete Choice Variables

Increase activity if MB > MC Decrease activity if MB < MC Optimal level of activity

Last level for which MB exceeds MC

3-62

Irrelevance of Sunk, Fixed, & Average Costs

Sunk costs Previously paid & cannot be recovered

Fixed costs Constant & must be paid no matter the level of

activity

Average (or unit) costs Computed by dividing total cost by the number of

units of the activity

These costs do not affect marginal cost & are irrelevant for optimal decisions

3-63

Constrained Optimization The ratio MB/P represents the additional

benefit per additional dollar spent on the activity

Ratios of marginal benefits to prices of various activities are used to allocate a fixed number of dollars among activities

3-64

Constrained Optimization To maximize or minimize an objective

function subject to a constraint Ratios of the marginal benefit to price must be

equal for all activities

Constraint must be met

A B Z

A B Z

MB MB MB...

P P P

Questions

Professor H. D Karunaratne 65

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