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Managerial Economics 

 

The Nature and Scope of Managerial Economics 

General maxims about decision making 

There are three valid answers to making a

decision:  yes, no or no decision right now.  Only 20% of the answers should be an immediate yes or no.

Find two good reasons to do something.  (you can always find one good reason).

 

General maxims about decision making 

When making a decision of minor importance, I have always found it advantageous to consider all the pros and cons.  In vital matters,

however, such as the choice of a mare or a profession, the decisions should come from the unconscious, from somewhere within ourselves. (Sigmund Freud)

Never, never use intuition (General Omar Bradley)

 

General maxims about decision making 

If you don’t know where you’re going, chances are you won’t get there.

We never make the same mistake twice.  All our blunders are different.

In a choice between two evils, I make it my general rule to choose the one I haven’t tried yet.  (Mae West).

If the only tool you have is a hammer, you tend to see every problem as a nail.

 

General maxims about decision making 

Here is a slightly exaggerated example from an Ann Landers column:

Dear Ann, Our marriage was once so beautiful but things have changed.  My spouse treats me like a slave, never shows any affection, comes home drunk every night, slaps me around, and may be having an affair with my best friend.   I alternate between loneliness and fear.  I have gained weight and am severely depressed.  My life is a living hell and I pray to get through the next day.  Ann, what should I do?

(Ann Landers responded with a question.  Are you better off with him or without him?  That is, what are the outcomes associated with each alternative?  Additional query: are these the only alternatives?)

 

DECISION MAKING 

The crucial step in tackling almost all important business and government decisions begins with a single question:  What is the alternative?

 

DECISION MAKING 

Decision making lies at the heart of most important business and government problems.  The range of business decisions is vast:  Should a high-tech company undertake a promising but expensive research and development program?  Should a petrochemical manufacturer cut the price of its best-selling industrial

chemical in response to a new competitor’s entry into the market?  What bid should company management submit to win a government telecommunications contract? Should management of a food products company launch a new product after mixed test-marketing results?

 

DECISION MAKING 

Likewise, government decisions range far and wide:  Should the Department of Transportation impose stricter rollover standards for sports utility vehicles?  Should a city allocate funds for construction of a harbor tunnel to provide easy airport and commuter access?  Should the federal government increase funding for the war on cancer?  These are all

interesting, important, and timely questions-with no easy answers.

 

DECISION MAKING 

As the term suggests, managerial economics is the analysis of major management decisions using the tools of economics.

 

DECISION MAKING – STEP 1 

DEFINE THE PROBLEM What is the problem the manager

faces?  Who is the decision maker? 

What is  the decisions setting or context, and how does it influence managerial objectives or options:

Decisions do not occur in a vacuum.  Many come about as part of the firm’s planning process.  Others are prompted by new opportunities or new problems.  It is natural to ask:  What brought about the need for the decision?  What is the decision all about?

 

DECISION MAKING – STEP 2 

DETERMINE THE OBJECTIVE

What is the decisions maker’s goal?  What

end is he or she pursuing?  How should the decision maker value outcomes with respect to this goal? What if he or she is pursuing multiple, conflicting objectives?

 

DECISION MAKING – STEP 2 Con’t 

When it comes to economic decisions, it is truism that “you can’t always get what you want.”  But to make any progress at all in your choice, you have to know what you want.  In most private-sector

decisions, profit is the principal objective of the firm and the usual barometer of its performance.  Thus, among alternative courses of actions, the manager will select the one that will maximize the profit of the firm.

 

DECISION MAKING – STEP 3 

EXPLORE THE ALTERNATIVES    

What are the alternative courses of action?  What are the variables under the decision maker’s control?  What

constraints limit the choice of options?

 

DECISION MAKING – STEP 3 Con’t 

After addressing the question “What do we want?”  it is natural to ask, “What are our options?”  The ideal decisions maker, if such a person exists, would lay out all the available courses of action and then choose the one that best achieves his or her objective.  Given human limitations, decisions makers cannot hope to identify and evaluate all possible options.  The cost of doing so simply would be too great.  Still, one would hope that attractive options would not be overlooked or, if discovered, not mistakenly dismissed.  No

analysis can begin with all the available options in hand.

 

DECISION MAKING – STEP 4 

PREDICT THE CONSEQUENCES

What are the consequences of each alternative action?  Should conditions change, how would this affect outcomes?  If outcomes are uncertain, what is the likelihood of

each?  Can better information be acquired to predict outcome?

 

DECISION MAKING – STEP 4 

Depending on the situation, the task of predicting the consequences may be straightforward or formidable.  Sometimes elementary arithmetic suffices.  For instance, the simplest profit calculation requires only subtract costs from revenues.  Or suppose the choice between two safety programs is made according to which saves the greater number of lives per dollar expended.  Here the use of arithmetic division is the key

to identifying the preferred alternative.

 

DECISION MAKING – STEP 5 

MAKE THE CHOICE After all the analysis is done, what is

the preferred course of action?  For obvious reasons, this step (along with step 4) occupies the lion’s share of the analysis and discussion in this book.  Once the decision maker has put the problem in context, formalized the objectives, and identified available alternatives, how does he or she go about finding a preferred course of action?

 

DECISION MAKING – STEP 6 

PERFORM SENSITIVITY ANAYSIS

What features of the problem determine the optimal choice of action?  How does the optimal decision change if conditions in the problem are altered?  Is the choice sensitive to key economic variables about which the decision maker is uncertain?

 

DECISION MAKING – STEP 6 

In tackling and solving a decision problem, it is important to understand and be able to explain to others the “why” of your decision.  The solution, after all, did not come out of thin air.  It depended on your stated objectives, the way you structured the problem (including the set of options you considered), and your method of predicting out comes. Thus, sensitivity analysis considers how an optimal decision would change if key economic facts or conditions were altered.

 

QUESTIONS 

What is managerial economics?  What role does it play in shaping business decisions? 

Management sometimes is described as the art and science of making decisions with too little information.  What kinds of additional information would a manager want in the eight examples cited in the chapter?

 

QUESTIONS 

Suppose a soft-drink firm is grappling with the decision about whether to introduce to the market a new carbonated beverage with 25 percent real fruit juice.  How might it use the six decision steps to guide its course of actions?

Listed here are several examples of bad, or at least questionable,

decisions. Evaluate the decision maker’s approach or logic.  In which of the six decision steps might the decision maker have gone wrong?

 

QUESTIONS 

Mr. and Mrs. A recently bought a house, the very first one they viewed.

Firm B has invested five years and $6 million in developing a new product.  Even now, it is not clear whether the product can compete profitably in the market.  Nonetheless, top management decides to commercialize it so that the development cost will not be wasted.

 

QUESTIONS 

You are given $l,000 to keep.  You are then offered a choice between receiving an additional $500 for certain or taking a 50-50 gamble with outcomes of $1,000 and $0.  Which would you choose?

You are given $2,000 to keep.  You are then offered a choice between paying $500 for certain or taking a 50-50 gamble with outcomes of - $1,000 or $0.  Which would you choose?

 

QUESTIONS 

Consider a firm that is in the business of treating hazardous waste.  What kinds of economic constraints limit the

scope of the firm’s actions?  What about technological constraints? Legal or regulatory constraints?  Political constraints? Time constraints? 

 

SUMMARY 

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

 

Theory of the Firm 

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.

 

Value of the Firm 

The present value of all expected future profits

 

Definitions 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.

 

Function of Profit 

Profit is a signal that guides the allocation of society’s 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.

 

Business Ethics 

Identifies types of behavior that businesses and their employees should not engage in.

Source of guidance that goes beyond enforceable laws.