Nature and Scope of Managerial Economics (Chapter 1 Hirschey)

INTRODUCTION

Definition of Managerial Economics

• Application of economic tools and techniques to business and administrative decision-making; another term for the title of this course, namely economic analysis for agribusiness and management.

• Helps decision-makers recognize how economic forces affect organizations and describes the economic consequences of managerial behavior. How? By linking economic concepts and quantitative methods to develop tools for managerial decision-making.

• Simply put, managerial economics uses economic concepts and quantitative methods to solve managerial problems.

• We place emphasis on the practical application of economic analysis to managerial decision problems; the primary virtue of managerial economics lies in its usefulness.

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Economic concepts:

influence which products to produce, which costs to consider, and the prices to charge;

necessitates the collection, organization, and analysis of information.

Emphasis is placed on microeconomic topics, although macroeconomic relations have implications for managerial decision-making as well.

ECONOMIC CONCEPTS

1) Optimization techniques (calculus-based and

linear programming)

2) Statistical relations

3) Demand analysis and estimation (through regression)

4) Forces of demand and supply

5) Forecasting of firm activities (sales, production, demand, prices)

6) Risk analysis

Economic decision-making requires the following:

Firms are useful for producing and distributing

goods and services

Motivation for firms:

profit maximization or expected value maximization; free enterprise depends upon profits and the profit motive

Expected value of maximization:

optimization of profits in light of uncertainty and time value of money.

FIRMS

 

VALUE OF THE FIRM

n

tttt

i

TCTR

1 )1( firm of Value

+

…

Suppose that Chevron Corporation makes

projections of profits (expected profits) over the next five years:

2011 = $18,690 million

2012 = $15,560 million

2013 = $14,935 million

2014 = $20,125 million

2015 = $24,585 million

EXAMPLE: VALUE OF THE FIRM

Let the discount rate be equal to three percent.

Calculate the value of Chevron Corporation today.

Value of the firm ( in millions)

=

Value of the firm discounted back to the present

= $_____________ million

EXAMPLE, CONT.

85,653

Expected value maximization relates to the

various functional departments of the firm; also illustrates the value of forecasting

TR: marketing department, primary responsibility for promotion and sales

TC: production department, primary responsibility for costs

i: finance department, primary responsibility for the acquisition of capital and hence the discount factor i.

EXPECTED VALUE MAXIMIZATION

The determination of TR and TC is a non-trivial

and often complex task.

Suppose that a firm produces only one product.

TRt = PtQt-1 requires the notion of a demand function

TCt = fixed costst + variable costst

Variable costs are a function of Q TCt = f(Qt)

Even more complex situation if a firm produces more than one product.

TOTAL REVENUE AND TOTAL COSTS

Skilled labor

Raw materials

Energy

Specialized machinery

Warehouse space

Amount of investment funds available for a particular project or activity

Legal /contractual restrictions

Consequently, optimization techniques with constraints are important in decision-making

Linear programming

Calculus-based optimization

FIRM FACES CONSTRAINTS

Business Profit:

= TR – TC

the residual of sales revenue minus the explicit costs of doing business.

Economic Profit:

= business profit minus the implicit costs of capital and any other owner-provided inputs

reflects the opportunity cost for the effort of the owner-entrepreneur.

PROFIT MEASUREMENT

Opportunity Costs:

Owner-provided inputs are a notable part of business profits, especially among small businesses.

Profit Margin:

= business profit (net income)/sales,

Expressed as a percent

PROFIT MEASUREMENT

In 2007, the sales revenue of the American

Express Company was $27,136 million. The Business profit or net income for this firm was $3,729 million. What was the profit margin for the American Express Company?

Profit Margin =

EXAMPLE: PROFIT MARGIN

b

Return on Equity(ROE)

business profit (net income)/equity

Expressed as a percent

Equity

total assets – total liabilities = net worth=equity

EQUITY

In 2007, the net income for Microsoft

Corporation was $11,909 million. The equity (or net worth) of this firm was $36,708 million. What is the ROE for Microsoft Corporation?

ROE =

EXAMPLE: ROE