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<p>Managerial Economics ECO404</p> <p>VU Lesson 1</p> <p>INTRODUCTION TO MANAGERIAL ECONOMICS The heart of Managerial economics is the micro economic theory. Much of this theory was formalized in a textbook written more than 100 years ago by Professor Alfred Marshall of Cambridge University. The world has changed a great deal since Marshalls ideas were developed. Yet, basic micro economic principles such as supply and demand, elasticity, shortrun and long-run shifts in resource allocation, diminishing returns, economies of scale, and pricing according to marginal revenue and marginal cost continue to be important tools of analysis for managerial decision makers. Economics is divided into two broad categories: Micro and Macro. Microeconomics is the study of the economic behavior of individual decision-making units. It has a great relevance to Managerial Economics. On the other hand, Macroeconomics is the study of the total or aggregate level of output, income, employment, consumption, investment, and prices for the economy viewed as a whole. In economics, the key term is Scarcity. In the presence of a limited supply relative to demand, countries must decide how to allocate their scarce resources. This decision is central to the study of economics: What to produce? How to produce? And for whom to produce? These are the well known what, how and for whom questions found in the introductory chapter of all economics textbooks. DEFINITION OF MANAGERIAL ECONOMICS Joel Dean, author of the first managerial economics textbook, defines managerial economics as the use of economic analysis in the formulation of business policies. Douglas - Managerial economics is the application of economic principles and methodologies to the decision-making process within the firm or organization. Pappas &amp; Hirschey - Managerial economics applies economic theory and methods to business and administrative decision-making. Salvatore - Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its objectives most effectively. The meaning of this definition can best be examined with the aid of Figure 1-1</p> <p> Copyright Virtual University of Pakistan</p> <p>1</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>RELATIONSHIP TO ECONOMIC THEORY Economic theories seek to predict and explain economic behavior. Economic theories usually begin with a model. For example, the theory of the firm assumes that the firm seeks to maximize profits, and on the basis of that it predicts how much of a particular commodity the firm should produce under different forms of market structure. The profit-maximization model accurately predicts the behavior of firms, and, therefore, we accept it. Thus, the methodology of economics is to accept a theory or model if it predicts accurately. RELATIONSHIP TO THE DECISION SCIENCES Managerial economics is also closely related to the decision sciences. These use the tools of mathematical economics and econometrics to construct and estimate decision models aimed at determining the optimal behavior of the firm. Mathematical economics is used to formalize the economic models in equational form postulated by economic theory. Econometrics then applies statistical tool (particularly regression analysis) to real-world data to estimate the models postulated by economic theory and for forecasting. SCOPE OF MANAGERIAL ECONOMICS Managerial economics has applications in both profit and not-for-profit sectors. For example, an administrator of a nonprofit hospital seeks to provide the best medical care possible given limited medical staff, beds and equipment. Using the tools and concepts of managerial economics, the administrator can determine the optimal allocation of these limited resources. In short, managerial economics helps managers arrive at a set of operating rules that help in the efficient use of scarce human and capital resources. By following these rules, businesses, educational institutions, hospitals, other nonprofit organizations, and government agencies are able to meet their objectives efficiently.</p> <p> Copyright Virtual University of Pakistan</p> <p>2</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>THEORY OF THE FIRM The theory of firm is the center-piece and central theme of Managerial economics. A firm is an organization that combines and organizes resources for the purpose of producing goods and/or services for sale. The model of business is called the theory of the firm. In its simplest version, the firm is thought to have profit maximization as its primary goal. Today, the emphasis on profits has been broadened to include uncertainty and the time value of money. In this more complete model, the primary goal of the firm is long-term expected value maximization. EXPECTED VALUE MAXIMIZATION The value of the firm is the present value of all expected future profit of the firm. Future profits must be discounted at an appropriate interest rate .to the present because a dollar of profit in the future is worth less than today. This model can be expressed as follows: Formally the wealth or value of the Firm = Present Value of Expected Future ProfitsP V =</p> <p>( 1 +</p> <p>1</p> <p>r</p> <p>)</p> <p>1</p> <p>+</p> <p>( 1 +</p> <p>2</p> <p>r</p> <p>)</p> <p>2</p> <p>+</p> <p>+</p> <p>( 1 +</p> <p>n</p> <p>r</p> <p>)</p> <p>n</p> <p>=</p> <p>t</p> <p>n =</p> <p>1</p> <p>t</p> <p>(</p> <p>1</p> <p>+</p> <p>r</p> <p>)</p> <p>t</p> <p>Here, 1, 2, . . . n represent expected profits in each year, t, and r is the appropriate interest, or discount, rate.V a l u e o f F i r m =</p> <p>n t = 1</p> <p>( 1 +</p> <p>t</p> <p>r</p> <p>)</p> <p>t</p> <p>=</p> <p>n t = 1</p> <p>T</p> <p>R (</p> <p>t</p> <p> + r</p> <p>T )</p> <p>Ct</p> <p>t</p> <p>1</p> <p>CONSTRAINTS AND THE THEORY OF THE FIRM Managerial decisions are often made in light of constraints imposed by technology, resource scarcity, contractual obligations, laws, and regulations. Organizations frequently face limited availability of essential inputs, such as skilled labor, raw materials, energy, specialized machinery, and warehouse space. LIMITATIONS OF THE THEORY OF THE FIRM Some critics question why the value maximization criterion is used as a foundation for studying firm behavior. The theory of the firm which postulates that the goal of the firm is to maximize wealth or the value of the firm has been criticized as being much too narrow and unrealistic. Hence, broader theories of the firm have been purposed. The most prominent among these are: Sales maximization ( Adequate rate of profit) Management utility maximization ( Principle-agent problem) Satisfying behavior These alternative theories, or models, of managerial behavior have added to our understanding of the firm. Still, none can replace the basic value maximization model as a foundation for analyzing managerial decisions. DEFINITIONS OF PROFIT Business or Accounting Profit: Total revenue minus the explicit or accounting costs of production. Copyright Virtual University of Pakistan 3</p> <p>Managerial Economics ECO404 Economic Profit: Total revenue minus the explicit and implicit costs of production.</p> <p>VU</p> <p>THEORIES OF PROFIT Risk-Bearing Theories of Profit Frictional Theory of Profit Monopoly Theory of Profit Innovation Theory of Profit Managerial Efficiency Theory of Profit</p> <p> Copyright Virtual University of Pakistan</p> <p>4</p> <p>Managerial Economics ECO404</p> <p>VU Lesson 2</p> <p>ECONOMIC OPTIMIZATION PROCESS Optimization is mainly concerned with finding maximum and minimum points, also known as optimum points of a function. Applications include finding optimum values for functions such as profit, cost, revenue, production and utility. These functions which are to be maximized or minimized are called objective function. Examples Consumers maximize utility by purchasing an optimal combination of goods Firms maximize profit by producing and selling an optimal quantity of goods Firms minimize their cost of production by using an optimal combination of inputs Just as there is no single best purchase decision for all customers at all times, there is no single best investment decision for all managers at all times. When alternative courses of action are available, the decision that produces a result most consistent with managerial objectives is the optimal decision. The process of arriving at the best managerial decision is the goal of economic optimization and the focus of managerial economics. MAXIMIZING THE VALUE OF THE FIRM In managerial economics, the primary objective of management is assumed to be maximization of the value of the firm. This value maximization objective which we have introduced in our lesson 1, is expressed as:V a l u e o f F i r m =</p> <p>n t = 1</p> <p>( 1 +</p> <p>t</p> <p>r</p> <p>)</p> <p>t</p> <p>=</p> <p>n t = 1</p> <p>T</p> <p>R (</p> <p>t</p> <p> + r</p> <p>T )</p> <p>Ct</p> <p>t</p> <p>1</p> <p>Maximizing the above equation is a complex task that involves consideration of future revenues, costs, and discount rates. For many day-to-day operating decisions, managers typically use less complicated, partial optimization techniques. EXPRESSING ECONOMIC RELATIONSHIPS Common ways of specifying Economic functions are: Set form Functional form Graphs tableQ TR 0 0 1 90 2 160 3 210 4 240 5 250 6 240</p> <p>Tables:</p> <p>S = {(a,b)/ a Q and b R} Equations:</p> <p>(set form)</p> <p>TR = 100Q - 10Q2 (Functional Form)</p> <p> Copyright Virtual University of Pakistan</p> <p>5</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>TR 300 250 200 150 100 50 0 0 1 2 3 4 5 6 7 Q</p> <p>Tables are the simplest and most direct form for presenting economic data. When these data are displayed electronically in the format of an accounting income statement or balance sheet, the tables are referred to as spreadsheets. When the underlying relation between economic data is simple, tables and spreadsheets may be sufficient for analytical purposes. In such instances, a simple graph or visual representation of the data can provide valuable insight. Complex economic relations require more sophisticated methods of expression. An equation is an expression of the functional relationship among economic variables. TOTAL, AVERAGE, AND MARGINAL RELATIONS Total, average, and marginal relations are very useful in optimization analysis. The relationship between total, average and marginal concepts is extremely important in optimization analysis. A marginal relation is the change in the dependent variable caused by a one-unit change in an independent variable. For example, marginal revenue is the change in total revenue associated with a one-unit change in output; marginal cost is the change in total cost following a one-unit change in output; and marginal profit is the change in total profit due to a one-unit change in output. REVENUE RELATIONS Price and Total Revenue Total Revenue = Price Quantity Marginal Revenue Change in total revenue associated with a one-unit change in output. Revenue Maximization Quantity with highest revenue, MR = 0.</p> <p>Q 0 1 2 3 4 5 6</p> <p>TR 0 90 160 210 240 250 240</p> <p>AR 90 80 70 60 50 40</p> <p>MR 90 70 50 30 10 -106</p> <p> Copyright Virtual University of Pakistan</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>TR 300 250 200 150 100 50 0 0 1 2 3 4 5 6 7 Q</p> <p>AR, MR 120 100 80 60 40 20 0 -20 -40 Q 0 1 2 3 4 5 6 7</p> <p>PROFIT RELATIONS</p> <p>PROFIT MAXIMIZATION</p> <p>Q 0 1 2 3 4 5</p> <p>TR 0 90 160 210 240 250</p> <p>TC Profit 20 -20 140 -50 160 0 180 30 240 0 480 -230</p> <p> Copyright Virtual University of Pakistan</p> <p>7</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>($) 300 TC 240 TR 180 M C 120 60 0 0 1 2 3 4 M R 5 Q</p> <p>60 30 0 -30 -60 Profit</p> <p>COST RELATIONS Total Cost Total Cost = Fixed Cost + Variable Cost. Marginal and Average Cost Marginal cost is the change in total cost associated with a one unit change in output. Average Cost = Total Cost/Quantity Average Cost Minimization Average cost is minimized when MC = AC. Reflects efficient production of a given output level. Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC) FC = a VC = bQ + Q2 TC = a + bQ + Q2 Marginal Costs (MC) = dTC/dQ MC = b + 2Q Average Total Cost (ATC) = Total Cost/Q ATC = (a + bQ + Q2)/Q so that: ATC = a/Q + b + Q</p> <p> Copyright Virtual University of Pakistan</p> <p>8</p> <p>Managerial Economics ECO404</p> <p>VU</p> <p>TC ($) 240 180 120 60 0 0 AC, MC ($) 120 1 2 3 4 MC Q</p> <p>A C</p> <p>60</p> <p>0 0 1 2 3 4 Q</p> <p>GEOMETRIC RELATIONSHIPS The slope of a tangent to a total curve at a point is equal to the marginal value at that point The slope of a ray from the origin to a point on a total curve is equal to the average value at that point A marginal value is positive, zero, and negative, respectively, when a total curve slopes upward, is horizontal, and slopes downward A marginal value is above, equal to, and below an average value, respectively, when the slope of the average curve is positive, zero, and negative</p> <p> Copyright Virtual University of Pakistan</p> <p>9</p> <p>Managerial Economics ECO404</p> <p>VU Lesson 3</p> <p>ECONOMIC OPTIMIZATION WITH CALCULUS MARGINAL ANALYSIS IN DECISION MAKING The marginal analysis is one of the most important concepts in managerial economics in general and in optimization analysis in particular. According to marginal analysis, the firm maximizes profits when marginal revenue equals marginal cost. Marginal cost (MC) is defined as the- change in total cost per unit change in output and is given by the slope of the TC curve. Marginal analysis gives clear rules to follow for optimal resource allocation. As a result, geometric relations between totals and marginals offer a fruitful basis for examining the role of marginal analysis in managerial decision making. Geometric relations between totals and marginals offer a fruitful basis for examining the role of marginal analysis in economic decision making. Managerial decisions frequently require finding the maximum value of a function. For a function to be at a maximum, its marginal value (slope) must be zero. Evaluating the slope, or marginal value, of a function, therefore, enables one to determine the point at which the function is maximized. TANGENTS AS LIMITS OF SECANT LINES Slope is a measure of the steepness of a line and is defined as the increase (or decrease) in height per unit of movement along the horizontal axis. The slope of a straight line passing through the origin is determined by dividing the Y coordinate at any point on the line by the corresponding X coordinate. Using (read delta) to designate change: Slope = Y/X The marginal relation has a similar geometric association with the total curve. The slope of a nonlinear curve varies at every point on the curve. Slopes of nonlinear curves are typically found geometrically by drawing a line tangent to the curve at the point of interest and determining the slope of the tangent. A tangent is a line that touches but does not intersect a given curve. The basic problem that leads to differentiation is to compute the slope of a tangent line of the graph of a given function f at a given point x0. The key observation, which allows one to compute slopes of tangent lines, is that the tangent is a certain limit of secant lines as illustrated in the figure below. A secant line intersects the graph...</p>