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Managerial Economics ECO404

VU Lesson 1

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 & 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

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Managerial Economics ECO404

VU

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.

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Managerial Economics ECO404

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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 =

( 1 +

1

r

)

1

+

( 1 +

2

r

)

2

+

+

( 1 +

n

r

)

n

=

t

n =

1

t

(

1

+

r

)

t

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 =

n t = 1

( 1 +

t

r

)

t

=

n t = 1

T

R (

t

+ r

T )

Ct

t

1

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

Managerial Economics ECO404 Economic Profit: Total revenue minus the explicit and implicit costs of production.

VU

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

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Managerial Economics ECO404

VU Lesson 2

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 =

n t = 1

( 1 +

t

r

)

t

=

n t = 1

T

R (

t

+ r

T )

Ct

t

1

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

Tables:

S = {(a,b)/ a Q and b R} Equations:

(set form)

TR = 100Q - 10Q2 (Functional Form)

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Managerial Economics ECO404

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TR 300 250 200 150 100 50 0 0 1 2 3 4 5 6 7 Q

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, th