Managerial Economics

Economy. . .

. . . The word economy comes from a Greek word Oikonomos which means “one who manages a household.”

Economics is the study of how society manages its scarce resources.

Microeconomics and Macroeconomics

• Microeconomics focuses on the individual parts of the economy.– How households and firms make decisions and

how they interact in specific markets• Macroeconomics looks at the economy as a

whole.– Economy-wide phenomena, including inflation,

unemployment, and economic growth

The Diverse Fields of EconomicsExamples of microeconomic and macroeconomic concernsExamples of microeconomic and macroeconomic concerns

ProductionProduction PricesPrices IncomeIncome EmploymentEmployment

MicroeconomicsMicroeconomics Production/Output Production/Output in Individual in Individual Industries and Industries and BusinessesBusinesses  How much steelHow much steelHow many officesHow many officesHow many carsHow many cars

Price of Individual Price of Individual Goods and ServicesGoods and Services  Price of medical Price of medical carecarePrice of gasolinePrice of gasolineFood pricesFood pricesApartment rentsApartment rents

Distribution of Distribution of Income and WealthIncome and Wealth  Wages in the auto Wages in the auto industryindustryMinimum wagesMinimum wagesExecutive salariesExecutive salariesPovertyPoverty

Employment by Employment by Individual Individual Businesses & Businesses & IndustriesIndustriesJobs in the steel Jobs in the steel industryindustryNumber of Number of employees in a employees in a firmfirm

MacroeconomicsMacroeconomics National National Production/OutputProduction/Output  Total Industrial Total Industrial OutputOutputGross Domestic Gross Domestic ProductProductGrowth of OutputGrowth of Output

Aggregate Price Aggregate Price LevelLevel  Consumer pricesConsumer pricesProducer PricesProducer PricesRate of InflationRate of Inflation

National IncomeNational IncomeTotal wages and Total wages and salaries  salaries  

Total corporate Total corporate profitsprofits

Employment and Employment and Unemployment in Unemployment in the the EconomyEconomy  Total number of Total number of jobsjobsUnemployment Unemployment raterate

POSITIVE VERSUS NORMATIVE ANALYSIS• Positive statements are statements that attempt to describe the world as it is. Positive economics studies economic behavior without making judgments. It describes what exists and how it works.– Called descriptive analysis

• Normative statements are statements about how the world should be. Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.

– Called prescriptive analysis

• Positive or Normative Statements? – An increase in the minimum wage will cause a

decrease in employment among the least-skilled.POSITIVE

– Higher federal budget deficits will cause interest rates to increase.

POSITIVE

?

?POSITIVE VERSUS NORMATIVE

ANALYSIS

?

Fundamental Economic Problem• There are three fundamental economic problems for every human

society. It is immaterial whether it is centrally planned, mixed or

advanced industrial society.

• They are what commodities are produced, how these goods are

made and for whom they are produced.

• What: Whether produce one good more and other less.

• How: how goods are produced; choice of technologies; division of

labor who will do what.

• For whom: for whom are goods produced? Distribution of products

among household; what pattern it takes; where the income goes.

Economic System• Market, Command and Mixed System

– We have indicated three fundamental problems in the previous section. One can solve those problems in different way. It is a question of organization that what, how and for whom can be dealt with. The three available systems try to address those problems under their respective market system.

– A market economy is one in which individuals private firms market the major decisions about production and consumption. A system of prices, market, of profits and losses, of incentives and rewards determines what, how and for whom. In extreme case the economy is seen practicing laissez-faire which means non-interference from the government side in economic decision making.

• In a command economy the extreme opposite happens where the government takes all decision about the economy.

• Mixed economy consists of the elements of command and market. Most prevalent one.

• Society can not have everything. In must decide through Input-Output relationship. It must choose the technology. Inputs: land, labor, capital, and entrepreneurship. Out is the commodity produced by these inputs.

Economic System

Lionel Robbins

Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

What is Economics?

• Let us have some idea of some economists and the main idea of economics.

INTRODUCTION OF MANAGERIAL ECONOMICSConcept of Managerial Economics (contd.)

Managerial economics is by nature goal oriented and prescriptive which may be viewed as economics applied in decision making at the level of firm. Like an individual most of the problems of the firm emerge in allocation of scarce resources.We can trace different ideas given by scholars in this subject.

“Managerial economics is the price theory in service of business executive.” -D.J. Watson

“Managerial economics can be viewed as an application of that part of microeconomics that focuses on such topics as risk, demand, production, cost, pricing, and market structure.” -Petersen and Lewis

“Managerial economics is concerned with the ways in which managers should make decisions in order to maximize the effectiveness or performance of the organizations they manage.” - Edwin Mansfield

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What is Managerial Economics

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 organisation can achieve its objectives most effectively.”

INTRODUCTION OF MANAGERIAL ECONOMICSConcept of Managerial Economics (contd.)

Following diagram shows how does the managerial economics provide the link between traditional economics and decision sciences

Management Problems

Economic Theory Decision Sciences

ManagerialEconomics

Economic Methodology:Descriptive ModelPrescriptive Model

Study of Functional Areas:Accounting, Finance, and Marketing

Optimal Decision

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Managerial Decision Problems

Economic theoryMicroeconomicsMacroeconomics

Decision SciencesMathematical Economics

Econometrics

MANAGERIAL ECONOMICSApplication of economic theory

and decision science tools to solvemanagerial decision problems

OPTIMAL SOLUTIONS TOMANAGERIAL DECISION PROBLEMS

What is Managerial Economics (contd.)

• Howard Davies and Pun-Lee Lam -

• “It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics.”

From these ideas it can be concluded managerial economics is the discipline, which deals with the application of economic theory to business management. Thus it lies on the borderline between economics and business management and serves as a bridge between these two disciplines.

INTRODUCTION OF MANAGERIAL ECONOMICS

Distinction between Managerial Economics and Traditional Economics

There are some differences between managerial economics and traditional economic theory because managerial economics seeks the help of other disciplines such as statistics, mathematics, accounting, management to get optimal solution to the managerial decision-making problems.

Differences between managerial economics and traditional economics which are outlined below:

i. Managerial economics concerns with the application of economic principles to the problems of the firm but the traditional economics deals with the body of principles itself.

ii. Managerial economics is highly microeconomics in character. It studies the problems of a firm but does not study the macroeconomic phenomenon. But traditional economics consist of both micro and macro economics.

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INTRODUCTION OF MANAGERIAL ECONOMICS

Distinction between Managerial Economics and Traditional Economics (contd.)

iii. Traditional economics is a study of both firm and an individual, whereas managerial economics is a study of the problem of a firm only.

iv. Managerial economics focuses its attention in the study of profits because it has great influence primarily on entrepreneurial decision and value theory of the firm. In traditional economics, the microeconomics is a branch under which all the theories of factor pricing such as rent, wages, interest and profit are studied.

v. Traditional economics studies human behavior on the basis of certain assumptions, but these assumptions may not be true in managerial economics because managerial economics is concerned with practical problems.

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What is Managerial Economics (contd.)

It is an application of that part of microeconomics that focuses on

RiskDemandProductionCostPricing, andMarket Structure.It helps rational decision making through MODEL MODEL

BUILDINGBUILDING

INTRODUCTION OF MANAGERIAL ECONOMICSScope of Managerial Economics (contd.)Microeconomics Applied to Operational Issues:

Operational issues of firms are of internal nature. Internal issues include all those problems which arise within the business organization and fall within the control of the management. Some of the basic internal issues are:

a) Choice of business and the nature of products, that is, what to produce,b) Choice of size of the firm, that is, how much to produce,c) Choice of technology, that is, choosing the factor-combination

(technique of production)d) Choice of price, that is, how to price the commodity,e) How to promote sales,f) How to face competition,g) How to decide on new investments,h) How to manage profit and capital,i) How to manage an inventory, that is, stock of both finished goods and

raw materials.20

INTRODUCTION OF MANAGERIAL ECONOMICSScope of Managerial Economics (contd.)

Microeconomics deals with such questions confronted by managers. The following microeconomic theories deal with most of these questions.

Microeconomics Applied to Operational Issues:

a) Demand Analysis and Forecasting: - An understanding of the forces behind demand is a powerful tool for managers. Such knowledge provides the background needed to make pricing decisions, forecast sales and formulate marketing strategies. A forecast of future sales is essential before employing resources.

b) Theory of Production and Production Decisions: - Production theory explains the relationship between inputs and output. It also explains under what conditions costs increase or decrease; how total output behaves when use of inputs is changed; and how can output be maximized from a given quantity of resources. Thus, it helps the managers in determining the size of the firm, and the amount of capital and labour to be employed keeping in view the objectives of the firm.21

INTRODUCTION OF MANAGERIAL ECONOMICSScope of Managerial Economics (contd.)Microeconomics Applied to Operational Issues:

c) Market Structure and Pricing Theory: - Price theory explains how prices of outputs and inputs are determined under different market conditions; when price discrimination is desirable, feasible and profitable; and to what extent advertising can be helpful in expanding sales in a competitive market. Hence, price theory can be helpful in determining the price policy of the firm.

d) Analysis of Cost: - Estimates of cost are essential for planning purposes. The factors determining costs are not always known or controllable which gives rise to cost uncertainty. Factors of production are scarce and they have alternative uses. Factors of production may be allocated in a particular way to get maximum output. Thus the analysis of costs and their links to output are also importance in managerial economics.

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INTRODUCTION OF MANAGERIAL ECONOMICSScope of Managerial Economics (contd.)Microeconomics Applied to Operational Issues:

e) Profit and Capital Management (Investment Decisions): - Profit provides the index of success of a business firm. Profit analysis is difficult, because the uncertainty of expectations makes realization of profit planning and measurement difficult and these areas are covered in the study of managerial economics.Capital management means planning and control of capital expenditures. Hence, it is very important for a firm to manage required capital through proper investment planning. The main topics covered are: cost of capital, types of investment decisions, and evaluation and selections of investment projects.

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INTRODUCTION OF MANAGERIAL ECONOMICSScope of Managerial Economics (contd.)Microeconomics Applied to Operational Issues:

f) Inventory Management: - Inventory refers to a stock of raw materials or finished goods which a firm keeps. Management of inventory is very important for a firm to keep intact of its current production and supply capacity and to meet the challenges arising from change in market and other conditions. In this regard, a major question that arises is: how much of the inventory is the ideal stock? If it is high, capital is unproductively tied up, and that might be useful for other productive purposes if the stock of inventory is reduced. On the other hand, if the level of inventory is low, production will be hampered. Hence, managerial economics uses different methods which are helpful in minimizing the inventory cost.

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Stories of Four Great Economists

Adam Smith (1723 – 1790) was a Scottish Economist.

He is said FATHER OF ECONOMICS He is also FATHER OF CAPITALISM His Book: WEALTH OF NATIONS We want to talk about POVERTY not

wealth. His main theory is “There is an

invisible hand that determine everything – Don’t disturb it”

What is the invisible hand?

• P

S D

Q

Invisible hands – demand and supply – determines quantity and price

Economics is very easy

• Teach a Parrot to say Demand and Supply – then the parrot becomes an economist.

• Ask her any questions – she will say ‘demand and supply’ – then she is a great economist.

David Ricardo

• David Ricardo 1772-1823• His theory said, increase in

agricultural production would ultimately decline.

Thomas Malthus

• Thomas Robert Malthus, (1766-1834), English economist and demographer.

Malthus• He was a Church Priest.• Once he noted he had never seen a dead bird.

(except bats and crows).• He searched the reasons.• Bird die on a flowing stream and the body is

taken away by the water.• Birds commit suicide when food is not available.

– A tragic case – God cannot do this.• He investigated further and studied economics –

especially Ricardo

Population TheoryHis theory: population growth will always tend to outrun the food supply,* There will be hunger, famine, war, disasters, * Population Control is needed.* This is called Malthusianism

Karl Marx

Karl Heinrich Marx (1818 – 1883) was a German philosopher, economist, sociologist, historian, journalist and revolutionary socialist. His ideas played a significant role in establishing communism. He published various books. Das Kapital (1867–1894);

His thinking,Factors of ProductionCongealed Labor theoryExploitationDialectic Materialism

John m Keynes 1883 – 21 April 1946 – A British

Economist. Studied Mathematics Very young professor, most learned

young man, Wanted to marry an illiterate

women, Then what happened??-- Wrote a book “General Theory” Could not sell.

Lord Keynes (continued)

• Went to stock market,• Dominated stock market,• Became rich,• Became Lord,• Married,• Divided economics into Macro and Micro,• An interview of his wife.• He successfully introduced mathematics in

economics

The Process of Model-building

• The economics ‘method’• The steps: the hypothetical-deductive approach

– make assumptions about behaviour– work out the consequences of those assumptions– make predictions– test the predictions against the evidence– PREDICTIONS SUPPORTED? The model is accepted

as a good explanation (for the moment)– PREDICTIONS REFUTED? Go back and re-work the

whole process

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Definitions&

assumptions

Predictions

If predictionsnot supported by

data, model isamended ordiscarded

If predictions borne out by

data, the model is valid, for the moment

Theoreticalanalysis

Predictionstested

against data

Economic Laws

Economic PolicyCriteria for judging economic outcomes:• Efficiency, or allocative efficiency. An efficient

economy is one that produces what people want at the least possible cost.

• Equity, or fairness of economic outcomes.• Growth, or an increase in the total output of an

economy.• Stability, or the condition in which output is steady or

growing, with low inflation and full employment of resources.

Figure 1 The Circular Flow

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of Taka

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

MARKETS FOR

FACTORS OF PRODUCTIO

N

MARKETS FOR GOODS

AND SERVICES

FIRMS HOUSEHOLDS

Good and services bought

Good and services sold

Revenue (=GDP)

Spending (=GDP)

Inputs for Production

Land, labor and capital

Wages, rent, interest and profit (=GDP) Flow of goods & services

Flow of money: Taka

Income (=GDP)

THE CIRCULAR FLOW DIAGRAM

Assumptions

Assumption: The economy composed of households and firms only

Households: own factors of production,

consume goods and service

Firms: hire factors of production to produce goods and services

The Circular Flow of Economic Activity

The diagram above represents the transactions between firms and households in a simple economy.

In the upper loop, the arrow emanating from firms to households represents the sale by firms of goods and services to households. On the other hand, the arrow from households to firms represents the payments.

In the lower loop, the arrow originating from the households to the firms shows that firms hire labor and capital from households in order to produce goods and services. The arrow emanating from the firms indicates their payments for the use of the factors of production.

The Circular Flow of Economic Activity

Prices of outputs and inputs are determined in these markets and guide the decisions of all market participants,

The firm, an entity, organizes factors of production to produce goods and services,

The prices of product and factor of production guide interaction between individual and firms.

The Production Possibilities FrontierModel: The Production Possibilities Frontier

The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Figure 2 The Production Possibilities Frontier

Productionpossibilitiesfrontier

A

B

C

Quantity ofRice Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofGarments

Produced

D

Figure 3 The Production Possibilities Frontier

Productionpossibilitiesfrontier

A

B

C

Quantity ofRice Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofGarments

Produced

D

Theory of the Firm• Expected Value Maximization

– Owner-managers maximize short-run profits.– Primary goal is long-term expected value

maximization.• Constraints and the Theory of the Firm

– Resource constraints.– Social constraints

• Limitations of the Theory of the Firm– Alternative theory adds perspective.– Competition forces efficiency.– Hostile takeovers threaten inefficient managers.

Value of the Firm

The present value of all expected future profits

1 21 2

1(1 ) (1 ) (1 ) (1 )

nn tn t

t

PVr r r r

1 1(1 ) (1 )

n nt t tt t

t t

TR TCValueof Firm

r r

Profit Measurement• Business Versus Economic Profit

– Business (accounting) profit reflects explicit costs and revenues.

– Economic profit.• Profit above a risk-adjusted normal return.• Considers cash and noncash items.

• Variability of Business Profits– Business profits vary widely.

Why Do Profits Vary Among Firms?

• Disequilibrium Profit Theories–Rapid growth in revenues.–Rapid decline in costs.

• Compensatory Profit Theories–Better, faster, or cheaper than the

competition is profitable.

Role of Business in Society• Why Firms Exist

– Business is useful in satisfying consumer wants.

– Business contributes to social welfare• Social Responsibility of Business

– Serve customers.– Provide employment opportunities.– Obey laws and regulations.

How to Read and Understand Graphs

• Each point on the Cartesian Each point on the Cartesian plane is a combination of plane is a combination of (X,Y) values.(X,Y) values.

• The relationship between X The relationship between X and Y is causal. For a given and Y is causal. For a given value of X, there is a value of X, there is a corresponding value of Y, or corresponding value of Y, or X causes Y.X causes Y.

Reading Between the Lines

• A A lineline is a continuous string is a continuous string of points, or sets of (X,Y) of points, or sets of (X,Y) values on the Cartesian values on the Cartesian plane.plane.

• The relationship between X The relationship between X and Y on this graph is and Y on this graph is negative. An increase in the negative. An increase in the value of X leads to a value of X leads to a decreasedecrease in the value of Y, in the value of Y, and vice versa.and vice versa.

Positive and Negative Relationships

A A downward-slopingdownward-sloping line line describes a negative relationship describes a negative relationship between X and Y.between X and Y.

An An upward-slopingupward-sloping line line describes a positive relationship describes a positive relationship between X andbetween X and Y.Y.

Different Slope Values

b 5

1 00 5. b

7

1 00 7.

b 0

1 00 b

1 0

0

Different Slope Values

b 5

1 00 5. b

7

1 00 7.

b 0

1 00 b

1 0

0