MANAGERIAL

ECONOMICS

By : Habtamu Legese (Asst.Prof)

 MANAGERIAL ECONOMICS: AN INTRODUCTION
1.1 Introduction
The business decision-making process has become
increasingly complex due to ever growing complexity of
the business world.
Experiences acquired through traditional training are no
longer sufficient to meet managerial challenges.
Thus, making an appropriate business decision requires a
clear understanding of market condition, market
fundamentals and the business environment.
As a result, the application of economic concepts,
theories, logic and analytical tools in the assessment and
prediction of market conditions and business environment
have proved to be of great help in business decision
making.
 1.2 What is Managerial Economics?
• Its name suggests the scope, content, form, and structure
of the subject.
• Managerial economics constitutes economic theories
and analytical tools that are widely applied to business
decisions.
• It is therefore important to define what the word
economics is.
• Economics is a social science, it studies how nations
make decision to allocate their resources between
competing needs of society so that the economic welfare
of the society can be maximized.
• However, choice-making is not so simple as it looks
because most economic decisions have to be taken under
the conditions of imperfect knowledge, risk
uncertainly.
Cont.
• Managerial economics is the discipline that deals
with the application of economic concepts, theories
and methodologies to the practical problems of
business in order to formulate rational managerial
decisions.
• With regard to the problems, there are various
problems related to the decision-making process such
as
A. Production decisions (what, how much, and how
to produce).
B. Exchange decisions (what price to charge and to
whom to sell) and
C. Consumption decisions (what and how much to
consume).
Cont.
• In other words, managerial economics can be
defined as the integration of economics theory
(application of economics theory) with business
practice for the purpose of facilitating decision
making and forward planning by management.
• It uses analytical tools and a set of concepts to
provide effective ways of thinking about decision
problem.
• Thus, managerial economics is concerned with the
application of economic concepts and economic
analysis to the problem of formulating rational
managerial decisions.
Cont.
 Managerial economics, therefore, is the study of
how to direct scarce resources in the way that most
efficiently achieves a managerial goal.
It is a very broad discipline in that it describes
methods useful for directing everything from the
resources of a household to maximize household
welfare to the resources of a firm to maximize
profits.
1.3 Importance of Managerial Economics for Managers
• A manager is a person who organizes factors of
production, introduce new ideas or product or
process, make business decisions, and is held
accountable for success or failure.
• Since managers in all types of enterprises face a
common set of problems; these tools of managerial
economics can be applied by all managers in profit-
seeking firms, in the public and not-for-profit
sectors.
• In profit-seeking firms the decision can be about
customers including pricing, and advertising;
suppliers; competitors, or the internal workings of
the organization.
Cont.
• In the public and not-for-profit sectors of the
economy, the same managerial economics principles
are applied for example to allocate funds among
different programs.
• Moreover, these principles exist whether a market is
local or global.
• The basic function of the managers of a business is
to achieve the objective of the firm thus to
maximum profit with the limited resources placed at
their disposal. Bearing this function in mind,
managerial economics helps managers in two ways.
Cont.
First, it provides a framework for evaluating
whether resources are being allocated efficiently
within the firm.
It helps to identify the alternative means of
achieving the given objectives, and then to select
the alternative that accomplishes the objectives in
the most resources efficient manner.
For example, to determine if profit could be
increased by substitute labor (variable cost) by
technology (fixed cost).
Second, these principles help managers to
respond to various economic signals. For
example, an increase in the prices of the output
would be the appropriate signal to increase output.
1.4 Scope of Managerial Economics and the Business
Environment
• Business environment has reference to the broad
characteristics of the economic system in which the
business firm operates.
• It includes the overall economic policies, social factors
and political atmosphere of the nation. Managerial
economics, however, concerned with only the
economic environment, and in particular with those
economic factors which form the business climate.
• Microeconomics focuses on individual economic
behavior (individual household) and firms and their
interaction in the market where resources are costly, for
example, how consumers respond to changes in prices
and income, how business decide on employment and
sales.
Cont.
• On the other hand, macroeconomics deals with the
aggregate economic variables or the economic
system as a whole.
• It addresses question like the effect of changes in
investment, government spending, employment,
exchange rates, inflation unemployment, and
import and export policies.
• It shows how the fiscal and monetary policies can
keep the aggregate system working well.
• Many macro economic theories are based on micro
economic principles and concepts. Similarly micro
economic behavior of many variables can be
meaningfully explained only with reference to
macro economics environment.
Cont.
• The scope of managerial economics to managerial
issues is more limited to microeconomics (topics like
demand, production, cost, pricing, and market
structure).
Accordingly, it has a wide scope to deal on the
following issues:
Estimation and analysis of demand for products
Determination of price of products
Planning of production and deciding input combination
Estimation and analysis of cost of production
Analysis of market structures and estimation of profit
Achieving other objectives of a business
Scope of Managerial Economics
1.5 Decision Systems and Process
• The ability to make good decisions is the key to
successful managerial performance. The success of
every decision depends mainly on decision process.
• Decision process refers to the procedure of making
decision; it involves co-ordination on the time scale,
present problem, past date and future action.
• The decision process in each of those areas of
decision shares a number of common elements and
basically it includes five steps.
• This five-step decision-making process is illustrated
in figure 1.1.
Cont.
•  First, the decision must establish or identify the objectives
of the organization. The failure to identify organizational
objectives correctly can result in the complete rejection of a
well-convinced and well-implemented plan.
• Next, the decision maker must identify the problem
requiring a solution.
• Third, once the source(s) of the problem is (are) identified,
the manager can move to an examination of potential
solutions. To provide potential solutions collection of data
available facts and figures are important. If for example, the
problem is the use of technologically inefficient equipment,
two possible solutions may be proposed updating and
replacing the plant's equipment or building a completely
new plant.
• The choice between these alternatives depends on the
relative data on cost and benefit, as well as other constraints
that may make one alternative preferable to another.
Cont.
• Fourth, formulation of a model (a model is an
analytical tool that helps for making decision under
different situation. After all alternatives have been
identified and evaluated the best alternatives have
been chosen using the model.
• The final step in the process is the implementation
of the decision. This phase often requires constraint
monitoring to ensure that results are as expected. If
they are not, corrective action needs to be taken
when possible.
 1.6 Nature of the Firm
A firm is an association of individuals who have organized
themselves for the purpose of turning inputs into output.
The firm organizes the factors of production to produce
goods and services to fulfill the needs of the households.
Each firm lays down its own objectives which is
fundamental to the existence of a firm.
The major objectives of the firm are:
To achieve the Organizational Goal
To maximize the Output
To maximize the Sales
To maximize the Profit of the Organization
To maximize the Customer and Stakeholders Satisfaction
To maximize Shareholder’s Return on Investment
To maximize the Growth of the Organization
Cont.
Firms are established to earn profit, to keep the
shareholders happy.
To increase their market share, they try to maximize
their sales. In the present business world firms try to
produce goods and services without harming the
environment.
Firms are not always able to operate at a profit.
They may be facing operating loss also. Economists
believe that firms maximize their long-run rather
than their short-run profit. So managers have to
make enough profit to satisfy the demands of their
shareholders and to maximize their wealth through
the company.
1.7 Identify Goals and Constraints
• The first step in making sound decisions is to have well-
defined goals because achieving different goals entails
making different decisions. If your goal is to maximize
your grade in this course rather than maximize your
overall grade point average, your study habits will differ
accordingly. Similarly, if the goal of a food bank is to
distribute food to needy people in rural areas, its
decisions and optimal distribution network will differ
from those it would use to distribute food to needy inner
city residents. Notice that in both instances, the decision
maker faces constraints that affect the ability to achieve
a goal. The 24-hour day affects your ability to earn an A
in this course; a budget affects the ability of the food
bank to distribute food to the needy. Constraints are an
artifact of scarcity.
1.8 Circular Flow of Economic Activity
Cont.
• The individuals own or control resources which are
necessary inputs for the firms in the production process.
These resources (factors of production) are classified
into four types.
• Land: It includes all natural resources on the earth and
below the earth. Non- renewable resources such as oil,
coal etc once used will never be replaced. It will not be
available for our children. Renewable resources can be
used and replaced and is not depleted with use.
• Labor: is the work force of an economy. The value of
the worker is called as human capital.
• Capital: It is classified as working capital and fixed
capital (not transformed into final products)
• Entrepreneurship: It refers to the individuals who
organize production and take risks.
Cont.
• All these resources are allocated in an effective manner
to achieve the objectives of consumers (to maximize
satisfaction), workers (to maximize wages), firms (to
maximize the output and profit) and government (to
maximize the welfare of the society).
• The circular flows of economic activities are explained
in a clockwise and counterclockwise flow of goods and
services. The four sectors namely households,
business, government and the rest of the world can
also be considered to see the flow of economic
activities.
• The circular flow of activity is a chain in which
production creates income, income generates
spending and spending in turn induces production.
Cont.
The major four sectors of the economy are engaged in three
economic activities of production, consumption and exchange of
goods and services. These sectors are as follows:
Households: Households fulfill their needs and wants through
purchase of goods and services from the firms. They are owners
and suppliers of factors of production and in turn they receive
income in the form of rent, wages and interest.
Firms: Firms employ the input factors to produce various goods
and services and make payments to the households.
Government: The government purchases goods and services from
firms and also factors of production from households by making
payments.
Foreign sector: Households, firms and government purchase
goods and services (import) from abroad and make payments. On
the other hand all these sectors sell goods and services to various
countries (export) and in turn receive payments from abroad.
1.9 Recognize the Nature and Importance of Profits
The overall goal of most firms is to maximize profits
or the firm's value.
Let us examine the nature and importance of profits in
an Economic and Accounting.
When most people hear the word profit, they think of
accounting profits. Accounting profit is the total
amount of money taken in from sales (total revenue,
or price times quantity sold) minus the dollar cost of
producing goods or services.
Accounting profits are what show up on the firm's
income statement and are typically reported to the
manager by the firm's accounting department.
Cont.
A more general way to define profits is in terms of
what economists refer to as economic profits.
Economic profits are the difference between the
total revenue and the total opportunity cost of
producing the firm's goods or services.
The opportunity cost of using a resource includes
both the explicit (or accounting) cost of the
resource and the implicit cost of giving up the best
alternative use of the resource.
The opportunity cost of producing a good or service
generally is higher than accounting costs because it
includes both the dollar value of costs (explicit, or
accounting, costs) and any implicit costs.
Cont.
• Implicit costs are very hard to measure and
therefore managers often overlook them.
• Effective managers, however, continually seek out
data from other sources to identify and quantify
implicit costs.
Example:
• Fred currently works for a corporate law firm. He is
considering opening his own legal practice, where
he expects to earn $200,000 per year once he gets
established.
• To run his own firm, he would need an office and a
law clerk. He has found the perfect office, which
rents for $50,000 per year. A law clerk could be
hired for $35,000 per year.
• Fred would have to quit his current job, where he is
earning an annual salary of $125,000 in the
corporate firm. If these figures are accurate, would
Fred’s legal practice be profitable?
Cont.
 1.10 Optimization
• Optimization deals with the determination of
extreme values which can be maximum or minimum
for the objective variable.
• The objective variable may be one or multiple. For
example, the private firm might pursue profit
maximization as single goal or the public sector firm
might aim at minimizing its average cost of
production as the sole goal.
• In contrast, the government undertaking might have
twin goals, namely, maximization of profit and
maximization of employment of unskilled labor.
Thus, below we will discuss optimization problems
of the firm.
 Profit Maximization
• If a firm’s objective is profit maximization, it would have
the power to control variables such as total revenue and
total cost which are variables related to profit. With regard
to the total cost, it is to mean the total economic cost
which is the sum of implicit and explicit costs. Explicit
costs are costs directly incurred by the firm for the
purchase of the inputs from the supplier of inputs where as
implicit costs are an indirect costs of the firm which are
related to depreciation of capital assets, employment of
owner-supplied resources and payments to the owner-
manager for his/her services. Thus, the economic profit is
the difference between the total revenue and the total
economic costs. So the firm maximizes its profit when
such difference comes with a possible maximum value.
Value Maximization
The firm’s value is the price for which the firm can
be sold and that price is equal to the present value of
the future expected profit.
The firm's value is affected by the risk associated
with the future profit, so the value would depend on
the risk premium, which is a discount rate to
compensate investors for the risk they have faced
due to uncertainty on future profits.
Thus, the value of a firm is computed as the present
value of the future economic profits expected to be
generated by the firm so that the value of the firm
maximizes when the summation of the present value
of the future economic profits over the lifetime of
the firm becomes at its maximum.
Cont.
Profit Maximization Vs Value Maximization
• Profit maximization refers to the maximization of a
single period profit by considering only the current
revenue and cost conditions as value maximization
refers to the maximization of the present value of
future profits expected to be generated by
considering not only the current revenue and cost
conditions but also the future revenue and cost
conditions.
Cont.
The profit maximization and value maximization
become equivalent and mean to the same thing if the
cost and revenue conditions in one time period are
independent of the revenue and costs in the future
time period so a manager will maximize the value of
the firm by making the decision that maximizes profit
in every single period.
However, if there is some dependency between the
current and future condition of revenue and costs, say
the current production output has an effect on
increasing costs in the future, profit maximization in
each (single) time period will not maximize the value
of the firm.