Unit – One

Introduction to Managerial Economics

Economics can be divided into two broad categories: micro economics and macro
economics. Macro economics is the study of the economic system as a whole. It includes
techniques for analyzing changes in total output, total employment, the unemployment
rate, and exports and imports. It also focuses on the effect of changes in investment,
government spending, and tax policy on exports, output, employment and prices.
Micro economics is the study and analysis of the behaviour of individual
segments of the economy: individual consumers, workers and owners of resources,
individual firms, industries, and markets for goods and services. Micro economics is
concerned with topics such as how consumers choose the goods and services they
purchase and how firms make hiring, pricing, production, advertising, research and
development and investment decisions.

Managerial economics

Managerial economics focuses on the application of micro economic theory to

business problems. Managerial economics provides a systematic, logical way of
analyzing business decisions – both today’s decisions and tomorrows. It addresses the
larger economic forces that shape both day-to-day operations and long-run planning
decisions.
Managerial economics is applied micro economics. It is an application of the part
of micro economics that focuses on the topics that are importance to managers. These
topics include demand, production, cost, pricing, market structure, and government
regulation. The rational application of these principles should result in better managerial
decisions, higher profits and an increase in the value of the firm.
Managerial economics applies economic theory and methods to business and
administrative decisions.
Managerial economics can be used by the goal-oriented manager in two ways:
1. The principles of managerial economics provide a framework for evaluating
whether resources are being allocated efficiently within a firm. For example,
economics can help the manager determine if profit could be increased by
reallocating labour from a marketing activity to the production line.
2. These principles help managers respond to various economic signals. For
example, given an increase in the price of output or the development of a new
lower-cost production technology, the appropriate managerial response would be
to increase output.

Importance of Managerial economics

 A working knowledge of the principles of managerial economics can increase the

value of both the firm and the manager.
 It prescribes rules for improving managerial decisions.
 It helps managers recognize how economic forces affect organizations and describes
the economic consequences of managerial behaviour.

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 It links economic concepts with quantitative methods to develop vital tools for
managerial decision making.
Managerial economics is a tool for improving managerial decision making. Managerial
economics uses economic concepts and quantitative methods to solve managerial
problems.
Management decision problems
 Product selection, output and pricing
 Internet strategy
 Organizational design
 Product development and promotion strategy
 Employee hiring and training
 Investment and hiring

Economic concepts Quantitative methods

 Marginal benefits  Numerical analysis
 Theory of consumer demand  Statistical estimation
 Theory of the firm  Forecasting procedures
 Industrial organization and firm  Game theory concepts
behaviour  Optimization techniques
 Public choice theory  Information systems

Managerial economics
 Use of economic concepts and quantitative methods
to solve management decision problems

Optimal solutions to management decision problems

Scope of Managerial Economics

Managerial economics suggests the course of action from the available alternatives for
optimal solution to a given managerial problem. The problem may be related to any of
the managerial decision areas such as production, inventory, accountancy, capital
management or human resources management. Different authors have given different
views regarding the scope of managerial economics. However, the following aspects
generally fall under managerial economics.

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1. Demand decision: Economists use the term 'demand' to mean the desire to have
possession and willingness to pay for that possession. In other words, demand is the
amount the consumers are willing to buy at a given price over a given period of time.
For a firm or an industry consisting of several firms, the extent of demand determines
the size of market. The analysis and forecasting of demand for a given product is very
important for the successful running of a business firm. Without a clear understanding
of consumer’s behavior and a clear knowledge of the market demand conditions, the
firm is handicapped in its attempt towards profit planning or any other business
strategy planning. Present demand and forecasting future demand constitute the first
step towards the objective of profit maximization. The stability and growth of
business is linked to the size and structure of demand.
2. Cost and production decision: Production is the process of creating' utilities'.
Production decisions have many facets. It is linked with several other decisions like
the decision to supply to the market, choice of technique and technology, product mix
decision, etc. It is true that some of the basic concepts of managerial economics are
directly helpful in arriving at optimum decisions concerning production, materials
purchase and handling. However, production decisions cannot be resolved through
considerations of only 'Physical efficiency' but also 'cost efficiency’; in fact,
production maximizing decisions are invariably cost minimizing decisions.
3. Pricing decisions: Price is the expression of value of an item in terms of a monetary
unit. Pricing is a very important area of managerial economics as it is the genesis of
the revenue of a firm. Also, the success of a business firm largely depends on the
correctness of price decisions taken by it. At any price, if demand exceeds supply,
their excess demand pushes up the prevailing price. At any price, if supply exceeds
demand, this excess supply pulls down the price, thus price is determined at a point
where demand is equal to the supply.
4. Profit decisions: Profit is the tool of generating internal funds. The primary focus of
any business firm is profit maximization. Profit is the tool of generating internal
funds. A firm which wants to grow in near future and would not like to depend on
external funds, may like to generate its own internal resources through reserves and
surpluses created by way of accumulated retained earnings, i.e., profit. Profit analysis

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 would be very easy if the knowledge of future were perfect. But in a world of
uncertainty there occurs a great difference between the expectations and happenings.
This constitutes the difficult area of managerial economics.
5. Capital decision: Capital is the foundation of a business. The amount of capital
utilized and its relative importance determines the financial structure of a company.
An effective financial management would ensure that the capital structure of the
company is tailor-made. Therefore, while deciding about the capital structure of the
company, the management should bear the following factors in mind
i. The use to be made of the capital,
ii. The cost of capital, and
iii. Most efficient allocation of capital.
In short, capital management implies planning and control of capital expenditure.
Capital decision includes cost of capital, rate of return and selection of projects.

THEORY OF THE FIRM

At its simplest level, a business enterprise represents a series of contractual relationships
that specify the rights and responsibilities of various parties. People directly involved
include customers, stockholders, management, employees, and suppliers. Society is also
involved because businesses use scarce resources, pay taxes, provide employment
opportunities, and produce much of society’s material and services output. Firms are a
useful device for producing and distributing goods and services. They are economic
entities and are best analyzed in the context of an economic model.
Expected Value Maximization
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. The firm’s owner-manager is
assumed to be working to maximize the firm’s short-run profits. Today, the emphasis on
profits has been broadened to encompass uncertainty and the time value of money. In this
more complete model, the primary goal of the firm is long-term expected value
maximization.
The value of the firm is the present value of the firm’s expected future net cash flows. If
cash flows are equated to profits for simplicity, the value of the firm today, or its present

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value, is the value of expected profits or cash flows, discounted back to the present at an
appropriate interest rate
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. To make decisions that
maximize value, managers must consider how external constraints affect their ability to
achieve organization objectives.
Organizations frequently face limited availability of essential inputs, such as skilled
labor, raw materials, energy, specialized machinery, and warehouse space. Managers
often face limitations on the amount of investment funds available for a particular project
or activity. Decisions can also be constrained by contractual requirements. Legal
restrictions, which affect both production and marketing activities, can also play an
important role in managerial decisions. The role that constraints play in managerial
decisions makes the topic of constrained optimization a basic element of managerial
economics.

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.

PROFIT MEASUREMENT
The free enterprise system would fail without profits and the profit motive. Even in
planned economies, where state ownership rather than private enterprise is typical, the

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profit motive is increasingly used to spur efficient resource use. Thus, profits and the
profit motive play a growing role in the efficient allocation of economic resources
worldwide.
Business Versus Economic Profit
The general public and the business community typically define profit as the residual of
sales revenue minus the explicit costs of doing business. It is the amount available to fund
equity capital after payment for all other resources used by the firm. This definition of
profit is accounting profit, or business profit

The economist also defines profit as the excess of revenues over costs. However, inputs
provided by owners, including entrepreneurial effort and capital, are resources that must
be compensated. The economist includes a normal rate of return on equity capital plus an
opportunity cost for the effort of the owner-entrepreneur as costs of doing business, just s
the interest paid on debt and the wages are costs in calculating business profit. The risk-
adjusted normal rate of return on capital is the minimum return necessary to attract and
retain investment. Similarly, the opportunity cost of owner effort is determined by the
value that could be received in alternative employment. In economic terms, profit is
business profit minus the implicit (noncash) costs of capital and other owner-provided
inputs used by the firm. This profit concept is frequently referred to as economic profit.
The concepts of business profit and economic profit can be used to explain the role of
profits in a free enterprise economy. A normal rate of return, or profit, is necessary to
induce individuals to invest funds rather than spend them for current consumption.
Normal profit is simply a cost for capital; it is no different from the cost of other
resources, such as labor, materials, and energy. A similar price exists for the
entrepreneurial effort of a firm’s owner manager and for other resources that owners
bring to the firm. These opportunity costs for owner-provided inputs offer a primary
explanation for the existence of business profits, especially among small businesses.
Economic profit versus Accounting profit

Economic profit is the amount by which total revenue exceeds total economic
cost.
The total economic cost is the sum of the opportunity costs of each and every
resource used by a firm.

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 Business generally utilize two kinds of resources;
1. Resources owned by others (such as labour services of skilled and unskilled
workers, raw materials purchased from commercial suppliers, and capital
equipment rented or leased from equipment suppliers). The opportunity cost of
using resources owned by others is the dollar amount paid to the resource owners
are called explicit costs.
2. Resources owned by the firm ( such as labour services provided to the firm by its
owners, money provided to the firm by its owners, money provided to the
business by its owners, and any land, buildings, or capital equipment owned and
used by the business). For the resources used by the firm that are owned by the
firm, the opportunity cost is the largest payment that the owner could have
received if those resources that it owns had been leased or sold instead of being
held by the firm for its own use. These costs of using a firm’s own resources are
called implicit costs since the firm makes no monetary payment to use its own
resources.

For both kinds of resources, firms incur opportunity costs to use these resources, and
the opportunity cost of the resource use is measured either by the dollar spent by owners
to secure the services of a resource owned by others or by the dollars sacrificed by
owners to hold and use a resource they own. Both kinds of opportunity costs of using
resources must be subtracted from total revenue to get economic profit;
Economic profit = Total revenue – total economic costs.
= Total revenue – Explicit costs – Implicit costs.

Accounting profit is the difference between total revenue and explicit costs
Accounting Profit = total revenue – explicit costs.
Thus, economic profit is smaller than accounting profit by the amount of the firm’s
implicit costs;
Economic Profit = Accounting profit - Implicit costs

Economists refer to the opportunity cost of using the owner’s own resources as
normal profit. Normal profit is another name for the implicit cost that a firm incurs when
it employs owner-supplied resources. It represents the payment that business owners must
receive for using their own resources in their own business. Normal profit is the implicit
part of total economic cost;
Economic Profit = Total revenue – Explicit cost – Normal profit
= Accounting profit – normal profit.

Theories of economic profits

1. Frictional theory of economic profits
It states that markets are sometimes in disequilibrium because of unanticipated
changes in demand or cost conditions. Unanticipated shocks produce positive or negative
economic profits for some firms. For example; ATM’s make it possible for customers of
financial institutions to easily obtain cash, enter deposits, and make loan payments. A rise
in the use of plastics and aluminum in automobiles drives down the profits of steel
manufacturers.

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2. Monopoly theory of economic profits
This theory asserts that some firms are sheltered from competition by high
barriers to entry. Economies of scale, high capital requirements, patents, or import
protection enable some firms to build monopoly positions that allow above- normal
profits for extended periods.
3. Innovation theory of economic profits
It describes the above-normal profits that arise following successful invention or
modernization. Example, Microsoft Corporation earned superior rates of return because
of its Graphical User Interface. Mc Donald’s Corporation earned above normal rates of
return as an early innovator in the fast food business.
4. Compensatory theory of economic profits
It describes above normal rates of return that reward firms for extra ordinary
success in meeting customer needs, maintaining efficient operations etc. If firms that
operate at the industry’s average levels of efficiency receive normal rates of return, it is
reasonable to expect firms operating at above average levels of efficiency to earn above
normal rates of return. Inefficient firms can be expected to earn unsatisfactory, below
normal rates of return. The theory also recognizes economic profit as an important reward
to the entrepreneurial function of owners and managers.

Examples:
1. Suppose a firm has revenues of $ 5 million and explicit costs of $ 3 million. The
owners of the firm have provided $ 1 million of capital to the firm. If the owners could
have earned a 10 percent return on the $ 1 million in their best alternative investment (of
similar risk), the normal profit is $ 100,000. Economic profit is $ 1.9 million (= $ 5
million - $ 3 million - $ 0.1 million).

Suppose this same firm receives a total revenue of only $ 3.1 million, then the
firm would be earning only a normal profit, and economic profit is zero. Even though
economic profit is zero, the owners are still “breaking even “because the firm’s
accounting profit of $ 0.1 million is just enough to pay the owners a normal profit for the
use of their resources.

2. Consider an individual who has an MBA degree and is considering investing $

200,000 in a retail store that she would manage. The projected income statement for the
years as prepared by an accountant is as shown here.
Sales $ 90,000
Less: Cost of good sold 40,000
__________
Gross Profit $ 50,000

Less: Advertising $ 10,000

Depreciation 10,000
Utilities 3,000
Property tax 2,000
Miscellaneous expenses 5,000

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 30,000
____________
Net accounting profit $ 20,000
_____________
The use of this concept may result in making wrong decision.

The economist recognizes other costs, defined as implicit costs. These costs are
not reflected in cash outlays by the firm, but are costs associated with forgone
opportunities. There are two major implicit costs in the example. First, the owner has
$200,000 invested in the business. Suppose the best alternative use for this money is a
bank paying a 5 percent interest rate. Therefore, this investment would return $ 10,000
annually. The $10,000 should be considered as the implicit or opportunity cost of having
the $200,000 invested in the retail store.

The second implicit cost includes the manager’s time and talent. The annual wage
return of an MBA degree from a reasonably good business school may be $ 60,000 per
year. This is the implicit cost of managing this business rather than working for some one
else. Thus the income statement should be amended in the following way in order to
determine economic profit:

Sales $ 90,000
Less Cost of goods sold 40,000
Gross profit $ 50,000

Less: Explicit Costs:

Advertising $ 10,000
Depreciation 10,000
Utilities 3,000
Property tax 2,000
Miscellaneous expenses 5,000 30,000

Accounting profit (i.e. profit before

Implicit costs) $ 20,000
Less: Implicit costs:
Return on $ 200,000 of invested
Capital 10,000
Foregone wages 60,000 70,000
________________________
Net economic profit $ - 50,000
________________________

From this broader perspective, the business is projected to lose $ 50,000 in the
first year. The $ 20,000 accounting profit disappears when all “relevant” costs are
included. Obviously, with the financial information reported in this way, an entirely
different decision might be made on whether to start this business.

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3. Sharon Smith is a full time home maker and is also an excellent seamstress. She has
material for which she paid $5 per yard several years ago. The material has increased in
value during that time and could be sold back to the local fabric shop for $15 per yard.
Sharon is considering using that material to make dress, which she would sell to her
friends and neighbors. She estimates that each dress would require four yards of material
and four hours of her time, which she values at $10 per hour. If the dresses could be sold
for $90 each, could Sharon earn a positive economic profit by making and selling the
dresses?

Solution:
The key to this decision is appropriately accounting for both Sharon’s time ($ 10 per
hour) and the true opportunity cost of the material, $15 per yard (the amount she could
receive by selling it to the fabric shop). The profit calculation per dress would be as
follows:
Revenue $90
Less: 4 hours of labour at $10/hour 40
4 yards of material at $15/yd 60
_______
Economic profit $-10

Clearly, making the dresses is not going to be profitable. If Sharon had not included the
value of her time and had used the historic price of $5 per yard as the cost of the material,
she would have estimated a “profit” of $70 per dress, that is

Revenue $90
Less: 4 yards of material at $5/yd 20
________
“Profit” $70
This is not an accurate measure of profit because it fails to account for the true
opportunity cost of Sharon’s time and the opportunity cost of a yard of material. She
could sell both in the market and make more than she could by producing the dresses.

Market structure and managerial decision making

Managers cannot expect to succeed without understanding how market forces

shape the firm’s ability to earn profit. An important aspect of managerial decision making
is the pricing decision. The structure of the market in which the firm operates can limit
the ability of a manager to raise the price of the firm’s product, without losing substantial
amount.
Market structure is a set of market characteristics that determines the economic
environment in which a firm operates. The economic characteristics needed to describe a
market are;
 The number and size of the firms operating in the market. If there are large
numbers of sellers, no single firm can influence market price by changing its production
level. When the total output of a market is produced by one or a few firms with relatively

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large market shares, a single firm can cause the price to rise by restricting its output and
to fall by increasing its output.
 The degree of product differentiation among competing producers. If sellers
produce identical products, then buyers will never need to pay more for a particular
firm’s product than the price charged by the rest of the firms. By differentiating a
product, a firm may be able to raise its price above its rival’s prices.
 The likelihood of new firms entering a market when existing firms are earning
economic profits. When firms in a market earn economic profits, other firms will learn of
this return in excess of opportunity costs and will try to enter the market. Once enough
firms enter a market, price will be bid down sufficiently to eliminate any economic profit.

Micro economists have analyzed firms operating in a number of different market

structures. Each market structure shapes a manager’s pricing decisions. In perfect
competition, a large number of relatively small firms sell an undifferentiated product in a
market with no barriers to the entry of new firms. Managers of firms operating in
perfectly competitive markets are price-takers, with no market power. Since price is
determined by the market forces of demand and supply, they decide how much to
produce to maximize profit. Any economic profit earned at the market-determined price
will vanish as new firms enter and drive the price down to the average cost of production.
Many of the markets for agricultural goods and other commodities traded on national and
international exchanges closely match the characteristics of perfect competition.

In a monopoly market, a single firm, protected by some kind of barrier to entry

produces a product for which no close substitutes are available. A monopoly is a price
setting firm. The degree of market power enjoyed by the monopoly is determined by the
ability of consumers to find imperfect substitutes for the monopolist’s product. The
higher the price charged by the monopolist, the more willing are consumers to buy other
products. The existence of a barrier to entry allows a monopolist to raise its price.
Examples of true monopolies are rare.

In monopolistic competition, a large number of firms that are small relative to the
total size of the market produce differentiated products without the protection of barriers
to entry. The product differentiation gives monopolistic competitors some degree of
market power. Any economic profit will eventually be bid away by new entrants. The
toothpaste market provides one example of monopolistic competition. Many brands of
toothpaste are close substitutes. Toothpaste manufacturers differentiate their toothpastes
by using different flavorings, abrasives, whiteners, fluoride levels, and other ingredients,
along with advertising to create brand loyalty.

In the case of an oligopoly market, just a few firms produce most or all of the market
output. So any one firm’s pricing policy will have a significant effect on the sales of other
firms in the market. The interdependence of oligopoly firms means that actions taken by
any one firm in the market will have an effect on the sales and profits of the other firms.

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