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SEEG 5013 Managerial Economics

Managerial Economics Defined

The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently.
applications of economic theory quantitative methods statistical methods computational methods

Topic 1: Introduction to Managerial Economics Chapter 1: The Nature and Scope of Managerial Economics

Dr. Hj. Mohd Razani Hj. Mohd Jali Economics Building - 0.55 College of Arts and Sciences razani@uum.edu.my 04-928 3524

Management decision problems arise in any organization firm, not-for-profit organization or government agency. It seeks to achieve some goals or objectives subject to some constraints. The goals and constraints may differ but basic decision making process is the same.
Hospital seeks to treat as many patients as possible with adequate medical standard with limited resources doctors, nurses, equipment, etc. University seeks provide adequate education to as many students as possible with limited physical and financial constraints. Government agency seeks to provide services to as many people as possible at lowest possible cost.

Economic Theory
Microeconomics Study of the economic behavior of individual decision-making units individual consumers, resource owners, and business firms in a free enterprise system. Macroeconomics Study of the total or aggregate level of output, income, employment, consumption, investment, and prices for the economy viewed as a whole.

Economic theory seeks to predict and explain economic behavior. It begins with a model, which is the abstract of many details surrounding an event and seeks to identify a few of the most important determinants of the event. Example theory assumes firm seeks to max profits, thus it predicts how much of particular commodity the firm should produce under different form of market structure. Thus, the methodology of economics is to accept a theory or model if it predicts accurately & if the predictions follow logically from the assumptions.

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Economic Methodology
Economic Models
Abstract from details Focus on most important determinants of economic behavior cause and effect

Decision Sciences
Mathematical Economics
Expresses and analyzes economic models using the tools of mathematics.

Evaluating Economic Models

A model is accepted if it predicts accurately and if the predictions follow logically from the assumptions.

Econometrics
Employs statistical methods to estimate and test economic models using empirical data.

Use of tools of mathematical economics and econometrics to construct & estimate decision models aimed at determining optimal behavior of the firm how firm can achieve its goals most efficiently. In short, managerial economics refers to the application of economic theory and decision science tools to find the optimal solution to managerial decision problems. It can be regarded as an overview course that integrates economic theory, decision science & the functional areas of business administration studies it examines how they interact to achieve its goal most efficiently.

Basic process of decision making

Can be divided into five basic steps Define the problem. Determine the objective Identify possible solutions Select the best possible solution Implement the decision

Define the problem. What is the actual issues or problems facing the firm. Example: Xerox Corp. find itself unable to compete with Japanese copiers, which can provide better quality and cheaper product.

Determine the objective. Firm must have objective that it wants to achieve. Example: leave the copier market to Japanese firms or meet the competition and try to produce quality and cheaper product than the Japanese product.

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Identify possible solutions. Options or range of possible solutions to the problem in order to achieve the objective. Example: improve quality while reducing cost of plant production, import parts from Japan which is cheaper, or transfer production to its Japanese subsidiary in Japan or other third world countries, which have cheaper labor cost.

Select the best possible solution. Select one solution from range of solutions previously identified. All possible solutions have to be examined using various tools available only one solution will be chosen. This would be the best one that meets its goal.

Theory of the firm

Implement the decision. Final step of decision making process. Decision taken would be able to turn the firm around, from less competitive to more competitive, producing cheap but quality product. It could be an improvement of firms process or could be a totally different process. Reasons for firms existence and their functions
Firm is an organization that combines and organizes resources for purpose of producing goods and services for sale. Firms exist because it would be very inefficient and costly for entrepreneurs to enter into contract with workers and owners of capital, land and other resources for production and distribution process. it can enter broader & long term contract with other parties. Firms exist to save on these transaction costs.

Reasons for firms existence and their functions (contd)

Firms function to purchase resources of labor services, capital & raw materials to transform into goods and services for sale. Resource owners use the income generated to purchase goods produced by the firm. The circular flow of economic activity is thus complete in the process of supplying goods and services that society demands, firms provide employment to workers & pay taxes, which government uses to provide services (defense, education, health) that firms could not provide at all or as efficiently.

Objective of the firm

Objective of firm is to maximize current or short-term profits. Firms are sometimes observed to sacrifice short term profits for the sake of incrasing future or long-term profits. Firms spent on research and development, new equipment and promotional campaign. Since short-term and long-term profits are important, the primary goal of the firm is to maximize the wealth or value of the firm.

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Value of the firm is given by the present value of all expected future profits of the firm. Future profits must be discounted to the present because a ringgit of profit in the future is worth less than a ringgit of profit today. Present value of the firm in the future can be calculated

Value of the Firm

The present value of all expected future profits

Constraints on operation of the firm

Limitations on availability of essential inputs labor, raw materials. Limitations on factory and warehouse space. Quantity of capital fund for a given project Legal constraints - minimum wage laws, health & safety standards, pollution emission standards and other government regulations. These are called constrained optimization.

Definitions of Profit

Business or Accounting Profit: Total revenue minus the explicit or accounting costs of production. Economic Profit: Total revenue minus the explicit and implicit costs of production. Opportunity Cost: Implicit value of a resource in its best alternative use.

PV Val
Theories of Profit

Explicit cost the actual out-of-pocket expenditures of the firm to purchase inputs it requires in production. These include wages to hire labor, interest on borrowed capital, rent, etc. Implicit cost value of inputs owned and used by the firm in its own production processes. This includes salary that entrepreneur could earn from working for someone else in a similar capacity and the return that firm could earn from investing its capital and renting its land to other firms.

Profit rates differ among firms in an industry or between industries - can be explained with theories of profit. Risk-Bearing Theories of Profit above normal returns are required by firms to enter and remain in such fields as petroleum exploration with aboveaverage risks. Frictional Theory of Profit profits resulted from friction or disturbances from long-run equilibrium. Perfectly competitive firms earn only a normal return or zero economic profit. However, firm may earn a profit or incur a loss. During energy crisis firms producing insulating materials enjoyed sharp increase in demand which led to large profits.

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Monopoly theory of profit firms with monopoly power can restrict output and charge higher prices, earning more profit. They can continue to earn profit in long run because of restricted entry into the industry. Firm can have monopoly power if it owns entire supply of material required for production of commodity, from economies of large-scale production, ownership of patents or from government restrictions that prohibits competition.

Innovation theory of profit economic profit is rewarded for the introduction of successful innovation. Managerial efficiency theory of profit this theory rests on the observation that if the average firm tends to earn only a normal return on its investment in the long run, firms that are more efficient than the average would earn above-normal return and economic profit.

Social Function of Profit

Profit is a signal that guides the allocation of societys resources. High profits in an industry are a signal that buyers want more of what the industry produces. Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.

Business Ethics
Identifies types of behavior that businesses and their employees should not engage in. Source of guidance that goes beyond enforceable laws.

The Changing Environment of Managerial Economics

Globalization of Economic Activity
Goods and Services Capital Technology Skilled Labor

Technological Change
Telecommunications Advances The Internet and the World Wide Web

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(contd)

(contd)

Questions or comments?

Reference: Salvatore (2008), Ch. 1

Appendix to Chapter 1

Law of Demand
A decrease in the price of a good, all other things held constant, will cause an increase in the quantity demanded of the good. An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.

Change in Quantity Demanded

Price An increase in price causes a decrease in quantity demanded.

P1 P0

Q1

Q0

Quantity

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Change in Quantity Demanded

Price A decrease in price causes an increase in quantity demanded.

Changes in Demand
Change in Buyers Tastes Change in Buyers Incomes
Normal Goods Inferior Goods

P0 P1 Q0 Q1 Quantity

Change in the Number of Buyers Change in the Price of Related Goods

Substitute Goods Complementary Goods

Change in Demand
Price An increase in demand refers to a rightward shift in the market demand curve.

Change in Demand
Price A decrease in demand refers to a leftward shift in the market demand curve.

P0

P0

Q0

Q1

Quantity

Q1

Q0

Quantity

Law of Supply
A decrease in the price of a good, all other things held constant, will cause a decrease in the quantity supplied of the good. An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.

Change in Quantity Supplied

Price A decrease in price causes a decrease in quantity supplied.

P0 P1

Q1

Q0

Quantity

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Change in Quantity Supplied

Price An increase in price causes an increase in quantity supplied.

Changes in Supply
Change in Production Technology Change in Input Prices Change in the Number of Sellers

P1 P0

Q0

Q1

Quantity

Change in Supply
Price An increase in supply refers to a rightward shift in the market supply curve.

Change in Supply
Price A decrease in supply refers to a leftward shift in the market supply curve.

P0

P0

Q0

Q1

Quantity

Q1

Q0

Quantity

Market Equilibrium
Market equilibrium is determined at the intersection of the market demand curve and the market supply curve. The equilibrium price causes quantity demanded to be equal to quantity supplied.

Market Equilibrium
Price D S

Quantity

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Market Equilibrium
Price D0 P1 P0 D1 S0 An increase in demand will cause the market equilibrium price and quantity to increase.

Market Equilibrium
Price D1 P0 P1 D0 S0 A decrease in demand will cause the market equilibrium price and quantity to decrease.

Q0 Q1

Quantity

Q1 Q0

Quantity

Market Equilibrium
Price D0 S0 S1 An increase in supply will cause the market equilibrium price to decrease and quantity to increase.

Market Equilibrium
Price D0 S1 S0 A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.

P0 P1

P1 P0

Q0 Q1

Quantity

Q1 Q0

Quantity

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Questions or comments?

Reference: Salvatore (2008), Ch. 1

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