Economics 340H - Managerial Economics

Lecture 1 Scope and Nature of Managerial Economics

1.1 - Defining Managerial Economics
Refers to the use of economic theory (micro and macro) and the tools
of analysis of decision science (mathematical economics and
econometrics) to examine how an organization can achieve its aims
and objectives most efficiently.
Microeconomics Is the study of decisions of individual people and
businesses and the interaction of these decisions:
Price & quantities of individual goods and services.
Effects of government regulation & taxation on prices
and quantities of goods and services produced.
Macroeconomics - Is the study of the national economy and the global
economy.
Effects of taxation and government spending on the
economy and is measured through jobs, labour, output,
income etc
Effects of money and interest rates.
Mathematical Economics Is used to formalize the economic models
postulated by economic theory.
Econometrics applies statistical tools (regression analysis) to real
world data to estimate models postulated by economic theory and
forecasting.
Managerial economics combines or applies economic tools and
techniques to business and administrative decision making using
micro, macro, mathematical and econometric models.
Prescribes rules for improving managerial decisions and public policy.
Integrates and applies microeconomic theory and methods to decision
making problems faced by private, public, and not-for-profit
organizations.
Managerial economics deals with microeconomic reasoning on real
world problems such as pricing decisions selecting the best strategy in
different competitive environments.

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

1.2 - Relationship of Managerial Economics to other fields of study.
Managerial economics uses concepts and quantitative methods to
solve managerial problems.

Management Decision Problems

- Product selection, output and pricing
- Internet strategy
- Organizational design
- Product development and promotion
- HR hiring and training
- Investment and financing

Economic Concepts
- Marginal analysis
- Theory of consumer demand
- Theory of the firm
- Industrial organization
and firm behaviour
- Public choice theory

Quantitative Methods
- Numerical analysis
- Statistical estimation
- Forecasting procedures
- Game theory
- Optimization techniques
- Information systems

Managerial Economics = Optimal Solutions to Management Decisions

To make good economic decisions, managers need to be able to
forecast & estimate relationships.

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Seven steps in the decision making process.

1.3 - Theory of the firm

A firm may seek to maximize profits subject to limitations on the
availability of essential inputs (skilled labour, land, capital and raw
materials) and legal constraints (minimum wage laws, health and
safety, and pollution).
Value of the firm = Present value of expected future profits

Such that:

PV 1 /(1 r )1 2 /(1 r ) 2 .... 3 /(1 r ) 3 or

PV i 1 t /(1 r ) t
n

PV = Present value of all expected future profits of the firm.

Expected profits in each of the n years considered.
r = discount rate.

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Example 1:
The owner of a small business expects to generate a profit of $100,000
per year for 2 years and is going to sell the firm at the end of the second
year for $800,000. The owner believes that the appropriate discount rate
for the firm is 10 percent per year. What is the value of the small
business based on the assumptions that the owner has set?
PV $100,000 /(1 .1)1 $100,000 /(1 .1) 2 $800,000 /(1 .1) 2
PV $100,000 /(1.1) $100,000 /(1.21) $800,000 /(1.21)
PV $90909.1 $82,644.6 $661,157.0
PV $834,710.7

Goals in the Public Sector and the Not-For-Profit (NFP) Enterprise

Public Goods are goods that can be consumed or used by more than
one person at the same time with no extra cost.

Instead of profit, NFP organizations may have as their goals:

1.
Maximization of output, subject to a budget constraint.
2.
Maximization of the utility of NFP administrators.
3.
Maximization of cash flows.
4.
Maximization of the utility of contributors to the NFP
organization.

Which goal a NFP manager selects affects decisions made.

A food bank manager may maximize the utility of clients by selecting

only "healthy foods"

Public sector managers are performance monitored.

Hospital administrators are rewarded for reducing the cost per bed
over a year. Hence, they become efficient with respect to costs.

The "friendliness" of the hospital staff is harder to measure, so

friendliness will tend not be a high priority of the public sector manager.

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Examples of NFPs
Not for profit organizations (NFP)
Hospitals
Universities / Colleges
Museums
NFPs seek to reach some goal or objective subject to a constraint.
What are the objectives of NFPs?
Hospital objective (patients)
University / college (students)
Museum (customers)
What are the constraints NPOs face?
Hospital (doctors, nurses, beds, facilities, equipment
etc)
University / college (Faculty, staff, funding sources,
facilities, etc.)
Museum (funding, space etc)
1.4 Nature and Function of Profits
Economic Profit
Economic profit = Total Revenue Economic Costs
Total Revenue = Price * Quantity
Economic costs include:
o Explicit costs
Are the actual out-of-pocket expenditures of the firm to
hire labour, borrow capital, rent land and buildings and
purchase raw materials.
o Implicit costs
Are the money value of inputs owned and used by the
firm in its own production processes.
Economic profit = Total Revenue explicit costs - implicit costs
Accounting profit = Total Revenue explicit costs
Economic profit = Accounting profit implicit costs

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Normal profit = implicit costs = opportunity cost of owner-supplied
resources
Economic profit = Accounting profit normal profit
Example 2:
The costs for a typical full-time student attending Trent University for
their first yr of study in 2006-07 is $4,372 for tuition fees, $1,184 for
compulsory and student fees, $8,500 for a residence room and a meal
plan, and $650 for textbooks. As an alternative to attending University
that same student could have earned $28,000 by getting a job in the
labour market. In addition, they could have earned 4.5% interest by
investing the money not spent on attending Trent University.
Calculate explicit costs, implicit costs and economic costs.
a) Explicit costs
EC = $4,372 + $1,184 + $8,500 + $650
EC = $14,706
b) Implicit costs
IC = Income Earned + Investing University Costs @ rate of return of 4.5%
IC = $28,000 + ($14,706 * .045)
IC = $28,000 + $661.77
IC = $28,661.77
c) Total economic cost that the student faces for that one year?
Economic Costs = Explicit costs + Implicit Costs
Economic Costs = $14,706 + $28,661.77
Economic Costs = $43,367.77

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Profit Maximization
Profit maximization and value maximization are equivalent in the
long run
If costs and revenue are independent of decisions made in other
periods, short-run profit-maximization is equivalent to value
maximization
Incentives
Separation of ownership and control
Principal-agent problem
Shareholders (principals) want profit
Managers (agents) want leisure & security
Moral hazard problem
Incentive compatibility
Equity ownership
Outside directors
Tie CEO pay to value of the firm
Debt finance
Adds risk of bankruptcy and loss of job for managers
Loans must be repaid
Lenders provide monitoring
Market structure and decisions
Economic theory postulates that the quantity demanded of a
product (Q) is a function of, or depends upon, the price (P), the
income of consumers (Y), and the prices of related commodities
(complementary and substitutes).
Such that:

Q f ( P, Y , Pc , Ps )

Control over price varies by market structure

o Price-setting firms
o Price-taking firms

Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Market = any arrangement through which buyers and sellers
exchange goods or services
Transactions costs affect market outcomes and price dispersion
Alternative market structures
# of and size of firms
Degree of product differentiation
Likelihood of entry of new firms in response to economic profits
Perfect competition
Large number of firms
Homogeneous product
No barriers to either entry or exit
Monopoly

Single seller
No close substitutes
Barriers to entry
Economies of scale
Exclusive ownership of raw material
Licensing, patents, copyrights, legal franchise
Local monopolies may exist

Monopolistic competition
Many firms
Differentiated product
Free entry and exit
Oligopoly
Few firms produce most output
Homogeneous or differentiated product
Barriers to entry
Christopher Michael, Department of Economics - Trent University

Economics 340H - Managerial Economics

Recognized mutual interdependence
Globalization
Increased global integration
Growth of imports and exports in all industrialized economies
Reduction in trade barriers
Internet and reduced transaction costs
NAFTA, FTAA, EU, EMU
Michael Porter - The 5 forces that determine competitive advantage are:
Substitutes
Potential Entrants
Buyer Power
Supplier Power
Intensity of Rivalry

Christopher Michael, Department of Economics - Trent University