MANAGERIAL ECONOMICS

An Analysis of Business Issues

Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall

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 Chapter 1:
The Definition and Scope of
Managerial Economics
Objectives:
After studying the chapter, you should
understand:
1. the subject matter of Managerial Economics
2. the analytical approach used in Managerial
Economics

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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.” 3
 What is Managerial Economics?

Howard Davies and Pun-Lee Lam -

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

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 These Definitions Cover a Number of
Different Approaches

1. Analysis based on the theory of the firm

2. Analysis based upon management sciences
3. Analysis based upon industrial economics

Related to, but not the same as management science

and industrial economics.

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The Process of Model-building
 The economics ‘method’
– ‘illicit relationships with beautiful models’
 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
If predictions
Theoretical not supported by
analysis data, model is
amended or
discarded
Predictions
If predictions
borne out by
Predictions data, the model
tested is valid, for
against data the moment
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 Should Assumptions
Should Assumptions be
be Realistic?
Realistic?
The assumption of profit-maximising may be
unrealistic or inaccurate
However, what matters is the explanatory or
predictive power of a theory (or model), not the
descriptive realism of its assumptions.
A model built on unrealistic assumptions may give
good predictions.
Assumptions are a necessary simplifying device
Example: Overtaking
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What Is A “Good” Model?
 It allows us to make predictions and set
hypotheses
 The predictions can be tested against the
empirical evidence
 The predictions are supported by the
empirical evidence

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The Use of Economic Models

Positive Economics:-
Derives useful theories with testable
propositions about WHAT IS.

Normative Economics:-
Provides the basis for value judgements on
economic outcomes.WHAT SHOULD BE

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Managerial Economics
 Economics in general takes a ‘positive’ and
predictive approach not prescriptive or ‘normative’
– trying to explain “what is” not what “should be”
– the main objective is to understand how a market economy
works
 Not very concerned about the descriptive realism of
assumptions: “I assume X” does not mean “I believe
X to be true”
 Some real tension if the models are used for
prescription
– assume “perfect knowledge”: OK for model-building
– cannot say to a manager: “behave AS IF you had perfect
knowledge”

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Economic Analysis
 Comparative Statics
– begin with an initial equilibrium position - the starting point
– change something
– identify the new equilibrium, e.g:in neo-classical model of the firm
• When demand increases?
• When costs rise?
• When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
 Normative prescriptions
– it will cost me $30 per unit to supply something which will give me
$20 per unit in revenue- should I do it?
– I must pay $20 billion to set up in my industry. Should I charge
higher prices to get that money back?
 Positive and Normative are linked by “if?” IF the aim of the firm is
to maximise profit what will it do/what should it do?
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What
What isis the
the purpose
purpose of
of economic
economic analysis?
analysis?
Why
Why do
do we
we want
want to
to apply
apply economic
economic analysis
analysis to
to
business
business problems?
problems?
For the academic economist: to understand, to make
predictions about firm’s behavior
The “positive” approach to theory: What is?
For the businessperson: “to assist decision-making”,
to provide decision-rules which can be applied
The “normative” approach to theory: What should be?
These purposes are different, they can lead to
misunderstanding, and economists are not always
honest about the limitations of their approach for 13
practical purposes.
 What are
What are these
these limitations?
limitations?

If the aim is prediction, unrealistic assumptions

are acceptable and may be needed;
for instance, the firm may be assumed to behave “as if”
its managers had perfect knowledge of its environment

If the aim is to produce decision-rules which can

be applied by practising managers, unrealistic
assumptions will produce decision-rules which
are not operational
for instance, set output and price by MC=MR
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 How Can
How Can Managerial
Managerial Economics
Economics Assist
Assist
Decision-Making?
Decision-Making?

1. Adopt a general perspective, not a

sample of one
2. Simple models provide stepping stone to
more complexity and realism
3. Thinking logically has value itself and can
expose sloppy thinking

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 Why Managerial Economics?
 A powerful “analytical engine”.
 A broader perspective on the firm.
• what is a firm?
• what are the firm’s overall objectives?
• what pressures drive the firm towards profit and
away from profit
 The basis for some of the more rigourous
analysis of issues in Marketing and Strategic
Management.

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Links between Managerial Economics
and Industrial Economics

In managerial economics, the emphasis is upon

the firm, the environment in which the firm
finds itself, and the decisions which individual
firms have to take.

In industrial economics (or industrial

organization), the emphasis is (or was) upon the
behavior of the whole industry, in which the
firm is simply a component.
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 What isis Industrial
What Industrial Organization?
Organization?

It studies how the performance of an

industry is related to its structure, that is, to
the number and size of firms it contains.
It is the study of markets for goods and of
the firms which produce them. It is the
study of industry. It is more concerned with
why markets are structured the way they
are and behave the way they do.
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Questions Asked in Industrial Organization:
 Why are some markets monopoly-like while
others are competitive?
 How can industry performance and structure
be measured or analyzed?
 How does the performance of individual
firms affect the structure and performance of
the industry in which they operate?
 If industry performance seems deficient but
remediable, which government policies are
likely to help more than they cost?
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The Structure-Conduct-Performance
The Structure-Conduct-Performance Paradigm:
Paradigm:
Basic Conditions: factors which shape the market of the industry,
e.g. demand, supply, political factors
Structure: attributes which give definition to the supply-side of
the market, e.g. economies of scale, barriers to entry, industry
concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing
behavior advertising, innovation.
Performance: a judgement about the results of market behaviour,
e.g. efficiency, profitability, fairness/income distribution,
economic growth.
How can the government improve the performance in an
industry?
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Basic Conditions

Structure Government
Policy

Conduct

Performance
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Links between Managerial Economics
and Management Science
Managerial economics: is often concerned with finding
optimal solutions to decision problems.However, the
primary purpose of using models is to predict how firms
will behave, not to advise them what ought to do.
Managers are assumed to find the optimal solutions for
themselves and that is how predictions are made.
Management science: is essentially concerned with
techniques for the improvement of decision-making and
hence it is essentially normative;firms are not assumed to
find the optimal solutions for themselves. They are found
by the researchers who then present them as prescriptions
for what the firm should do.
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