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Unit 1

Introduction to Managerial Economics

Instructor: Asmamaw T.
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
segments of the economy: individual consumers, workers and owners
individual firms, industries, and markets for goods and services. Micro
concerned with topics such as how consumers choose the goods and
purchase and how firms make hiring, pricing, production, advertising,
development and investment decisions.

of individual
of resources,
economics is
services they
research and

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 todays decisions and tomorrows. It addresses the
larger economic forces that shape both day-to-day operations and long-run planning
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.

Introduction to Managerial Economics

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.
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

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

Marginal benefits
Theory of consumer demand
Theory of the firm
Industrial organization and firm
Public choice theory

Quantitative methods
Numerical analysis
Statistical estimation
Forecasting procedures
Game theory concepts
Optimization techniques
Information systems

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

Optimal solutions to management decision problems

Introduction to Managerial Economics

The circular flow of economic activity

Goods and services ($)

Product markets

Goods and services ($)



Economic resources

Economic resources
Factor markets

Factor payments ($)

Figure: 1 Circular flow of income, output resources and factor payments

Individuals and firms are the fundamental participants in a market economy.
Individuals own or control resources that have value to firms because they are necessary
inputs in the production process. These resources are broadly classified as labour, capital
and natural resources. Most people have labour resources to sell, and may own capital
and natural resources that are rented, loaned or sold to firms to be used as inputs in the
production process. The money received by an individual from the sale of these resources
is called a factor payment. This income to individuals then is used to satisfy their
consumption demands for good and services.
The interaction between individuals and firms occurs in two distinct arenas. First,
there is a product market where good and services are bought and sold. Second, there is a
market for factors of production where labour, capital and natural resources are traded.
These interactions are depicted in figure-1 which describes the circular flow of income,
output, resources and factor payments in a market economy.
In the product market shown in the top part of the figure, individuals demand
goods and services in order to satisfy their consumption desires. They make these
demands known by bidding in the product market for these goods and services. Firms
respond to these demands by supplying goods and services to that market to earn profit.
The firms production technology and input costs determine the supply conditions, while
consumer preference and income determine the demand conditions. The interaction of
supply and demand determines the price and quantity sold. In the product market,

Introduction to Managerial Economics

purchasing power, usually in the form of money, flows from consumers to firms. At the
same time, goods and services flow in the opposite direction from firms to consumers.
The factor market is shown at the bottom of figure -1. Here, the flows are the
reverse of those in the product market. Individuals are the suppliers in the factor market.
They supply labour services, capital and natural resources to firms that demand them to
produce goods and services. Firms indicate the strength of their desire for these inputs by
bidding for them in the market. The flow of money is from firms to individuals, and
factors of production flow from individuals to firms. The price of these production factors
are set in this market.
Prices and profits serve as the signals for regulating the flows of money and
resources through the factor markets and the flows of money and goods through the
product market.
In the market economy depicted by this circular flow, individuals and firms are
highly interdependent; each participant needs the others. For example, an individuals
labour will have no value in the market unless there is a firm that is willing to pay for it.
Alternatively, firms cannot justify production unless some consumers want to buy their
products. As a result, all participants have an incentive to provide what others want. All
participate willingly because they have something to gain by doing so. Firms earn profits,
the consumption demands of individuals are satisfied, and resource owners receive wage,
rent and interest payments.
Nature and rationale for the firm
In order to earn profits, the firm organizes the factors of production to produce
goods and services that will meet the demands of individual consumers and other firms.
The concept of the firm plays a central role in the theory and practice of managerial
In a free-market economy, the organization and interaction of producers (i.e.
firms) and consumers is accomplished through the price system. There is no need for any
central direction by government. Within the firm, transactions and the organization of
productive factors are generally accomplished by the central control of one or more
managers. Thus, there is an apparent dichotomy in the organization of production in a
market economy. The price system guides the decentralized interaction among consumers
and firms, whereas central planning and control tend to guide the interaction within firms.
Why do firms exist in a market economy?
Firms exist as organizations because the total cost of producing any rate of output
is lower than if the firm did not exist. The costs are lower due to following reasons;

Introduction to Managerial Economics

1. There is a cost of using the price system to organize production. The cost of
obtaining information on prices and the cost of negotiating and concluding
separate contracts for each step of the production process would be burdensome.
2. One general contract covers what usually will be a large number of transactions
between the owners and workers. The two parties do not have to negotiate a new
contract every time the worker is given a new assignment. The saving of the
transactions costs associated with such negotiations is advantageous to both
parties, and thus both labour and management voluntarily seek out such
Basic principles of effective management
The nature of sound managerial decisions varies depending on the underlying
goals of the manager. An effective manager must;
1. identify goals and constraints
2. recognize the nature and importance of profits
3. understand incentives
4. understand markets
5. recognize the time value of money
6. use marginal analysis
1. 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. The decision maker faces
constraints that affect the ability to achieve a goal. Optimal decisions are taken by the
manager to minimize the constraints to maximize the goals.
2. Recognize the nature ad importance of profits
The overall goal of most firms is to maximize profits or the firms value. A
manager should be aware of economic profits, accounting profits and its role.
3. Understand incentives
Profits signal the holders of resources when to enter and exit particular industries.
Changes in profits provide an incentive to resource holders to alter their use of resources.
Incentives affect how resources are used and how hard workers work. Managers should
understand the role of incentives within an organization and construct incentives to
induce maximal effort from people.
4. Understand markets
The final outcome of the market process depends on the relative power of buyers
and sellers in the market place. The power or bargaining position of consumers and
producers in the market place is limited by three sources of rivalry;
a) Consumer- producer rivalry: occurs because of the competing interests.
Consumers attempt to negotiate low prices, while producers attempt negotiate
high prices.

Introduction to Managerial Economics

b) Consumer- Consumer rivalry: reduces the negotiating power of consumers in the

market place. When limited quantities of goods are available, consumers will
compete with one another for the right to purchase the available goods.
c) Producer-Producer rivalry: functions when multiple sellers of a product compete
in the market place; producers compete with one another for the right service the
customers available. Those firms that offer the best quality product at the lowest
price can earn the right to serve the customers.
5. Recognize the time value of money
The timing of many decisions involves a gap between the time when the costs of a
project are borne, and time when the benefits of the projects are received. It is important
to recognize that $1 today is worth more than $1 received in the future. The manager
must understand present value analysis.
6. Use marginal analysis
Marginal analysis states that optimal managerial decisions involve comparing the
marginal (or incremental) benefits of a decision with the marginal (or incremental) costs.
Economic profit versus Accounting profit
Economic profit is the amount by which total revenue exceeds total economic
The total economic cost is the sum of the opportunity costs of each and every
resource used by a firm.
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 firms own resources are
called implicit costs since the firm makes no monetary payment to use its own
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

Introduction to Managerial Economics

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 firms
implicit costs;
Economic Profit = Accounting profit - Implicit costs
Economists refer to the opportunity cost of using the owners 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; ATMs 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
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 Donalds 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

Introduction to Managerial Economics

operate at the industrys 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.
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 firms
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.
$ 90,000
Less: Cost of good sold
Gross Profit
$ 50,000
Less: Advertising
Property tax
Miscellaneous expenses

$ 10,000

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.

Introduction to Managerial Economics

The second implicit cost includes the managers 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:

Cost of goods sold
Gross profit

Explicit Costs:
Property tax
Miscellaneous expenses

$ 90,000
$ 50,000


Accounting profit (i.e. profit before

Implicit costs)
Less: Implicit costs:
Return on $ 200,000 of invested
Foregone wages
Net economic profit

$ 10,000

$ 20,000

$ - 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.
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 $90 each, could Sharon earn a positive economic profit by making and selling the
The key to this decision is appropriately accounting for both Sharons time ($ 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

Introduction to Managerial Economics

Less: 4 hours of labour at $10/hour 40
4 yards of material at $15/yd 60
Economic profit
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
Less: 4 yards of material at $5/yd

This is not an accurate measure of profit because it fails to account for the true
opportunity cost of Sharons 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 firms 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 firms product, without losing substantial
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
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
firms 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 rivals 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 managers 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


Introduction to Managerial Economics

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 monopolists 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 firms 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.
Work out problems
1. During a year of operation, a firm collects $175,000 in revenue and spends $ 80,000 on
raw materials, labour expense, utilities and rent. The owners of the firm have provided $
500,000 of their own money to the firm instead of investing the money and earning a 14
percent annual rate of return.
(a) The explicit costs of the firm are $ ________
The implicit cost are $ ____________
Total economic cost is $ __________
(b) The firm earns economic profit of $ _________
The firms normal profit is $ _________
(c) The firms accounting profit is $ _________
d) If the firms costs stay the same but its revenue falls to $ __________, only a
normal profit is earned.


Introduction to Managerial Economics

(e) If the owners could earn 20 percent annually on the money they have invested in
the firm, the economic profit of the firm would be ___________ (when revenue is
2. At the beginning of the year, an audio engineer quit his job and gave up a salary of
$175,000 per year in order to start his own business, Sound Devices, Inc. The new
company builds, installs and maintains custom audio equipment for businesses that
require high-quality audio systems. A partial income statement for Sound Devices, Inc is
shown below:


Revenue from sales of Product and service

Operating costs and expenses
Cost of products and services sold
Selling expenses
Administrative expenses
Total operating costs and expenses

$ 970,000
$ 555,000

Income from operations

Interest expense (bank loan)
Legal expenses to start business
Income taxes

$ 415,000
$ 177,000

Net income

To get started, the owner of Sound Devices spent $ 100,000 of his personal savings to pay
for some of the capital equipment used in the business. In 2001, the owner of Sound
Devices could have earned a 15 percent return by investing in stocks of other new
business with risk levels similar to the risk level at Sound Devices.
a) What are the total explicit, total implicit and total economic costs in 2001?
b) What are accounting profit, economic profit and normal profit in 2001?
c) Given your answer in part (b), evaluate the owners decision to leave his job to
start Sound Devices.
3. A recent engineering graduate turns down a job offer at $ 30,000 per year to start his
own business. He will invest $ 50,000 of his own money, which has been in a bank
account earning 7 percent per year. He also plans to use a building he owns that has been
rented for $ 1500 per month. Revenue in the new business during the first year was $
107,000, while other expenses were


Introduction to Managerial Economics

$ 5,000
Employees salaries
Prepare two income statements, one using the traditional accounting approach and one
using the opportunity cost approach to determine profit.
4. Tempo Electronics, Inc. has an inventory of 5000 unique electronic chips originally
purchased at $2.50 each; the market value is now $5 each. The production department
has proposed to use these by putting each one together with $6 worth of labour and other
materials to produce a wrist watch that would be sold for $10. Should that proposal be
implemented? Explain.
5. Smith, a college sophomore, generally spends his summers working on the university
maintenance crew at a wage rate of $6.00 per hour for a 40 hour week. Overtime work is
always available at an hourly rate of 1.5 times the regular wage rate. For the coming
summer, he has been offered the pizza stand concession at the Student Union building,
which would have to be open 10 hours per day, six days a week. He estimates that he can
sell 100 pizzas a week at $6 per day. The production cost of each pizza is $2.00 and the
rent on the stand is $1.50 per week. Should Smith take the pizza concession? Explain.
6. An executives employment contract calls for a salary of $ 400,000 per year, a bonus
equal to 2 percent of profits in excess of $ 10,000,000, and an option to buy 5000 shares
of common stock at a price of $50 per share. The market price of the stock is $70 per
share, and the firms profits for the current year are $12,000,000. Assuming the executive
exercises the stock option and then sells the stock, what is the total compensation for the
7. A manufacture of personal computers has an inventory of 10,000 back-up storage
drives that sold for $ 100 per unit last year. The current market price of these drives is
now $ 70 per unit. By adding one of these drives to their stock of personal computers, the
price of each computer is increased by $ 80 per unit. Should the driver be added? What is
the opportunity cost of these drivers? Explain?


Introduction to Managerial Economics