You are on page 1of 41

INTERDISCIPLINARY APPROACH TO TEACHING MANAGERIAL ECONOMICS

Samuel Enajero Department of Social Sciences University of Michigan-Dearborn 4901 Evergreen Road Dearborn, MI 48128 senajero@umd.umich.edu

ABSTRACT Many economic topics can be presented either as a pure social science or as applications in business. Linear programming, production costs and factor productivity are among topics presented differently in economics and business courses. Gaps exist, such that students who come across the same topics in economics and business courses may lack the information necessary to relate the concepts. This paper argues that business students would have more interest in economics and be better rounded in business if the conceptual gaps were closed. Managerial economics, as offered in many business departments, could be the bridge that links economic theories to their business applications.

JEL Classification: A23, A22, M21

1
Electronic copy available at: http://ssrn.com/abstract=1394233

I - INTRODUCTION Managerial economics, offered in many undergraduate and graduate programs throughout the country, can be regarded as an important business course. It appears as a required course in an undergraduate curriculum and as a foundation/core course in some MBA programs. In some departments, managerial economics is the only upper level

economics course in both an undergraduate business degree and an MBA program. As the name suggests, there is supposed to be abundance of business and management content integrated with economics. However, managerial economics is taught in many institutions as a pure social science course. Some departments offer it as an alternative to intermediate microeconomics. This is appropriate in a social science department offering BA or MA programs with a concentration in economics. In this context, students learn economics from a liberal arts or social science approach using algebra and graphs. The fact that economics departments in some universities are in a college of arts and sciences while in others, economics departments are in the school of business, lends support to the need to separate the teaching contents of economics in these two different schools. This is not an attempt to dichotomize economics as a social science and as a business course (Dean & Dolan, 2001), but to draw up teaching contents tailored to suit and benefit students in both schools. The theories offered in economics, as a social science cannot be ignored. These economic theories are applied in many spheres of life to derive efficiency (e.g., in environmental economics, health economics, sport economics, labor economics, nonrenewable resource economics, urban economics, and business economics). A good

2
Electronic copy available at: http://ssrn.com/abstract=1394233

portion of economic theories, nonetheless, may sound like novel ideas, if an upper level economics course such as managerial economics, designed for business students, is taught purely from a liberal arts perspective. Without injecting comparable business content, students assume that economics is not a business course and their interest in economics seems to diminish (Marburger, 2004; Anderson & Muraoka, 1990; Gregorowicz & Hegji, 1998). Little wonder that many business departments are struggling to retain economics as a major (Gregorowicz & Hegji ,1998; Siegfried, 2007). “One familiar hypothesis suggests that majoring in economics is a reluctant choice for students more interested in a business major” (Kasper, 2008, pp. 457-472). Effectively, business students convey their resentment indirectly by not majoring in a liberal arts discipline in a business department. If economics were taught as a business course, perhaps, some students would major in economics and minor in accounting, finance, management, marketing or organizational behavior—or vice versa. On one hand, teaching managerial economics as a social science without sufficient links to related business contents leaves conceptual gaps in the minds of students. On the other hand, teaching managerial economics as a business course divorced of theoretical framework as analyzed in social science departments would create a shallow understanding of these business topics. In fact, the economic theories underlying business are necessary for a thorough understanding of business courses. Cements combined with sands, gravels or granites and rods are mixtures for concrete that forms a building foundation. This mixture remains concrete with the power of limestone in the cement, which is similar to granites or gravels. Analogically, in order

3

to form a concrete foundation for a business curriculum, a course such as managerial economics should be emphatically linked or overlapped with business courses. Otherwise, except for students who apply mastery1 goal in learning (Baron & Harackiewicz, 1997, 2001), business concepts will be fragmented in the minds of many students even after graduation. Thus, the potential exists for some students to be deprived of acquiring a well-rounded business education, with many questions still unanswered during their career. Among regular chapters in intermediate microeconomics repeated in a typical managerial economics textbook are chapters on production costs, perfect competition, monopoly, monopolistic competition, oligopoly, factor markets and game theory (Baye, 2006; Hirschey, 2006; Mansfield, 1993; Boyes, 2004; Samuelson & Mark, 2005; Allen, et al, 2005). These topics covered in intermediate microeconomics appear and are taught in the same form in managerial economics. Some texts have more business content than others. Nonetheless, such business content is not enough to adequately equip the student to link economics and business courses. In teaching managerial economics, regardless of the textbook adopted, the professor can inject business content into discussions to enable students appreciate the importance of economics in business courses, such as accounting, finance, management science, quantitative analysis, strategic management, operations management, and organizational behavior. Interlinking these courses would give students the choice of majoring in economics while spontaneously acquiring adequate business knowledge for the real world.

4

Business students are left to figure out by themselves the links between social science illustrations and business applications. section III analyzes a cost function in economics 5 . The next section of this paper discusses linear programming as presented in economics and management science. These additions could stimulate the imagination and experiences of the students. money and banking. as per AACSB (Gooding. Since economics PhDs are most likely to come from Arts and Sciences. These professors are academically or professionally qualified to teach in business schools. isoquants and production possibility frontiers (PPF) as discussed in economics. antitrust and regulation. and feasible regions in optimization problems as explained in management science or quantitative analysis? Is the total cost curve in economics the same as linear total cost in business? Does the degree of operating leverage (DOL) as taught in managerial accounting or finance defy efficient combinations of fixed and variable costs as derived in economics? These and many other questions that leave gaps in the minds of the students could be answered by proper teaching of managerial economics. Cobb & Scroggins. For instance. they are inclined to approach the teaching of managerial economics and other economics courses from a purely social science perspective. are there similarities between isocosts. just to name a few—there are numerous areas where business content can be injected during the course to the benefit of the students. In many economics courses taught as social sciences—managerial economics.Furthermore. and international finance. irrespective of the department. industrial organization. many professors of managerial economics may not have a business background. 2007). thereby providing students good reasons to consider economics as a major in business schools.

In economics. TC = rK + wL subject to Q = f (K. there is technologically efficient combination of K (capital) and L (labor) that yields the optimal level of output. equal cost. the TC equation is the objective function the LP tries to minimize given the Q function. taking into account prices of the inputs. Part C (and D when necessary) integrates both parts. L). r and w. II LINEAR AND NON-LINEAR PROGRAMMING A – Economics Analysis The objective of this topic is to demonstrate the use of optimization in economics.and its specific application (relevant range and DOL) in business. Here. Individuals maximize utility subject to market constraints. and section V concludes. minimize total cost. A given output level could be produced using more K and less L or less K and more L. are used to illustrate the technologically efficient combinations of K and L in the objective and constraint functions. Society in general maximizes outputs from limited or scarce resources. All economic agents including the firm are faced with constraints. A basic linear programming (LP) problem in economics is the cost minimization. Firms maximize profits and revenues and also minimize costs. Part A of each section contains presentations in a typical economics course and Part B shows the business counterparts. Q. Along a production function. L). meaning equal quantity and isocosts. These are all managerial economics topics that could be extended to enable students to gain deep appreciation for economics while acquiring complementary business skills. The optimal units of K and L are derived from the LP statement. isoquants. Q = f(K. Capital (K) is normally graphed as the production input on the 6 . section IV illustrates resource marginal productivity and performance evaluations as they relates to financial markets.

The isocost line is depicted by TC = wL + rK. they sloped downward. That is where: MRTSLK =(MPL)/(MPK) = w/r. The isoquants are generally convex to the origin (since inputs are not perfect substitutes) and the isocosts are linear.vertical axis and labor (L) on the horizontal axis. The slope of the isoquant is the marginal rate of technical substitution of labor for capital (MRTSLK). which is w/r. intersecting capital (K) axis and labor (L) axis. which equals the marginal product of labor (MPL) divided by the marginal product of capital (MP K): MRTSLK = (MPL)/(MPK). K and L. isoquants further from the origin denote larger level of outputs. (2. Moving along the isoquant changes the combinations of K and L and this is dictated by the slope of the isoquant.2) Graphically. at the optimal point. where TC is the total costs.1) Isoquants have four main properties: they are convex to the origin. the two right-hand terms become: 7 . The absolute value of the slope of the isocost line equals the relative prices of the inputs. Economic results are attained based on incremental or marginal analysis. By cross multiplication. The isocost line reflects all combinations of K and L the firm can employ in production for a given budget. the isoquant is tangent to the isocost. Efficiency (least costly method of production) requires that firms employ the units of capital and labor where the slopes of the isoquant and isocost lines are equal. In addition to technological efficiency illustrated by the isoquant. (2. and isoquants never intersect. w equals price of labor (wage rate) and r equals cost of capital (interest rate). market constraint is illustrated by the isocost.

that is. Lx. A firm producing two outputs. K = TC/r – w/r(L) Figure 2. The profit statement would be = pQ(X.Y) – TC. Y) = f(Kx. where px and py equal the prices of the product. there will be a family of isocosts and isoquants as indicated by the broken line and curve known as expansion path. Isolating K in objective function (TC = rk + wL). Q(X. X and Y. [pxQ(X)+pyQ(Y)] – (rKx + wLx + rKy+ wLy).(MPL)/w = (MPK)/r (2. LP constraint maximization for the firm can be graphically depicted by the 8 . The dual version of cost minimization is revenue or profit maximization.3) The producer’s least-cost input combination golden rule is for the manager operating in a competitive input market to employ inputs such that the marginal product per dollar spent is equal across all inputs applied. respectively.Ky.1 – Isocost and Isoquant K isocost (2.Ly) subject to TC = [r(Kx+Ky) + w(Lx+Ly)]. The production possibilities (PPF) facing an entrepreneur are similar to that of an economy. using K and L as inputs would maximize output.4) TC/r isoquant TC/w L As the scale of production expands.

The PPF is bowed off from the origin due to the increasing opportunity cost. The most common method applied in illustrating optimization using linear or nonlinear programming is the use of the Lagrangian technique (See Appendix A for illustration). B – Business Analysis 9 . The production possibility frontier is constrained by fixed inputs and technology. the student is assumed to have a reasonable background in linear algebra to solve for optimal levels of unknown variables. the PPF would be linear. This is illustrated in figure 2. In economics graduate departments.2 Figure 2. If equal units of resources are exchanged in the production of both goods. It is emphasized that an economy cannot produce outside the PPF.PPF—the boundary between output attainable and unattainable using available resources and technology.2 – Production Possibilities Frontier Y PPF X The slope of the PPF is the marginal rate of transformation (MRT). more units of Y would have to be sacrificed. As producers in the economy transfers resources from the production of Y (a capital good for example) to the production of X (consumption good). because resources or inputs are fixed.

The prices of the meals and nutritional contents of vitamin C.00 5 4 8 Cost per meal Vitamin C (units) Iron Zinc Minimum daily needs 27 16 14 The problem facing the dietician is to determine what combination of the two meals will satisfy the minimum daily needs and at the same time incur the least cost. Suppose a dietician in a home for the elderly is faced with the objective of providing her residents with two meals. The linear programming would be: Minimize C = 0. the approach is prescriptive and the analysis is more applied. iron and zinc.75m1 + m2 (objective function) Subject to 12m1 + 5m2 >= 27 (vitamin C constraint) 4m1 + 4m2 >= 16 (iron constraint) 2m1 + 8m2 >= 14 (zinc constraint) m1 and m2 > 0 (positive and whole meal requirement) 10 . Each meal should be rich in vitamin C.1. Table 2. then compare parts A and B in part C. I will illustrate both minimization and maximization problems. such as management science. It could be total profits for maximization or total costs for minimization.1 – Prices and nutrients per lb for each meal Meal (m1) $0.75 12 4 2 Meal m2 $1. As in part A. optimization using linear programming is approached differently. Although the model is the same as in economics. m1 and m2 . The objective function and constraints containing the decision variables are stated. iron and zinc per hypothetical unit are provided in table 2.In business courses. quantitative methods or decision analysis.

Each sedan car that is produced per hour uses 4. C =0.25 2m1+8m2=14.75(3)+1(1)=$3. and spend $3.3 below shows the graphical optimal solutions to the dietician’s problem and the exact points derived with simple algebraic manipulations of the LP equations.75 3 2 1 4m1+4m2=16 iron border c. sheet metal stamping plant and sport car assembly plant. Figure 2. (zinc) d 1 2 3 4 5 6 a 12m1+5m2=27 vitamin C border 0 m1 There are four extreme points—a. The optimal solution to this simplified minimization problem is at extreme point c where the dietitian would prepare 3 lb and 1 lb of meals 1 and 2. C=0. Suppose XXX Auto Company can produce sedan and sport cars using four facilities: sedan assembly plant.5% of the 11 . Owing to the positive food requirements for both meals. only points b and c are of importance to the dietician. A similar illustration can be found in Chiang & Wainwright (2005). engine assembly plant. The area to the right of the extreme points is the feasible region.Figure 2.3 – The Feasible Region m2 6 5 4 b. respectively. LP might be a production maximization problem. In a management science course. c and d.75(1)+1(3)=$3.25 per day for both meals. b. Mansfield (1993) has a good example of linear programming for a multipleproduct firm.

5 0 2 4 $400 Sport 0 4 3.4 – Profit Maximization – XXX Auto Company 12 .02QSP <= 1 (sheet metal stamping capacity constraint) QSD and QSP >= 0 (positive unit requirements) Graphically and algebraically we can find the optimal combined units of sedan and sport cars this company can produce with available resources.2 – Percentage of XXX Auto Company Fixed Capacity Needed per Hour Plant Sedan assembly Sport car assembly Engine assembly Sheet metal stamping Contribution margin2 Sedan 4.04QSD + . and  equals total contribution margin per hour.02QSD + 3. Other percentage requirements per hour for engine and sheet metal stamping are presented in table 2. produced per hour.33QSP <= 1 (engine assembly capacity constraint) . Figure 2. respectively.sedan assembly capacity and each sport car utilizes 4% of the sport car assembly plant. The maximization problem would be: Maximize  = 400QSD + 600QSP Subject to: .045 QSD <= 1 (sedan assembly capacity constraint) . Table 2.33 2 $600 Let QSD and QSP be units of sedan and sport cars.04QSP <= 1 (sport car assembly capacity constraint) .2.

Maps of isoprofit lines can be drawn to determine sedan and sport car units that generate the largest profits (per hour) for XXX Auto Company. the feasible solutions for the extreme points are presented below on table 2.2 Sport 25 25 21.348 18.000 18.Qsport 60 Sheet metal border 40 Sedan car border A B Sport car border 20 C Engine border D E 0 Qsedan 40 60 20 Points ABCDE are the extreme points.2.2 22.690 12.160 8.3 – Optimal Feasible Solutions Points A B C D E Sedan 0 8. where XXX Auto Company produces approximately 14 sedan and 22 sports cars per hour.6 0 Contribution Margins 400 600 400 600 400 600 400 600 400 600 Total $15.13 22.37 14. The feasible region is defined by 0ABCDE. assuming that there are customers who are able and willing to buy these cars.73 5.880 13 . The optimal point set that gives the maximum profit is at C. Table 2. Algebraically.

Excel’s Solver is readily available on every computer. Sensitivity analysis provides information on how much the objective function coefficient could change without affecting the optimal solution of the LP. profits change as well. To avoid mathematical complications that might usurp the students’ concentration. The formula columns have spreadsheet cell keys showing upper or lower bounds (see Table A1 at the end). In addition to solving for optimal values.Linear programming problems with more than two decision variables are cumbersome to solve using graphs and algebra.” The shadow price for a constraint shows how much the optimal 14 . The first part of Answer Report provides the final values. Excel’s Solver produces Answer. Businesses are surrounded by uncertainty. nonbinding constraints have unutilized resources. Slacks are associated with the status column. Slacks are unutilized resources. A binding constraint has zero slack and a nonbinding constraint has positive slack. Thus. If prices change or the costs of production change. The last part has formula. which are the optimal solutions to the LP (linear programming problem). Another important information provided by Sensitivity Report in LP output is the “shadow price. many business departments make use of software packages made available by modern technology in teaching linear or nonlinear programming. These reports are important for a manager in the day-to-day allocation of business resources. The sensitivity Report becomes handy to the manager in times of volatile prices. 2001). This report contains allowable increase and decrease of the objective and constraint coefficients (see Tables A2 and A3 at the end). status and slack columns. Sensitivity and Limits Reports (Ragsdale. The status column indicates binding and nonbinding constraints.

Shadow price would be useful when the organization is concerned with relevant cost or faced with divisional transfer pricing. Isoquant and Isocost 15 . if the shadow price of a constraint is positive. the shadow price of a nonbinding constraint is always zero. even though both are linear or nonlinear programming. The way linear programming is taught in courses such as management science. Is the shadow price related to the concept of opportunity cost as used in economics? The Limits Report shows upper and lower limits. it shows the largest and smallest values each variable can take. That is.3 for example. c and d) showing the feasible region. A zero shadow price indicates that the available resources have no further impact on the optimal solution. b. Figure 2. The presentation of linear and nonlinear programming in economics is shown in part A. most of them might not adequately relate the two approaches.3C – Feasible Region. The dotted parts of the borderlines depicting the constraints are removed and we have the solid-line parts (points a. If the same group of students is enrolled in both courses. while the values of all other variables are held constant. quantitative analysis or operation management in a business department is shown in part B. increasing the factor within the allowable increase would increase the optimal solution to the LP’s objective function and vice versa. reproduced here as Figure 2. Thus.3C. Take Figure 2.solution would change with some changes in available resources (the b’s in Appendix A). C – Interdisciplinary Approach Parts A and B of this section illustrate different approaches in economics and business departments. Holding other variables constant.

¾. we have a smooth.75(1)+1(3)=$3. marginal rate of technical substitution should equal ratio of input prices. Second. differentiable and convex to the origin isoquant. which is also equal to the slope of the objective function. the price of meal 1 divided by the price of meal 2. and the slope of the feasible region at point of tangency in Figure 2. this is mathematically expressed as in equations (2.3C.2) and (2. this ratio is 0. where the slope of the isocost is tangent to the slope of the isoquant.75(3)+1(1)=$3.75. 0 1 2 3 4 5 6 d a 12m1+5m2=27 vitamin C border m1 The student should understand the equivalent illustrations in parts A and B of this section. C=0.m2 6 5 4 b. the equivalence in management science is a rugged and kinked feasible boundary line constructed by fixed input constraints.25 2m1+8m2=14. decreasing. the optimal solution in management science is equivalent to the efficient technological inputs combination as illustrated in economics—that is. C =0. MRTSLK =(MPL)/(MPK) = w/r.3)—(dQ/dL)/(dQ/dK) = w/r. while in economics. 16 .75 3 2 1 4m1+4m2=16 iron border c. First. well-behaved. For the dietician.

In fact. the properties of the isoquant would be more memorable to the students using the constructs responsible for the shape. This could be explained by the fact that higher feasible regions are constructed by higher and different levels of input constraints. Instead of a concave. while economics students would mistake the constraints for the isocost. Figure 2.2).Third.4 depicting sedan. as can be seen in Figure 2. For example. sport cars. Feasible Region/PPF 17 . for the XXX Auto company problem. sheet metal and assembly constraints are removed.3C. area 0ABCDE.4. The business counterparts and industries that display such input characteristics and generate these types of feasible regions would be of interest for economics and business researchers.4C – Maximization. the LP constraints are determinants of the feasible region (isoquant). isoquants further from the origin reflect greater output and isoquants do not intersect. continuous and increasing PPF as illustrated in economics (Figure 2. the isocost is different. The dotted parts of Figure 2. There are families of isoquants that are either linear for perfect substitutes or Lshaped for perfect complements. The same argument applies to a firm’s PPF and a maximization problem as shown in Figure 2. Figure 2. two of the properties say.4C reflects the feasible region. the solid line ABCDE becomes a kinked PPF showing the possible combinations of sedan and sport cars XXX Auto Company can produce with available inputs. Fourth.

If the company decides to produce at any points other than point C.348 A B (14. 2001. In this case. (Harackiewicz.Qsport 60 40 (8.160 0 Qsedan 40 60 20 If properly drawn to scale. it would be $342 at point B and $6.13. 1997.2. At point B. At point D. the slope of the isoprofit line tangent to the optimal feasible set should equal the ratio of the prices of the cars. the opportunity cost of making such decision would be equal to the profits forgone.520 at point D (in net values). 2000.37.6)= $12. 21. it produces roughly 22 sport cars and 6 sedans. the company can produce approximately 14 sedans and 22 sport cars. XXX Auto Company can produce approximately 8 sedans and 25 sport cars.73)  = $18. Ames & Archer. 1988. Barron & Harackiewicz. 25)  = $18. the optimal feasible set.680 C 20 D E (22. 5. The question remains whether the student can relate the materials as learned in economics to what (s)he learned in management science. At point C. Integrating both parts as 18 . Barron & Elliot. Hidi & Harachiewicz. 2001). The best learners as described in learning motivation literature are students who link what they learned from one course to other courses.

A – Economics Analysis The production function depends on fixed and variable inputs. that is. In the long run. and part B shows how costs are explained in accounting. variable costs change with output but total fixed costs do not vary as output varies. Capital usually is the fixed input while labor and materials are the variable inputs.described in part C in managerial economics would contribute to the students’ overall comprehension of the topic. Knowing that the objective and constraint functions in LPs are created from unit revenues and unit costs. Output (Q) is expressed as a function of inputs or factors. In the short-run. Economic costs are comprised of explicit and implicit costs. AFC is TFC divided by Q produced. Part A illustrates the general approach used in teaching production costs in economics. M). Average variable cost (AVC) is TVC divided by quantity (Q) produced. 19 . such as capital. A short run is a production period when the amount of at least one production input is held fixed. These costs are the same but are discussed differently. Parts C and D discuss the links. Short-run and long-run periods are distinguished. As in Section II above. Average cost (AC) equals TC divided by quantity (Q) produced. Q = f(K. the next best alternative use of these resources. recognized and upheld in business analysis. all inputs can be changed. L. DOL AND THE RELEVANT RANGE Production costs are common topics both in economics and business courses. would be pursued. labor and materials. Total costs (TC) equal total fixed cost (TFC) plus total variable cost (TVC). III – COST FUNCTIONS. That is. which are the opportunity costs. efficiency which is the tenet of economics.

Economists are concerned with the inflection points. AVC and MC are U-shaped. Figure 3. MC falls with an increase in output. the first order derivative of total cost. marginal cost (MC) is the change in cost associated with a one-unit change in quantity (output) produced. It has concave and convex segments.Next. For the purpose of distinction between cost behaviors as illustrated in economics. Figure 3. 20 . How do costs behave with increases in output? Initially. and starts to rise again as output increases. The declining and rising parts of the MC curve are caused by the shape of the TVC. This also reflects the properties of diminishing marginal returns.1 – Costs Functions Cost TC TVC TFC Output The total cost function is monotonically increasing and continuously differentiable. MC = dTC/dQ. Thus. which makes the ATC and AVC curves convex. TVC and TFC curves.1 shows TC. the ATC.

The long-run average total cost (LRAC) curve is the envelope of the short-run average cost curves. Indirect costs are shared and also called overhead costs. costs are further decomposed into direct and indirect costs.2 Cost TC TVC TFC Output Here. Figure 3. Linear graphs rather than curves suffice to convey TC. FC and VC as shown in Figure 3. Business class discussions are less mathematical and the graphical representations of these costs are different from those displayed in part A of this section. In this case. B – Business Analysis Total cost (TC) is also comprised of fixed and variable costs. Long-run involves plant expansion. graphs are often used to illustrate these important properties of cost behaviors. the object is the output. In undergraduate economics textbooks. In graduate courses differential calculus is applied to describe and prove these properties. Cost elasticities and economies of scale in production levels are illustrated.2. Direct 21 . Direct costs are costs of labor and materials that can specifically be identified with an object.

and indirect costs can be fixed or variable. fixed manufacturing overhead is a period cost while under absorption costing.Variable Costs (L) Assignment Assignment Accounting Accounting 1.Sales Commission Indirect 6.Property Taxes Indirect 7. for instance.Buildings (dep) Indirect 2. In order for a business student to have a full understanding of this topic.Insurance Indirect 6. but the conceptualizations are different. Under variable costing. Supervisory employees’ salaries.Factory Supplies Indirect** 5. *Fixed manufacturing overhead.Labor Fringe3 Indirect** 8. Electricity used to operate a plant is an indirect variable cost.Utilities Indirect** 4. the definitions of fixed and variable costs are the same in economics and accounting.Mngment Salaries Indirect ^Plant supervisor’s pay could be indirect if (s)he supervises more than one plant.Delivery Charges Indirect 7.Cost of capital Indirect 3.Labor Direct 3.Fixed Costs (K) B .Machine (dep)* Indirect 1. labor wages are direct and variable costs since they change as the volume of activity changes. direct material and variable manufacturing overhead) to the product. fixed manufacturing overhead is a product cost. respectively. Table 3. Fixed costs are costs that remain 22 . Apparently. we cannot discuss variable cost without referring to product and period costs.Plant Maintenance* Indirect 5. while machine depreciation is an indirect fixed cost. **Variable manufacturing overhead. are direct fixed costs. Absorption costing assigns full costs including fixed manufacturing overhead to the product.1 – Economics and Accounting Costs Economics Classification A . that is absorption (full) costing and variable costing. Variable costing assigns variable manufacturing costs (direct labor.Advertising Indirect 9.Material Direct 2.Plant Supervisor* Direct/indirect^ 4.

including bond. it is unlikely to change much during an operating period. A course in economics groups these items in column A as fixed costs and conceptualizes them as property. and oftentimes. identifies them as labor. Let’s use ATC. While a course in economic theory is more concerned with deriving the efficiency benchmark. but the nature is similar whether the firm is operating an airline. or is involved with health care. Business students would find it more meaningful to incorporate a bankruptcy situation in the processes leading to shutdown.constant in total as volume changes. manufacturing autos. A course such as managerial economics should not follow suit. Plant maintenance covers maintenance contracts. 23 . It classifies column B items as variable costs. education or food processing companies. Bankruptcy Protection and Shutdown We can see the importance of integrating the economic illustration with real accounting terms by analyzing different market scenarios. once a company makes a budget for advertising. For instance. All items in column A qualify as fixed costs. plant and equipment due to their constant behaviors as volume changes. The size of each of these items is different across industries. for simplicity. managerial economics should be more elaborate and specific about the business equivalence of the economic classifications. AVC and MC curves as defined in part A of this section. preferred and common stocks holders. Cost of capital is the normal profit that the firm planned to pay its investors. janitors and guards. C – Operating Income. Advertising qualifies as a fixed selling cost. sales commission and delivery charges are variable selling costs.

Below point c. signals great performance and appears favorable on Wall Street. AVC and MC $ MC ATC g e c b a AVC 0 d f q Assume this firm is operating in a competitive market. The firm’s performance exceeds Wall Street’s expectation.3.Figure 3. Point c upward along the marginal cost (MC) is the short-run supply curve of the neo-classical economic firm. this firm makes zero economic profit but makes normal accounting profits that cover the cost of capital. Positive economic profit is a huge accounting profit that is partly distributed to shareholders and partly kept as retained earnings. At price g. point b. point a on Figure 3. the neo-classical firm is making positive economic profit. Retained earnings. 24 . Investors and financial analysts could live with this level of profit. it pays the firm to shut down because total revenue is less than variable costs and the firm is operating at a loss. If the firm shuts down at point c. If there is high competition and the price of the product drops to e.3 – ATC. which is placed on the stockholders’ equity section of the firm’s balance sheet. It maximizes economic profits by producing where price (MR) equals MC. it bears losses equal to its fixed costs.

2 shows a simplified working capital of a firm.2 – Working Capital A . a typical firm in many industries is more likely to find itself in this section of the graph.Current Liabilities Accounts and Notes Payable Interest Payable Accrued Liabilities Accrued Salaries and Fringe Other Debts 25 . it indicates a company has enough cash flow to cover its current obligations. Economic analyses assume that fixed costs must be paid in the short run regardless of whether the firm continues operation or shuts down. Table 3. the firm would be forced to file for Chapter 11. Between points b and c. It measures efficiency and the liquidity of the current operating cycle. Table 3. the firm can avoid all items in column B if it stops operating.If revenues exceed variable costs. On the other hand. The question is. if current assets are less than current liabilities and the firm cannot pay its creditors. Due to competition and economic downturns. the firm is making operating income and it may pay the firm to remain in business because it can afford all variable costs and parts of its fixed costs.2). the key to survival between points b and c in Figure 3. if current assets exceed current liabilities. Table 3. Therefore. column A are unavoidable in the short run? Clearly. suppliers and employees (items in column B. it becomes relevant to consider the working capital of the firm. Working capital equals current assets minus current liabilities.Current Assets Cash Accounts and Notes Receivable Prepaid Expenses Marketable Securities Inventories Other Liquid Assets B . between points b and c.1.3 would be proper working capital management. which of those fixed costs on Table 3. In order to answer this question.

on the other hand. Depending on the industry. items 4 through 9 are fixed costs. items numbered 1 and 2. Table 3. inventory turnover and accounts receivable turnover ratios to assess the ability of the firm to pay current costs in Table 3. Financial analysts often use current ratio. these items could be significant on the firm’s balance sheet..3. between points b and c of figure 3. while indirect or overhead costs are allocated to different objects. sometime in the past the firm borrowed to set up plants.1. In column A. Table 3. some firms would survive longer than others during bankruptcy protection. Also. raise the product’s intrinsic values.2. the quality of the product can directly be traced to the material and labor used. labor and supervisory costs. depreciation expense. are the undepreciated (carrying values) parts of items 1 and 2 of Table 3.2. Advertising. conveys information to the consumer and may only reflect on the consumer’s perception of the product. especially material. Except for items 6 and 7. however. Table 3. 26 . because they cannot directly be identified with the product.1 would siphon cash in column A or increase all items in column B. which may be prepaid. properties and equipment. is not a cash item. column B on Table 3.1. some of the costs on Table 3. The only unavoidable fixed costs. These costs are indirect. depending on their working capital management. Item 3.1 into indirect and direct costs. which the firm can avoid if it stops operating.1 also increases interest payable on Table 3. Some of the borrowed principals are matured and reflect on column B. Direct costs are costs that can be traced directly to the object.All items on Table 3. The next question of concern to a managerial economics student is the essence of separating these costs in Table 3. Thus.1.1. if the firm shuts down.2.

It is the current operating range for which the linear cost and revenue relationship are valid (Hansen & Mowen. might also be baffled by the curved TC and TVC (Figure 3. p.2) learned in business courses. 2003).The Relevant Range and Operating Leverage Some curious students.Whether or not a firm commits more resources to such indirect costs depends on the management’s philosophy about a product. This gap needs to be filled by appropriate illustrations in managerial economics. however. However. margin of safety and operating leverage. See Figure 3. Business analyses assume that there is a portion of the TC and TVC where both costs and revenues are linear.1) learned in economics courses and the linear TC and TVC graphs (Figure 3. For instance. There is a large conceptual gap between this region of costs as learned in economics and as learned in business courses. relevant range is completely nonexistent in most economics texts. D . Other important terms within this range are contribution margin (CM). 2003. The instructor might not get to that chapter by the end of the course. The relevant range appears among the last chapters of some management accounting texts (Hansen & Mowen. management that believes that a product is 90% perception may commit more resources to indirect costs such as advertising and gold-plated headquarters to create a brand and goodwill (nonproductive assets) than to invest more in labor and materials. Linearity properties of total revenue and total cost are among important assumptions in cost-volume-profit (CVP) analysis where breakeven (BE) quantities are derived. 671).4. Breakeven quantity is the level of production where total revenue and total cost are equal and could also be derived by dividing TFC by unit 27 .

1). Table 3. In an operation where fixed costs (fixed assets) can be substituted for variable costs (labor).5 below.3. point b on figure 3.CM. Margin of safety is the sales or revenue expected above the breakeven quantity. the firm uses fixed cost as a lever to increase its contribution margin. contribution margin (CM) equals total fixed costs (column A Table 3.3 illustrates CVP income statement. Figure 3. it also acquires more risks. at breakeven (BE).4 Cost TC TVC TFC Output The Relevant Range Operating leverage is the relative combination of fixed and variable costs and the use of fixed assets (costs) to generate revenue. CM equals sales minus variable costs. a firm can raise its CM by investing more in fixed assets and lowering variable costs. As the firm invests in fixed costs. Therefore. Table 3. In this case. The degree of operating leverage (DOL) is a measure of this risk as shown in equation 3.3 – CVP Income Statement ZZZ COMPANY 28 .

33% 33. AVC equals unit variable cost.5) (3. if TFC denotes only costs associated with properties. Given that Q equals quantity sold. A higher level of operating leverage magnifies profits in times of high sales and magnifies losses during recession.000) CM ratio 33. on Table 3. excluding a host of other items that meet the definitions of fixed costs. Table 3. DOL becomes: {Q(P – AVC)}/{Q(P – AVC) – TFC} (3. Thus.000) Net Income 0 0 20.000) CM 200. therefore. It is an elasticity concept. Higher levels of fixed costs. a drop in sales by 200 units reduces profit from a positive $40. the greater is the DOL for the firm. 20XX 1000 sold Per unit 1100 sold 1100 sold 900 sold Sales $600.1). For example. dividing a percentage change in sales into a percentage change in profit. the application of operating leverage as analyzed in business courses undermines technologically efficient combinations of capital and labor as discussed under 29 . with 6. VC now $350 per unit DOL = 6.33% 42% *FC are substituted for some VC.PROFORMA CVP INCOME STATEMENT FOR THE MONTH ENDING MAR 31.000 225.3.000) (385. plants and equipment.000 $540.000 200 220.000 to a loss of $10.000.000 VC (400. could be linked to higher levels of risk.000) (400) (440.000 (10. DOL = (d/)/(dQ/Q) = {dQ(P – AVC)/[Q(P – AVC) – TFC]}/dQ/Q Rearranging equation (3. that is.000)* (315.000 $660. P equals price of the good.000 40.000 $600 $660.000 275.4). TFC is total fixed costs and profit is = Q(P – AVC) – TFC.000) (235. the risks facing the firm are understated.000 FC (200.875 DOL. Moreover.875% DOL is sensitivity of profits to changes in output.4) The higher the TFC4 (items in column A.000) (235.000) (200) (200.

these topics are heavily tested in professional business examinations such as CPA. Production function is the other side of the coin to the cost function. In the region where the marginal cost is increasing. Students would improve their performance on these exams if they understood the underlying theoretical basis. CVP is a managerial economics topic as well as a management accounting topic. IV – MARGINAL PRODUCT AND PERFORMANCE EVALUATION A – Economics Analysis A firm incurs costs to produce. While the level of production is endogenously determined by the production function in economics analysis. CIA and CMA. Thus. however. Linearity assumption. The same variables are used in the preparation of CVP income statements in an accounting course and operating leverage in a finance course. respectively). the relevant range and operating leverage.isoquant and isocost (equations 2. Furthermore.2 and 2. are the same units used in the construction of feasible regions in business courses such as quantitative analysis.3) in section II. with the power to produce at any level. the short-run total product curve is a 30 . management science or operations management. the marginal product curve is decreasing and vice versa. The firm production point might not take into consideration scale diseconomies. Note also that the variables used under the topics of isocosts and isoquants. The firm applying operating leverage would therefore over-invest in assets. therefore must be linked and contrasted with the golden rule of inputs combination as discussed in economics if the objective of a managerial economics course is to encourage business students to apply mastery style of learning. which are capital and labor (fixed and variable costs. modern firms using operating leverage are bestowed.

MRPk = PFk.1) and (4. (dR/dQ) is the marginal revenue (MR) and (dQ/dK) and (dQ/dL) are the marginal physical product of capital (MPk) and the marginal physical product of labor MPL.mirror image of the short-run total costs curve as shown in Figure 3. and Revenue (R) be a function of output Q. That is.1) and (4.3) 31 . Marginal analysis is a useful tool in economics. equals MR x MPk. The efficiency rule is to hire factors until revenues brought in by a factor equals the cost of hiring the factor.L). the marginal revenue product of capital (MRPk). The law of diminishing marginal returns applies where the total cost curve is rising quickly and the marginal product is decreasing.1) (4. Let Q = output be a function of K (capital) and L (labor). economic efficiency requires that MRPk is set to equal the unit costs of acquisition of physical capital or factor price (PF). especially in resource management and factor addition and reduction. as: dR/dK dR/dL = = (dR/dQ)(dQ/dK) (dR/dQ)(dQ/dL) (4. we can find the marginal revenue product of capital (MRPk) and marginal revenue product of labor (MRPL) in equations (4. B – Business Analysis (4. Therefore. In adding capital. respectively. which is of interest to this section of the paper.1 in Section III. Q = g(K. marginal revenue product equals the factor price.2) From equations (4. By the chain rule.2).2) respectively. R = f(Q).

Some call it a hurdle rate. Whether CAPM is the 32 . preferred stocks and equity) is generally known as the weighted average cost of capital (WACC). the cost of capital may not be readily available. The desired or required rate of return (RRR) might be a good estimate—that is.While economics is concerned with productivity of physical capital such as plants and other assets.3). part A . These are the selling of common stocks. The cost of preferred stocks is related to the dividends paid. The appropriate rate of return for any capital project. generally classified into debt and equity.Economic Analysis. Firms finance their assets with different combinations of sources of financing known as capital structures. Others believe that the cost of capital would be an appropriate threshold for the rate of return. most commonly used for cost of equity are the dividend growth model and CAPM (capital assets pricing model).. the use of retained earnings. etc. Theoretically. The cost of equity financing oftentimes is based on estimates. The after-tax cost of debt is the firm’s borrowing rate less applicable taxes. a course in finance would be concerned with the funds to acquire these plants. the minimum rate an investor would accept on a project of a comparable nature. is controversial. the heuristic approach in capital budgeting is for firms to invest in capital projects until the rate of return from the project is equal to the cost of capital or an ongoing interest rate. The weighted average of these three sources of financing (debts. bonds. preferred stocks. This efficiency rule is theoretically equivalent to the rule derived in equation (4. The use of any of these sources of financing entails an opportunity cost of capital. where dR/dK = MRPk = PFk. Thus. nonetheless. Determining these benchmark rates can be a breathtaking exercise. Combining different sources of financing.

marginal product (MP).00 and the product sells for $5. With a unit cost of capital $130. = (P x MPk)/TR = (P x MPk)/(P x Q) = MPk/Q or MPk /TPk (4. marginal revenue (MR) is equal to the price (P) of the good the firm produces. efficiency requires that this company invest 33 . The firm would first equate its MRPk to the PF (actual acquisition cost) in order to select the efficient levels of investment. The market price (P) is known.00.1 contains total product (TP). C – MRPk.5) is the percentage change in production and could be considered the economic version of return on investment (ROI) or return on assets (ROA).appropriate measure of the cost of equity and WACC is the accurate measure of the actual cost of capital remains a hot debate in finance literature. Rate of Return and Performance Evaluation Perhaps applying a marginal capital productivity rate set equal to the factor price as in economics might give a better measure for the rate of return and the unit cost of capital.4) Equation (4. The price (P) multiplied by the MPk would give MRPk which could be compared to industrial rates to give an accurate measure of the rate of return of acquired capital. Assuming the firm is operating in a perfectly competitive industry. The cost of renting one unit is $130. (MRPk). Suppose a given company can invest in units of capital. Table 4. is MR multiplied by MPk. and then determine the PR.5) (4. marginal revenue product (MRP) and the productivity rate (PR) of capital. The marginal revenue product of capital. respectively. thus facing a perfectly elastic demand curve. The productivity rate (PR) could be derived (PRk) = (MRPk)/TR.

If the cost of acquisition drops to $120. which is Income – (Required Rate of Return x Investment).5) into the EVA equation: EVA = ATOI – [PRk x (total assets – current liabilities)] where ATOI is After-Tax Operating Income. the firm gains by investing in 4 units of capital earning productivity rate of 13%.1 – Total Product(TP) and Productivity Rate (PR) Units of Capital 1 2 3 4 5 TPk 88 124 152 176 198 MPk 88 36 28 24 22 MRPk 440 180 140 120 110 PRk 29% 18% 13% 11% This efficiency rule could also be applied to determine the performance of human capital such as CEOs or professional athletes to ascertain if the additional revenue they generate (MRPk) as CEOs or pro-footballers is equivalent to their pay.in 3 units of capital that yield 18% productivity.00. can also be altered by substituting (4. another important performance measure in the literature. Therefore. without reference to Part B would leave many students unable to reconcile theoretical concepts in (4. Table 4. Substituting the productivity rate (PRk) into RI equation for the rate of return. The Economic Value Added (EVA) equation. with regard to resource acquisitions. Residual Income (RI). RI = Income – (PRk x Investment) Residual income is usually compared with Return on Investment (ROI).7) (4. The idea is to integrate economics concepts into a finance course. Teaching managerial economics as in Part A. Bonuses should be compared to their productivity rate (PRk).6) 34 .

if the classroom contents overlap. and finance. As economics majors from business schools. This would affect abstract analytical and decision-making skills and graduates during their careers may generally rely on noneconomic factors in decision-making. Students would generate more interest in economics as they can visualize conceptual connections in these courses. Part C (and D when necessary) links and tries to integrate the concepts in economics and business. accounting and finance taught as business courses. Managerial economics would bridge the gap if approached from interdisciplinary perspective. Economics forms the theoretical framework for many business courses. Part B is the business school counterpart.economics courses with finance courses. It is argued that. Linear programming. There are conceptual gaps that dampen business students’ interest in economics and in turn deprive the students from being well rounded in business. production costs and marginal revenue product of capital are all economics topics. and operation management. which are also topics in management science or quantitative methods. VI CONCLUSION Different methods of classroom presentation are illustrated. students would develop more skills and be exposed to more career choices. 35 . It is shown that presenting these topics in a business department from a pure social science perspective isolates economics theories from the other business courses. respectively. accounting. Part A of each section is a typical economics discussion. managerial economics offered in many business departments could bridge the conceptual gaps between economics taught as a social science in liberal arts settings.

Students adopt different learning strategies known as achievement goals. Students who apply mastery style of learning put in more effort. 2000. 1997. Side Allowable Increase Allowable Decrease Notes 1. an individual’s objective is to develop competence by acquiring new knowledge and skills.H. These students compare and relate what they learn from one course to another (Harachiewicz. Students who pursue performance goal. Ames & Archer. They are considered deep learners and apply thorough study habits. are found to be shallow learners.Tables Table A1 – Hypothetical Answer Report . These styles of learning are grouped into mastery and performance goals. 1988). on the other hand. When pursuing mastery goal. Baron & Elliot. The main objective of students who apply 36 .Constraints Cell $C$7 $C$8 Variable X1 X2 Cell Value 400 1600 Formula $C$7<=$D$7 $C$8<=$D$8 Status Binding Not binding Slack 0 255 Table A2 – Example of Sensitivity Report Columns – Adjustable Cells Cell Variable Final Value Reduced Cost Objective Coefficient Allowable Increase Allowable Decrease Table A3 – Example of Sensitivity Report Columns – Constraints Cell Variable Final Value Shadow Price Constraint R.

which equals total revenue minus total variable costs. 3. overtime and idle time. as shown in Table 3. Contribution Margin is a term used in variable costing. the firm’s DOL increases as well as the risks facing the firm. pension. 37 . are classified as fixed costs. life insurance. If executive compensations including bonuses. 4. Many of these items are expressed as a percentage of labor hours. performance learners are found to score higher in examinations than students who apply mastery style. health insurance. Knowing which items in the firm’s financial statements are fixed. direct and indirect is important in making managerial decisions. vacation. they fit into variable costs. Gross Margin is the appropriate term when absorption costing is used. variable. The latter includes beginning and ending finished goods inventories and work-in-process inventories.performance strategy is to outperform other students and earn higher grades.1. Paradoxically. Labor fringe includes social security. for example. sick leave. Some companies classify these as indirect costs and others as direct. therefore. 2. Gross margin equals revenues minus cost of goods sold. training.

Carl. 2005. Muraoka. Vol. Boston: McGraw-Hill. Judith M. 1284-1295. Vol. No. 4th edition. Hansen. ____________ 1997. New York: W. New York: Harper Collins Publishers. 1990. Journal of Academic Administration in Higher Education. Economics in the MBA Curriculum: Some Preliminary Survey Results. 2007. Survey of Managerial Economics Textbooks. 316-330. Fundamental Methods of Mathematical Economics. Carole and Jennifer Archer. No. 80. R. Don R. 18-35 Gooding. 3. 1-5. Mowen. 2004. Vol. Dean. Binger. 6th edition. 32. Journal of Economic Education. Alpha C and Wainwright. 21. 2. and Dennis D. Journal of Economic Education. 29. Boston. Brian R. Sixth edition. The New Managerial Economics. Spring-Fall. Vol. Norton & Company. and Elizabeth Hoffman. The AACSB Faculty Qualifications Standard: A Regional University’s Metrics for Assessing AQ and PQ. 5th edition. 92. 1998. and Maryanne M. Ames. Applications. Management Accounting. 2003. Inc. and Cases. Microeconomics with Calculus. Theory. 38 .. 1998. William. Boyes.REFERENCES Allen. 3. Harachiewicz. Anderson. Gregorowicz. and Dolan. MA: Houghton. No. et al. 1. No.C. P. Short-term and Long-term Consequences of Achievement Goals: Predicting Interest and Performance Over Time. 73. Michael R. Journal of Personality and Social Psychology. Richard Cobb and William Scroggins. Vol. 1988. Ohio: Southwestern Thomson Learning. No. 2001. 6. Managerial Economics and Business Strategy. Vol. New York: McGraw-Hill Book Company. D. 81-87. Roy C. 2005. 260-267. Predictors and Consequences of Achievement Goals in the College Classroom: Maintaining Interest and Making the Grade. Managerial Economics. Vol. 79-91. No. 2000.” Journal of Educational Psychology. 2nd edition. 1.W. Liberal Arts or Business: Does the Location of Economics Department Alter the Major? Journal of Economic Education. Mason. Baye. 1. Achievement Goals in the Classroom: Students’ Learning Strategies and Motivation Process. Chiang. W. Journal of Educational Psychology. et al. Bruce. and Hegji. C. 2006.H.

39 . Marburger. Less Business. 360-364. 2005. Samuelson. Making Managerial Economics Relevant to the MBA. No. Cincinnati: Southwestern. Managerial Economics. 2004. eleventh edition. 3rd edition. 2. Ragsdale. Managerial Economics. 2007. William and Stephen Marks. Social Science Research Network. Norton & Company. 1991-2006. Journal of Economic Education. Vol 75. Daniel R. Canada: Thomson. Southwestern. Thomson Learning. Siegfried. H. Kasper.Hidi. Trends in Undergraduate Economics Degrees. Suzanne and Judith M. January. Southern Economic Journal. 70. Motivating the Academically Unmotivated: A Critical Issue for the 21st Century. 2006. Theory. No. 1-22. Spreadsheet Modeling and Decision Analysis. Hirschey. Somerset. 2008. 3. 2001. 151-179.2. Harachiewicz. Edwin. NJ: John Wiley & Sons. fifth edition. Vol.W. Mansfield. John J. Mark. Applications. 457-472. Sources of Economics Majors: More Biology. 1993. New York: W. second edition. Inc. Managerial Economics. Cliff T. Inc. et al. Review of Educational Research. Vol 38. and Cases. No. 2000.

and the latter are compared to zero (sufficient conditions).4) are the constraints. After using differential calculus.5) including the Lagrangian multiplier () is solved in terms of other coefficients and constants (a’s. The Lagrangian multiplier is then interpreted as the marginal effect on the objective function from one unit increase or decrease of the constraint variables. and Xn are >= 0. b’s and c’s) for the optimal values.4 A2. each choice or decision variable in the equations (A2. The a’s are the fixed resource requirements per unit and the b’s are the available resources. The first and second derivatives are taken. the former are set equal to zero (necessary conditions).Appendix A The objective function and the constraints are stated.am1X1 + am2X2 + … amnXn)]} A2.2 Equation (A2. The X’s are the decision variables. 40 .2) to (A2.1 A2.1) is the objective function to the more general form f(X1. taking first-order conditions.3 A2. X1. MAX (or MIN) Subject to: c1X1 + c2 X2 + … + cn Xn a11X1 + a12X2 + … a1nXn <= b1 : ak1X1 + ak2X2 + … aknXn <= bk : am1X1 + am2X2 + … amnXn <= bm and non-negativity requirements.5 A2. Equations (A2. The Lagrangian becomes: L = {(c1X1 + c2 X2 + … + cnXn) + 1[b1 – (a11X1 + a12X2 + … a1nXn)] + … + k[bk – (ak1X1 + ak2X2 + … aknXn)] + … + m[bm . Xn) for a non-linear programming problem. …. X2. ….

2005) are other techniques the professor might apply in solving optimization problems in a graduate economics course. the coefficients and the constants.A further breakdown is to carry out a comparative static analysis to check the effect of any changes in the exogenous parameters. 1998. Envelope theorem and Kuhn-Tucker conditions (Binger & Hoffman. on the optimal solutions. In some cases. Cobb-Douglas or CES functions come to mind. 41 . Chiang & Wainwright. the professor may extend the illustration to include specific functions in the objective function.