MANAGERIAL ECONOMICS

What is Managerial Economics?

- The science of cost effective management of scarce resources.
- It consists of three (3) branches:
1. Competitive Markets
2. Market Power
3. Imperfect Markets
Value Added
The primary goal of a profit-oriented business is to maximize profit. Indeed, the aim of competitive strategy is to deliver
sustained profit above the competitive level.
Accordingly, an essential concept for managerial decision making is Economic Profit.
To appreciate the concept of economic profit, consider the basic equation of managerial economics:
Value Added=Buyer Benefit – Seller Cost=buyer Surplus + Seller Economic Profit
The equation states that value added is the difference between buyer benefit and seller cost. It is only to the extent that
businesses deliver benefit to buyers that exceed the cost of production that they create value. To create value, they must deliver
benefits that exceed cost. Anyone who delivers benefit which is less than the cost of production is destroying value.

Referring to Figure 1.1, value added is shared by buyer and seller. The buyer gets some part of the value added in buyer surplus,
which is the difference between the buyer’s benefit and their expenditure.
The seller gets the other part of the value added in economic profit, which is the difference between the revenue that the
seller receives (equal to the buyer expenditure) and the cost of production.
The larger is the value added, the larger is the amount to be shared by buyer and seller. For profit-oriented businesses, that
means the potential for economic profit is greater.
The concept of value added applies to governments and non-profits as well.

Decision-Making
The two fundamental decisions in business can be stated simply as participation (“which”) and extent (“how much”).
Which market to enter? How much to invest?

Which and How Much?

The decisions on participation (which) and extent (how much) resolve into analysing the total and marginal benefits and
costs.
Average Value
-The total value of the variable divided by the total quantity of the measure.
Marginal Value
-The change in the variable associated with a unit increase in a measure.
Bounded Rationality
Managers are human and as such are subject to bounded rationality. Typically, managerial economics models assume that
people make decisions rationally, in the sense that individuals always choose the alternative that maximizes the difference
between benefit and cost.
Individuals tend to adopt simplified rules in making decisions, especially under conditions of uncertainty. These simplified
rules result in systematic biases including the following:
 Sunk-cost fallacy
  Status quo bias
 Anchoring
Timing
Managerial economics analysis includes two (2) types of models:
1. Static Models – describe behaviour at a single point in time, or equivalently, disregard differences in the sequence of actions
and payments.
2. Dynamic Models – explicitly focus on the timing and sequence of actions and payments.
Discounting
Investments necessarily involve using resources at certain times in order to receive benefits at other times. In order to account
correctly for the importance of time for managerial decisions it is necessary to discount future values so that they can compared
with the present.
Discounting - a procedure to transform future dollars into an equivalent number of present dollars.
Net Present Value
Evaluating flows of revenue and costs over time requires repeated application of the principle of discounting. Every dollar amount
should be discounted according to how far in the future it occurs to evaluate its present value.
Net Present Value – is the sum of the discounted values of inflows and outflows over time.
Organizational Boundaries
The activities of an organization are subject to vertical and horizontal boundaries.
Vertical boundaries of an organization delineate activities closer to or further froma the end user.
Horizontal boundaries of an organization are defined by the organization’s scale and scope of operation
Scale refers to the rate of production or delivery of a good or service.
Scope refers to the range of different items produced or delivered.
Outsourcing
It is the purchase of services or supplies from external sources. It is the opposite of vertical integration, and affects the
vertical boundaries of the organization.
Market
One concept of managerial economics – the market –is so fundamental that it appears in the names of each brand of the
discipline.
A market consists of buyers and sellers who communicate with one another for voluntary exchange.
In this sense, a market is not limited to any physical structure or particular location.
In markets for consumer products, the buyers are households and sellers are businesses. In markets for industrial
products, both buyers and sellers are businesses. Finally, in markets for human resources, the buyers are businesses and sellers
are households.
By contrast with a market, an industry consists of businesses engaged in the production or delivery of the same or similar
items.
Competitive Markets
The basic starting point of managerial economics is the model of competitive markets. This applies to markets with many buyers
and many sellers.
In a competitive market, buyers provide the demand and sellers provide the supply. Accordingly, the model is also called
the demand-supply model.
The model describes the systematic effect of changes in prices and other economic variables on buyers and sellers.
In a competitive market, an individual manager may have little freedom of action. Key variables such as prices, scale of operations,
and input mix are determined by market forces. The role of a manager is simply to follow the market and survive. Not all markets,
however, have so many buyers and sellers to be competitive.
Market power is the ability of a buyer or seller to influence market conditions. A seller with market power will have
relatively more freedom to choose suppliers, set prices, and use advertising to influence demand. A buyer with market power will
be able to influence the supply of products that it purchases.
A business with market power must determine its horizontal boundaries. These depend on how its costs vary with the
scale and scope of operations.
Accordingly, businesses with market power - whether buyers or sellers-need to understand and manage their costs.
In addition to managing costs, sellers with market power need to manage their demand. Three key tools in managing
demand are price, advertising, and policy toward competitors.
A market may be imperfect in two ways:
when one party directly conveys a benefit or cost to others; or when one party has better information than others.