• Nature and Scope of Managerial Economics ch 1

What is Economics?
A social science that studies choice with efficient utilization of scarce resources.
Economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses,
governments, and nations make choices about how to allocate resources. 
Microeconomics deals in Theory of Individual/Market Demand, Theory of
Production and Cost, Theory of Markets and Price , Theory of
Profit.Microeconomics focus on  Analyzing certain aspects of human behavior, it
tries to explain how they respond to changes in price and why they demand what
they do at particular price levels.
Macroeconomics deals in Theory of total output and employment, General Price
level ,Theory of Inflation ,Theory of trade cycles ,Economic Growth.
Macroeconomics studies an overall economy on both a national and international
level, using highly aggregated economic data and variables to model the
economy. Its focus can include a distinct geographical region, a country, a
continent, or even the whole world. 
Managerial Economics
Managerial economics is concerned with the application of economic concepts
and economics tools and techniques to the problems of formulating rational
decision making – (Mansfield)
Managerial economics applies the principals and methods of economics to
analyze problems faced by the management of a business, or other types of
organizations and to help and to help find solutions that advance the best
interests of such organizations – (Davis & Chang)
Why do business manager need to know economics?
Business decisions are taken under uncertainty and risk which arises due to
following aspects: Behavior of market forces , Changing business environment
,Emergence of competitors with highly competitive products ,Government Policy
,External influence on domestic on domestic market ,Social and political changes
How is managerial economics useful?
Managerial economics applies economic theory and methods to business and
administrative decision making.it prescribes rules for improving managerial
decisions.It helps managers recognize how economic forces affect organizations
and describes the economic consequences of managerial behavior.It links
economic concepts with quantitative methods to develop vital tools for
managerial decision making.It is critical for a manager to know basic
economic theory and how it applies to offering products and
services to the public in a market economy, in order for a business
to be managed successfully. Managers need to have a basic
understanding of economics to understand the concept of value

There are 2 Areas of Decision Making

1.Production related issues
• Available techniques of production
• Cost of production associated with each production technique
• Supply position of inputs required to produce the planned commodity
• Price structure of Inputs
• Cost structure of competitive products
• Availability of foreign exchange if inputs are to be imported

2.Sales Prospects and Problems

• General market trends
• Trends in the industry to which the planned products belong
• Major existing and potential competitors and their respective market
shares
• Prices of competing products
 • Pricing strategy of the prospective competitors
• Market structure and degree of competition
• Supply position of complimentary goods
• Evaluating Choice Alternatives: Managerial economics identifies ways to
efficiently achieve goals.
• Making the Best Decision: managers must understand their economic
environment, their customers, the ideal price etc.
Theory of the Firm
Business represents a series of contractual relationships. People directly involved
include customers, stockholders, management, employees and suppliers. Society
is also involved because businesses use scarce resources, pay taxes, provide
employment opportunities, produce much of society’s material and services
output. Firms are economic entities and they are best analyzed in the context of
an economic model. Basic model of business is called the Theory of the Firm. Firm
combines and organizes resources for the purpose of producing goods and/or
services for sale. Internalizes transactions, reducing transactions costs/time.
Resource owners use the income generated from the sale of their
services/resources, to purchase goods and services produced by firms. Circular
flow of economic activity is thus completed. Primary goal is to maximize the
wealth or value of the firm.
Expected Value Maximization
The firm has profit maximization as its primary goal. Its owner-manager is
assumed to be working to maximize the firm’s short run profit. Now, the
emphasis on profits has broadened to encompass uncertainty and the time value
of money. In this the primary goal of the firm is long term expected value
maximization.
The Value of the Firm
• Is the present value of firm’s expected future net cash flows.Is the present
value of all expected future profits
 π1 π2 πn
• VF= 1
+ 2 + …… +
(1+i) (1+ i) (1+i)n
n
πt
¿∑
t=1
( (1+i)t )
n
TR t−TC t
¿∑
t=1
( (1+ i)t )
Constraints and the Theory of the Firm
Decisions are often made in the light of constraints imposed by technology,
resource scarcity, contractual obligations, laws and regulations, in order to
achieve the objectives.
Limitations of the Theory of the Firm
• Optimize: do the managers optimize i.e. seek the best possible solution
• Satisfice: or do they satisfice i.e. seek satisfactory rather than optimal
results.
• Research shows that competition in the markets for most goods and
services forces managers to seek value maximization in their operating
decisions.
Alternate Theories of the Firm
Sales maximization (William Baumol)
Adequate rate of profit to satisfy shareholders; assuming this, maximize sales,
even by sacrificing some profits.
Management utility maximization (Oliver Williamson)
– Principle-agent problem: managers try to maximize their benefits like salaries,
fringe benefits, stock options, staff size, lavish offices, etc. This can be resolved by
linking managers’ rewards to firm’s performance compared to similar firms in the
industry.
Business Profit Vs Economic Profit
 • Business Profit: Total revenue minus the explicit or accounting costs of
production.
• Economic Profit: Total revenue minus the explicit and implicit costs of
production.
• Opportunity Cost: Implicit value of a resource in its best alternative use.
Why Profits Vary?
• Frictional Theory of Economic Profits: Abnormal profits observed following
unanticipated changes in demand or cost conditions.
• Monopoly Theory of Economic Profits: Above normal profits caused by
barriers to entry that limit competition.
• Innovation Profit Theory: Above normal profits that follow successful
invention or modernization.
• Compensatory Profit Theory: Above normal rates of return that reward
efficiency.
Why Firms exist?
• Firms exists by public consent to serve social needs.
• Role of social constraints
• Social Responsibility of Business.
• Value maximization: a complex process that involves an ongoing
sequence of successful management decisions.

Economic Optimization
Chapter 2
Economic Optimization Process
Optimal Decisions – Best decision helps achieve objectives most efficiently.
Maximizing the Value of the Firm--- Value maximization requires serving
customers efficiently. For ex what do customers want? ,How can customers best
be served?
Expressing Economic Relations: Total, Average, and Marginal Relations
-Total : Total Product, Total Revenue, Total Cost, Total Profit.
-Average : Total profit per unit of output, total cost per unit of output,
-Marginal is change in the dependent variable caused by a one unit change in
independent variable. Y = a + bX
-Marginal Revenue: is the change in total revenue associated with a one unit
change in output.
-Marginal Cost : Change in total cost following by a one unit change in output.
-Marginal Profit: Change in total profit due to a one unit change in output
• TP = Total Production change∈Total Product
MP= change ∈Labor Input
Total Product The change in TP caused by the addition
• AP = units of Input
of one more unit of variable input.

Geometric Representation of Total, Marginal, and Avge Relations: Total Profits

Marginal = change in dependent variable caused by a one unit change in an
independent variable.
Total Revenue:TR = Price X Output
Marginal Revenue = change in total revenue associated with one unit change in
output
∆ TR TR2−TR1
∆Q
= Q −Q
2 1

Total Cost:TC = variable cost + fixed cost

Marginal Cost = change in total cost following a one unit change in output
Total Profit:TP = TR – TC
MP = change in TP due to a one unit change in output.
Imp point
Maximization occurs when marginal switches from positive to zero or negative.
If MP=0, TP is maximum
If marginal is above average, average is rising.
If marginal is below average, average is falling.
MP cuts AP at its maximum
MARGINAL AS A DERIVATIVE OF FUNCTIONS
Concept of a Derivative – Derivative is a marginal relation.
Derivatives and Slope
Derivative of total revenue is marginal revenue.
Derivative of total cost is marginal cost.
Derivative of total profit is marginal profit.
∆Y
Slope: Measure of the steepness of a line ∆ X

Tangent : A straight line that touches a curve at only one point

Point of Inflection: Point of maximum or minimum slope.
Derivative: A marginal value is the change in dependent variable associated with
a one unit change in an independent variable.
∂Y ∆Y Y 2−Y 1
= =
∂ X ∆ X X 2− X 1

The derivative of Y with respect to X identifies the slope of the curve.

MARGINAL ANALYSIS IN DECISION MAKING
Finding Maximums or Minimums
Managerial decision making frequently requires one to find a maximum or
minimum value of a function.
For a function to be at its maximum or minimum, its slope, its derivative or
marginal value must be equal to zero.
Consider the following profit function: π=−10000+ 400 Q−2 Q2
dπ
Marginal Profit (M π ) = dQ = 400 – 4Q

Setting MP equal to zero results in

400 – 4Q = 0 400=4Q Q=100 At Q = 100, marginal profit is zero & total
profit is at a maximum.Beyond Q = 100, marginal profit is negative and total profit
is decreasing.
Profit as a function of output
A problem can arise when marginal relations (derivatives) are used to locate
maximums or minimums.
The marginal of a function indicates whether the function is rising or falling at
any point.
To be maximized or minimized, the function must be neither rising nor falling
Slope as measured by the marginal must be zero.
Setting this marginal relation equal to zero indicates inflection points.
The marginal value (or derivative) is zero for both maximum and minimum
values of a function therefore further analysis is necessary to determine
whether the point is a maximum or a minimum.
Locating Maximum and Minimum Values of a function
The concept of second derivative is used to distinguish maximums from
minimums along a function.
The second derivative is simply the derivative of the marginal relations. The
derivative of a derivative.
Distinguishing Maximums from Minimums
Maximum is where first derivative is zero, second derivative is negative.
Minimum is where first derivative is zero, second derivative is positive.
Maximum profit requires MR = MC.
 • Optimization with calculus
∆Y
• Find X such that ∆ X = 0

Second Derivative rules:

d2 Y d2 Y
If > 0, then X is a minimum • If < 0, then X is a
d X2 d X2
maximum

In Cost functions, we attempt to find In Profit functions, we attempt to find

the minimum value the maximum value
Hence, the objective is to minimize costs and maximize profits.
Consider the following Total profit function:
π=a−bQ+ c Q 2−d Q3
dπ
First derivative : Marginal Profit (M π ) = dQ = -b +2cQ – 3d Q2

d 2 π dMπ
Second derivative: = = 2c – 6dQ
dQ 2 dQ

INCREMENTAL CONCEPT IN ECONOMIC ANALYSIS

Marginal v. Incremental Concept : Incremental change refers to total difference
resulting from a decision.
Incremental Profits – Profits tied to a managerial decision.
Appendix
Concept of a derivative
The derivative of Y with respect to X is equal to the limit of the ratio ∆Y/∆X as ∆X
approaches zero.
dY ∆Y
=limit
dX ∆X

Rules of differentiation
1. Constant Function Rule: The derivative of a constant,
 Y = f(X) = a, is zero for all values of a (the constant).
Y = f(X)= a
dY
dX
=0

Rules of differentiation
2. Power Function Rule:
The derivative of a power function, where a and b are constants, is defined as
follows.
Y=f(x)=a X b
dY
= b∙a X b−1
dX

3. Sum-and-Differences Rule:
The derivative of the sum or difference of two functions U and V, is defined as
follows.
U=g(X) V=h(X) Y=U+V
dY dU dV
= +
dX dX dX

4. Product Rule:
The derivative of the product of two functions U and V, is defined as follows.
U=g(X) V=h(X) Y=U∙V
dY dV dU
=U +V
dX dX dX

5. Quotient Rule:
The derivative of the ratio of two functions U and V, is defined as follows.
U
U=g(X) V=h(X) Y= V

dY dV dU
= (U +V ) ÷ V2
dX dX dX
6. Chain Rule:
The derivative of a function that is a function of X is defined as follows.
Y = f(U) U = g(X)
dY dY dU
= ∙
dX dU dX

CH5
Simultaneous Relations: when a concurrent association exists between demand
and supply.
Identification Problem: difficulty of estimating and economic relation in the
presence of simultaneous relations.
To separate shifts in demand and supply from changes or movements along a
single curve, information about changes in demand and supply conditions is
necessary to identify and estimate demand and supply relations.
Sometimes the information is hard to find.
In such instances, standard statistical techniques, such as ordinary least squares,
do not provide reliable estimates of demand and supply functions.
More advanced statistical techniques, such as two stage least squares or
seemingly unrelated regression analysis are necessary.
Even if the identification problem exists, consumer interviews and market
experiments can sometimes be used to obtain relevant information.
Consumer Interviews: (survey) method requires questioning customers or
potential customers to estimate the relationship between demand and a variety
of underlying factors.
Market Experiments:
Demand estimation in a controlled environment.
Regression analysis
Regression Analysis is a statistical technique that describes the relations among
dependent and independent variables.
Regression Analysis is a valuable tool for a manager.It can be used to understand
the relationship between variables.Also, to predict the value of one variable
based on another variable. For e.g. studying the effectiveness of advertising
expenditure on the sales volume.
Time Series data: Daily, weekly, monthly or annual sequence of economic data.
Cross section data: Data sample of firms, market or a product taken at a given
point in time.
Simple Regression Model: relation between one dependent Y variable and one
independent X variable.
Multiple Regression Model: relation between on Y variable and two or more X
variables.
GOODNESS OF FIT
Correlation coefficient, r: is the goodness of fit measure for a simple regression.
The value of r falls in the range of 1 and -1.
If r=1; there is a perfect direct linear relation between dependent Y variable and
the independent X variable.
If r= -1; there is a perfect inverse linear relation between dependent Y variable
and the independent X variable.
If r=0; there is no relation between dependent Y variable and the independent X
variable
Coefficient of determination, R2:is the measure of goodness of fit for a multiple
regression model; the square of the coefficient of multiple correlations.