Managerial Economics

AC4102
Topics
 Intro to managerial economics

 Relevance of managerial economics in decision making

 The decision making model

 Managerial ethics

 Theory of the firm

 Role of profits
Managerial economics - Introduction
 “The integration of economic theory with business
practice for the purpose of facilitating decision making
and forward planning for management.”- Spencer &
Siegelman

 “Managerial economics is the analysis of major

management decisions using the tools of economics.”
– Samuelson & Marks
Managerial economics – Objective /
Relevance
 develops critical thinking skills
 provides managers with a logical way of analyzing both
the routine decisions of managing the daily operations of the
business and the longer-run strategic plans that seek to
manipulate / influence / affect the actions and reactions of
rival firms
 Teach and apply the foundation topics in microeconomics and
industrial organization essential for making both the day to
day business decisions that maximize profit as well as the
strategic decisions designed to create and protect profit in
the long run.
Microeconomics
 Microeconomics – study of individuals, households and
firms’ behavior in decision making and allocation of
resources. It generally applies to markets of goods and
services and deals with individual and economic issues.

 - deal with what choices people make, what factors influence

their choices, and how their decisions affect the goods markets
by affecting the price, demand and supply.
Industrial Organization
 A field of economics that builds on the theory of the
firm by examining structure of firms and markets.

 - deals with the strategic behavior of firms, regulatory policy,

antitrust policy and market competition.
Importance of Managerial economics
- The cost and benefits at stake in decision making are
increasing.
- Accountability of managers to senior management and
stakeholders are increasing.
- In the age of plentiful data, it has now become essential, of
utmost importance to use quantitative and rational based
methods and analysis in decision making rather than
“intuition”.
Managerial economics

Managerial
decision issues
(concerns)
Microeconomic Quantitative
concepts Approach
(Demand & Supply, (Mathematical
competition, economics,
Market) econometrics)

Managerial
Economics
Decision Making Models – Decision Maker
A. Individual decision making:
1. a.1) Team leader decides and informs the team
2. a.2) Team leader gathers input from the team and
decides

B. Group decision making:

1. b.1) Consensus decisions
2. b. 2) Consensus with a fallback
3. b.3) Team leader sets constraints and delegates
decisions to team members
Decision Making Models – Process
Rational decision making model

Bounded rationality decision

making model

Vroom-Yetton Jago decision making

model

Intuitive decision making model

Recognition-primed decision
making model
 Rational Decision Making Model Steps

3. Identify
1. Define 2. the criteria 4. Put 5. Generate 7. 8.
6. Evaluate 9. Evaluate
the Gathering to be used weight for a list of Determine Implement
those the
problem/ of relevant to judge each possible the best the
alternatives decision.
opportunity data possible criterion alternatives solutions decision.
solutions
Rational Decision Making Model
- Also known as Classical Decision Making
model
Advantages:
a) Can be used either as an individual decision
maker or in group
b) Faulty assumptions can be eliminated
c) Minimize risk and uncertainty
d) Relies on scientific data, therefore equips
managers in complex environment
e) Eliminates emotions of managers
Rational Decision Making Model
Disadvantages:
a) Given limited time available that decision is
needed, the appropriate information might not
be available.
b) Cannot be used in a fast paced environment.
c) Not efficient to be used in all decisions

Who uses this:

Larger innovation companies in Sweden like Volvo
& Ericson. (careers.gazprom-mt.com)
Rational Decision Making Model Steps
Features:
a) Problems are clear.
b) Objectives are clear.
c) People agree on criteria and weights.
d) All Alternatives are known.
e) All consequences can be anticipated.
f) Decision makers are rational & are not biased in
recognizing problems.
g) They are capable of processing all relevant information.
h) They anticipate present and future consequences of
decisions.
i) They search for all alternatives that maximizes the
desired results.
Bounded rationality decision making model
-Developed by Herbert Simon
-Also called the satisficing model – picking a course of
action that is “satisfactory” or “good enough” under the
circumstance. It is the tendency of decision makers to
accept the first alternative that meets their minimally
acceptable requirements rather than pushing them
further for an alternative that produces the best result.
-Also known as Administrative Man Model
-The good enough decision making model
-Is used when time and information is limited
-It is better to have a good enough decision sooner vs.
a perfect decision that is delayed.
-Use rule of thumbs or shortcuts
Vroom Yetton (Jago) Decision Making Model
The Vroom–Yetton contingency model is a
situational leadership theory of industrial and
organizational psychology developed by
Victor Vroom, in collaboration with
Phillip Yetton (1973) and later with Arthur Jago
(1988). The situational theory argues the
best style of leadership is contingent to the
situation.
Vroom Yetton (Jago) Decision Making Model
Figure 1 below shows the Vroom-Yetton model. The framework has 7 yes (y) no (n)
questions, which one needs to answer to find the best decision making process for a
particular situation.
Vroom Yetton (Jago) Decision Making Model

Consultative Consultative Collaborative

Autocratic A1 Autocratic AII
C1 CII GII
• Leader uses • Leader obtains • Leader shares • Leader shares • Leader meets
information he additional problems with problem with group to
has and simply information members members discuss
makes the from team, but individually but collectively, but situation.
decision, then decides alone. responsibility decides alone. • Leader directs
tell the team May or may of decision is and focuses
what he has not inform his alone. discussion but
decided. team of does not
decision. impose will.
• Group makes
final decision.
Vroom Yetton (Jago) Decision Making Model
Vroom Yetton (Jago) Decision Making Model
1. Quality Requirement (QR)

How important is the technical quality of the decision?

2. Commitment Requirement (CR)

How important is team member commitment to the decision?

3. Leaders Information (LI)

Do you (leader) have sufficient information to make a decision on your
own.

4. Problem Structure (PS)

Is the problem well structure? (clear, well defined, organized, lend itself
to solution, time limited, etc?)
Vroom Yetton (Jago) Decision Making Model
5. Commitment Probability (CP)

If you make the decision yourself, would your team support it?

6. Goal Congruence (GC)

Do members share the organizational goals to be attained in solving
the problem?

7. Subordinate Conflict (SC)

Is conflict among members over preferred solutions likely?

8. Subordinate Information (SI)

Do members have sufficient information to make high quality decision?
Intuitive Decision Making Model
-Brain acts lightning fast pattern recognition. Its quickly
reviewing everything you’ve learned from similar past situations
to help make a decision of the current situation.

-Yields good result if used when dealing with areas where leader
has a lot of experience and expertise.

-Not applicable or less efficient and effective if in an unfamiliar

circumstance – like new job, new market, new location bec not
enough experience to quickly recognize patterns.
Recognition-primed Decision Making Model
-Combination of rational and intuitive
-Starts when manager quickly assesses the situation, compares it
to past situations, recognizes patterns and quickly create a
“mental action script” which runs through the scenario until its
conclusion.
-Then 2 options are available:
1) leader/ manager finds no error in the scenario & sets
out it chosen course of action as outline in the action script
2) leader/manager encounters error in the action script,
starts over with a different script, repeating the process until a
scenario successfully play out.
Problem solving principles
Questions to ask in analyzing problems:
1. Who made the bad decision?
2. Did the decision maker have enough information to make a
good decision?
3. Did the decision maker have the incentive to make a good
decision?

Solutions:
1. Let someone with better information or better incentive
make the decision.
2. Give more information to the current decision maker, or
3. Change the current decision maker’s incentives (performance
evaluation metric or reward scheme)
Problem solving principles
Practical tips in developing problem solving skills:
1. Think about the problem from the perspective of the
organization (firm’s point of view)
2. Think about the organizational design.
3. What is the trade off?
4. Don’t define the problem as the lack of solution.
5. Avoid JARGON (KISS)
 Sample case:
In 1992, a junior geologist was preparing a bid recommendation
for an oil tract in the Gulf of Mexico. She suspected that the
tract contained a large accumulation of oil because her
company, Oil Ventures International (OVI), had an adjacent
tract with several productive wells. Since no competitors
had neighboring tracts, none of them suspected a large
accumulation of oil. Because of this, she thought that the
tract could be won relatively cheaply and recommended a
bid of $5million. Surprisingly, OVI’s senior management
ignored the recommendation and submitted a bid of $21
million. OVI won the tract over the next highest bid of
$750,000.
 Sample case:
If the board of directors asked you to review the bidding
procedures at OVI, how would you proceed? Where would
you begin your investigation? What questions would you
ask?
You will find it difficult to gather information from those
closest to the bidding. Senior management would be
suspicious and uncooperative because no one likes to be
singled out for bidding $20million more than was necessary.
 Sample case:
After her company won the auction, the geologist increased
the company’s oil reserves by the amount of oil estimated
to be in the tract. But when the company drilled a well, it
was essentially “dry”, so the acquisition did little to increase
the size of the company’s oil reserves. Using the
information from the newly drilled well, the geologist
updated the reservoir map and reduced the estimated
reserves to where they were before OVI won the tract.
Senior management rejected the lower estimate and directed
the geologist to “do what she could” to increase the size of
the estimated reserves. So, she revised the reservoir map
again, adding “additional” (not real) reserves to the
company’s asset base.The reason behind this behavior
 Sample case:
clear when, several months later, OVI’s senior managers
resigned, collecting bonuses tied to the increase in oil
reserves that had accumulated during their tenure.

How will you fix this problem?

Managerial ethics
-Rules and principles
set by upper
management, that
spell out what is right
and wrong in an
organization.
-Intended to make it
easier for managers to
make the right
decision when a
conflict of values is
presented.
Managerial ethics
-.3 models of management ethics
- 1) Immoral – recognize the ethical issues involved but still
choose the wrong thing.
-2) Moral – recognize the ethical issues involved and choose
the right thing.
-3) Amoral – does not consider the ethical implications of an
action or believes that ethics are irrelevant.
Ethics and Economics
-To control unethical behavior, we first have to understand why
it occurs.
-We need to anticipate opportunistic behavior and design
organizations that are less susceptible to it.
Analysis of the case
 Who made the bad decision? Senior managers
 Did they have enough information to make a good decision?
Yes
 Did they have enough incentives to make a good decision? No,
bec incentives was tied to increase in asset during their tenure
rather than profitability.
 What is the problem? High acquisition cost (over bidding) and
over declaration
 Possible solutions:
 A) change incentives tied to profitability instead, then made
performance evaluation parameter for officers or use
earnings/stock price appreciation as performance metrics.
 B) Conduct internal audit actual vs record (existence of assets
esp for large purchase or asset acquisition)