Managerial Economics

LESSON#1: Fundamentals of Managerial Economics

ECONOMICS:
 It is a SOCIAL SCIENCE that DEALS with the PROPER ALLOCATION OF
SCARCE RESOURCES to SATISFY UNLIMITED WANTS AND NEEDS.
 Looks into the DISTRIBUTION OF INCOME AND INTO WAYS OF
HELLPING THE POOR WITHOUT CAUSING HARM TO THE
COUNTRY’S ECONOMIC PERFORMANCE
 It is the study of the BEHAVIOR OF HUMAN BEINGS IN PRODUCING,
DISTRIBUTING AND CONSUMING MATERIAL GOODS AND
SERVICES IN SCARCE RESOURCES.

MANAGEMENT:
 It is the discipline of ORGANIZING AND ALLOCATING A FIRM’S
SCARCE RESOURCES TO ACHIEVE ITS DESIRED OBJECTIVES.
Involves the ABILITY TO ORGANIZE AND ADMINISTER VARIOUS
TASKS IN PURSUIT OF CERTAIN OBJECTIVES

THE MANAGER:
 It is a PERSON WHO DIRECTS RESOURCES TO ACHIEVE A STATE
GOAL. This defition includes all individuals who;
 DIRECT EFFORTS OG OTHERS, INCLUDING THOSE WHO DELEGATE TASKS
WITHIN AN ORGANIZATION
 PURCHASE INPUTS TO BE USED IN THE PRODUCTION OF GOODS AND
SERVICES
 IN CHARGE OF MAKING OTHER DECISIONS.

MANAGERIAL ECONOMICS:
 Use of ECONOMIC ANALYSIS IN THE FORMULATION OF BUSINESS POLICIES
INVOLVING THE BEST USE OF AN ORGANIZATION’S SCARCE RESOURCES
  DEFINED AS A STUDY OF HOW DIRECT SCARCE RESOURCES IN THE WAY THAT
MOST EFFICIENTLY ACHIEVES A MANAGERIAL GOAL
 RELEVANT TO THE MANAGEMENT OF GOVERNMENT AGENCIES,
COOPERATIVES SCHOOLS, HOSPITALS, MUSEUMS AND SIMILAR NON-PROFIT
ORGANIZATIONS.

RELATIONSHIP TO OTHER DISCIPLINES

MARKETING:
Managerial Economics helps marketing in TWO WAYS

 AS A BASIC DISCIPLINE, PROVIDES TOOLS AND CONCEPTS OF ANALYSIS

 AS AN INTEGRATING ERA, PROVIDING ITS JUDGEMENT ON THE
OPTIMUM SALES VOLUME UNDER THE GIVEN COST FUNCTION OF A
FIRM, MAKET STRUCTURE, AND THE OBJECTIVE FUNCTION TO BE
OPTIMIZED.

FINANCE:
 It RELATES CORPORATE FINANCE when STATISTICAL AND MATHEMATICAL
MODELING CAN BE APPLIED to OPTIMIZE RESOURCE ALLOCATION
DECISIONS ON STOCKHOLDER/STOCK ISSUANCE DECISIONS, CAPITAL
BUDGETING DECISIONS, BREAK EVEN ANAYSIS, OPPORTUNITY COSTS
AND OTHERS.

MANGERIAL SCIENCE:
 LINEAR PROGRAMMING, REGRESSION ANALYSIS AND FORECASTING
ARE APPLIED TO ALLOCATE SCARCE RESOURCE

FOUR STAGE MODEL OF CHANGE

The ECONOMICS OF A BUSINESS REFERS TO THE KEY FACTORS THAT AFFECT THE
ABILITY OF A FIRM TO EARN AN ACCEPTABLE RATE OF RETURN ON ITS OWNERS’
INVESTMENT
MOST IMPORATANT FACTOR
o COMPETITION
o TECHNOLOGY
o CUSTOMERS

STAGE 1
THE GOOD ALL-DAYS
STAGE 2
 COST MANAGEMENT
COST CUTTING
STAGE 3
LIMITS TO THE GROWTH IN PROFITS
REVENUE MANAGEMENT
TOP-LINE GROWTH
STAGE 4
REVENUE PLUS

ECONOMICS CONCEPTS
MICROECONOMICS
IT IS THE STUDY OF INDIVIDUAL CONSUMERS AND PRODUCER IIN SPECIFIC MARKETS

o SUPPLY AND DEMAND

o PRICING OUTPUT
o PRODUCTION PROCESS
o COST STRUCTURE
o DISTRIBUTION

MACROECONOMICS
IT IS THE STUDY OF AGGREGATE ECONOMY

o NATIONAL INCOME ANALYSIS

o GROSS DOMESTIC PRODUCT
o UNEMPLOYMENT
o INFLATION
o FISCAL POLICY

SCARCITY
o It is the CONDITION in which RESOURCES ARE NOT AVAILABLE TO SATISFY ALL
NEEDS AND WANTS OF SPECIFIED GROUP OF PEOPLE.

OPPORTUNITY COST
o It is the AMOUNT OR SUBJECTIVE VALUE THAT MUST BE SACRIFICED IN
CHOOSING ONE ACTIVITY OVER THE NEXT BEST ALTERNATIVE
o DEFINED AS A VALUE OF FOREGONE ALTERNATIVE OF A SPECIFIC RESOURCE
 ECONOMICS SYSTEM

TRADITIONAL SYSTEM
o Production decisions ARE MADE ACCORDING TO CUSTOMS AND DECISIONS

COMMAND ECONOMIC SYSTEM

o THE ANSWER to the BASIC ECONOMIC PROBLEMS ARE DICTATED BY
THE GOVERNMENT THROUGH THE HEAD OF THE NATION

MARKET SYSTEM
o DEALS with the ECONOMIC PROBLEMS BY CONSIDERING CONSUMERS
CHOICES

ECONOMIC RESOURCES
LAND:
REFERS TO ALL NATURAL RESOURCES WHICH ARE USABLE IN THE PRODUCTIVE PROCESS

LABOR:
PHYSICAL AND MEANTAL EFFORTS OF A MAN which CAN BE Used TO PRODUCE GOODS AND
SERVICES

CAPITAL:
MAN MADE AIDS TO PRODUCTION

ENTREPRENEUR:
PERSON OR PERSONS WHO SET UP A FIRM BY COMBINING THE 3 RESOURCES

NATURE OF MANAGERIAL ECONOMICS

MANAGERS study managerial economics because IT GIVES THEM INSIGHT TO REIGN THE
FUNCTIONING OF THE ORGANIZATION
o Managerial Economics IS A SCIENCE
o Managerial Economics REQUIRES ART
 o Managerial Economics FOR ADMINISTRATION OF ORGANIZATION
o Managerial Economics IS HELPFUL IN OPTIMUM RESOURCE ALLOCATION
o Managerial Economics HAS A COMPONENT OF MICROECONOMICS AND
MACROECONOMICS
o Managerial Economics is DYNAMIC IN NATURE.

SCOPE OF MANAGERIAL ECONOMICS

RESOURCE ALLOCATION
SCARCE RESOURCES have to be used with utmost efficiency to get optimal results

INVENTORY AND QUEUING PROBLEM

INVENTORY PROBLEMS involve DECISIONS about HOLDING OF OPTIMAL
LEVELS OF STOCKS OF RAW MATERIALS AND FINISHED GOODS OVER A PERIOD.
QUEUING PROBLEMS involve DECISIONS about INSTALLATION OF ADDITIONAL
MACHINES OR HIRING OF EXTRA LABOR IN ORDER to balance the business lost by not
undertaking these activities.

PRICING PROBLEMS
FIXING PRICES for the products of the firm IS AN IMPORTANT PART OF THE
DECISION-MAKING PROCESS.

INVESTMENT PROBLEMS
FORWARD PLANNING INVOLVES INVESTMENT PROBLEMS

IMPORTANCE OF MANAGERIAL
 The use of ECONOMIC ANALYSIS IN THE FORMULATION OF BUSINESS
POLICIES involving the best use of an organization’s scarce resources
 It is DEFINED AS THE STUDY OF HOW TO DIRECT SCARCE RESOURCES in the
way that most efficiently achieves a managerial goal.
 It is a RELEVANT TO THE MANAGEMENT OF government agencies, cooperatives,
schools, hospitals, museums, and similar non-profit organizations.

LESSON#2 GOAL OF FIRM

THE FIRM
 “Black box”
 It is a COLLECTION OF RESOURCES that is TRANSFORMED INTO
PRODUCTS DEMANDED BY CONSUMERS.
 It BEARS COSTS OF PRODUCTION.
WHY DOES A FIRM EXIST?

 Firms exist to ECONOMIZE ON THE COST OF COORDINATING ECONOMIC

ACTIVITY.
 Transaction costs – COSTS OF ACQUIRING PRICE INFORMATION,
NEGOTIATION AND EXCHANGING.
Transaction costs are influenced by:
Uncertainty
Frequency of transaction
Asset specificity
“EVERY BUSINESS HAS A GOAL”

ECONOMIC GOAL OF A FIRM AND OPTIMAL

DECISION
PROFIT MAXIMIZATION
 It is traditionally known to be the ultimate goal of a firm.
 Profit is the difference between revenue received and costs incurred.
= TR – TC

OPTIMAL DECISION
 It is the ONE THAT BRINGS THE FIRMS CLOSEST TO ITS GOAL

DISTICTION OF TIME PERIOD

SHORT RUN
 The firm can VARY THE AMOUNT of resources but must operate with a fixed amount
of one of its resources.

LONG RUN
 the firm is able to VARY QUANTITIES of all resources being utlized.

GOAL OF A FIRM
MAXIMIZE PROFITS
 MAIN GOAL OR OBJECTIVE OF A FIRM

ECOMNOMIC OBJECTIVES
 MARKET SHARE
 PROFIT MARGIN
 ROI
 TECHNOLOGICAL ADVANCEMENT
 CUSTOMER SATISFACTION
 SHAREHOLDER VALUE
NON-ECONOMIC OBJECTIVES
 WORKPLACE ENVIRONMENT
 PRODUCT QUALITY
 SERVICE TO COMMUNITY
DO COMPANIES MAXIMIZE PROFITS?
CRITISICISM: COMPANIES DO NOT MAXIMIZE PROFITS BUT INSTEAD THEIR
AIM IS TO SATISFICE
Two components of criticism:
POSITION AND POWER OF STOCKHOLDERS – Medium or large sized corporations
are owned by thousand of shareholders WHO MAY OWN ONLY MINUTE INTERESTS
IN THE FIRM. Most stockholders are not well informed on how well the
corporation can do.
POSITION AND POWER OF PROFESSIONAL MANAGEMENT – High-level managers
who are RESPONSIBLE FOR MAJOR DECISION making may own very little of the
company’s stock.

MAXIMIZING THE WEALTH OF

STOCKHOLDERS
 Views the firm from the perspective of a stream of profits (cash flow) over time.

 The value of the steam depends on when cash flows occur

  Requires the concept of the time value of money: says a dollar earned in the
future is worth less than a dollar earned today.

 Future cash flows must be discounted to the present.

 The discount rate is affected by risk.

TWO TYPES OF RISK:

BUSINESS RISK – involves VARIATION IN RETURNS DUE TO THE UPS AND DOWNS
OF THE ECONOMY.
FINANCIAL RISK – CONCERNS THE VARIATION IN RETURNS THAT IS INDUCED BY
LEVERAGE.

HOW IS THE STOCK PRICE AFFECTED BY:

Changes in the SIZE of the DIVIDENDS
changes in the GROWTH of DIVIDENDS
Changes in the RISK FACED BY THE FIRM.

Another measure is called MARKET VALUE ADDED (MVA)

It REPRESENTS the DIFFERENCE BETWEEN THE MARKET VALUE OF THE
COMPANY AND THE CAPITAL THAT THE INVESTORS HAVE PAID INTO THE
COMPANY.
INCLUDES ADJUSTMENTS FOR ACCUMULATED R&D AND GOODWILL
Another measure is called ECONOMIC VALUE ADDED (EVA)
It is calculated as:
EVA = (Return on Total Capital – Cost of Capital)
If EVA is positive, shareholder wealth is increasing
If EVA is negative, shareholder wealth is being destroyed
Another measure is called FUTURE GROWTH VALUE (FVG)
It measures HOW MUCH OF THE COMPANY’S VALUE is due to expected growth.

ECONOMIC PROFITS
ECONOMIC PROFITS EQUAL revenue MINUS economic cost
TYPES OF COST
ACCOUNTING COSTS – are BASED ON HISTORICAL COSTS.
ECONOMIC COSTS are BASED ON REPLACEMENT COST and also include
opportunity cost.
 NORMAL PROFIT is the amount of profit that is equal to the profit that
could be earned in the firm’s next best alternative activity.
 IT IS THE MINIMUM PROFIT NECESSARY TO KEEP RESOURCES
ENGAGED IN A
PARTICULAR ACTIVITY.

STRATEGIC DECISION
MAKING
 Is the PROCESS OF CHARTING A COURSE BASED ON LONG-TERM GOALS
AND A LONGER-TERM VISION. By clarifying your company's big picture aims,
you'll have the opportunity to align your shorter-term plans with this deeper,
broader mission – giving your operations clarity and consistency.

UNDERSTANDING MARKETS AND

INDUSTRY CHANGES
 A MARKET HAS A PRODUCT, GEOGRAPHIC, AND TIME DIMENSION. DEFINE
THE MARKET BEFORE USING SUPPLY AND DEMAND ANALYSIS.
 MARKET DEMAND DESCRIBES BUYER BEHAVIOR; MARKET SUPPLY
DESCRIBES SELLER BEHAVIOR IN A COMPETITIVE MARKET
 IF PRICE CHANGES, QUANTITY DEMANDED INCREASES OR DECREASES
(REPRESENTED BY A MOVEMENT ALONG THE DEMAND CURVE)
 IF A FACTOR OTHER THAN PRICE LIKE (INCOME) CHANGES WE SAY THAT
DEMAND CURVE INCREASES OR DECREASES (A SHIFT OF DEMAND CURVE)
 SUPPLY CURVES - DESCRIBE THE BEHAVIOR OF SELLERS AND TELL YOU
HOW MUCH WILL BE SOLD AT A GIVEN PRICE.
 MARKET EQUILIBRIUM - IS THE PRICE AT WHICH QUANTITY SUPPLIES
EQUALS QUANTITY DEMANDED. IF THE PRICE IS ABOVE THE
EQUILIBRIUM PRICE, THERE ARE TOO MANY SELLERS, FORCING PRICE
DOWN, AND VICE VERSA.
 AT A GIVEN EQUILIBRIUM PRICE, THERE IS NO PRESSURE FOR THE
PRICE TO CHANGE GIVEN THE QUALITY OF QUANTITY DEMANDED
AND SUPPLIED.
 CURRENCY DEVALUATION IN A COUNTRY INCREASES DEMAND FOR
EXPORTS (SUPPLY TO ANOTHER COUNTRY) AND DECREASES DEMAND
FOR IMPORTS (DEMAND FOR ANOTHER COUNTRYS PRODUCTS.
 MAKING A MARKET IS COSTLY, AND COMPETITION BETWEEN MARKET
MAKERS FORCE THE BID-ASK SPREAD DOWN TO THE COSTS OF
MAKING A MARKET.

PRICES CONVEY INFORMATION

 PRICES ARE A PRIMARY WAY THAT MARKET PARTICIPANTS
COMMUNICATE WITH ONE ANOTHER
 BUYERS SIGNAL THEIR WILLINGNESS TO PAY
 SELLERS SIGNAL THEIR WILLINGNESS TO SELL WITH PRICES
 PRICE INFORMATION ESPECIALLY IMPORTANT IN FINANCIAL
MARKETS