CHAPTER 1 The Nature and Scope of Managerial Economics KEY TERMS CHAPTER OUTLINE (9 order of their appearance) | a 2 Managerial economics. Definition of Managerial Economics” Economic theory Relationship to Economic Theory Microeconomics ‘Relationship to the Decision Sciences. Macroeconomics Relationship to the Functional Areas of Business Administration Studies Mooel Case Study 1-1: Decision Making in Business and Military Strategy Mathematical economics Case Study 1-2: The Management Revolution Econometrics 1-2. The Theory of the Firm Functional areas of business Reasons for the Existence of Firms and Their Functions Scriietaton stxkes ‘The Objective and Value of the Firm baal Constraints on the Operation of the Firm Transaction costs Umitations of the Theory of the Firm Circular flow of economic activity Case Study 1-3: The Objective and Strategy of Fiems in the Cigarette Industry Lamhe ine frm (Case Study 1-4: The Virtual Corporation . eee 1-3. The Nature and Function of Profits Constrained optintzation Business versus Economic Profit Principal-agent problem ‘Theories of Profit Satisficing behavior Function of Prof Business profit Case Study 1-5: Profits inthe Personal Computer Industy Sees oa 1-4 The International Framework of Managerial Economics See Case Study 1-6: The Rise'ol the Globat Corporation owen a Case Study 1-7: Training Global Executives, ectuty Case Study 1-8: The Business Leader of ‘the Future ‘Summary * Discussion Questions + Problems Appendix: The Basics of Demand, ‘Supply,-and Equilibrium ‘The Demand Side of the Market ‘The Supply Side of the Market The Equilibrium Price : Shift in the Domand Curve and Equilibrium Shift in the Supply Curve and Equilidrium . Cane Study 1-9; Cranges in Demand and Supply and the Price of PCS Supplementary Readings41-1 In this chapter we examine the nature and scope of managerial economics. We begin with a definition of managerial economics and a discussion of its relation- ship to other fields of study. We then go on to examine the theory of the firm. Here, we discuss the reason for the existence of firms and their functions, and we define the value of the firm, examine the constraints faced by firms, and examine the limitations of the theory of the firm, including the so-called principal-agent problem. Subsequently, we examine the nature of profits by distinguishing between economic and business profits and by analyzing their function in a free- enterprise system. Finally, we examine the importance of introducing an interna- tional dimension into managerial economics to reflect the globalization of pro- duction and distribution in today’s world. In the appendix, we review the basics of demand, supply,.and equilibrium, Each section of the chapter includes one or more real-world case studies which clearly illustrate the major concept introduced in the particular section. This is an important chapter because it defines the subject matter of managerial economics, it clearly shows its relationship to other fields of study, and it examines the great importance and relevance of managerial economics in all business and economic decision-making situations and programs in today’s global economy. THE SCOPE OF MANAGERIAL ECONOMICS In this section we define the function of managerial economics and examine its relationship to econgmic theory, management decision sciences, and functional areas of business administration studies. |Pefinttion of Managerial Economics Managerial economics* refers to the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its aims or objectives most efficiently. The meaning of this definition can best be examined with the aid of Figure'l-1} Management decision problems (see the top of Figure 1-1) arise in any orga- nization—be it a firm, @ not-for-profit organization (such as a hospital or a university), or a government agency—when it seeks to achieve some goal or ob- jective subject to some constraints. For example, a firm may seck.to maximize profits subject to limitations on the availability of essential inputs and in the face of legal constraints. A hospital may seek to treat as many patients as possible at an “adequate” medical standard with its limited physical resources (physicians, technicians, nurses, equipment, beds) and budget. The goal of a state university may be to provide an adequate education to as many students as Possible, sub- ject to the physical and financial constraints it faces. Similarly, a government agency may seck to provide a particular service (which cannot be provided as “The definition of all bokdfaced terms, arranged alphabetically, is provided in the Glossary at the end of the book. 3 | f {Uf. 4 Part One: Introduction Management decision problems Decision sciences: Mathematical economics, ‘macroeconomics | MANAGERIAL ECONOMIC: Application of economic theory «and decision seience tools to solv managerial decision problems ; OPTIMAL SOLUTION TO MANAGERIAL DECISION PROBLEMS Figure 1-1 ‘The Nature of Managerial Economics Managerial economics fefers to the application of economi find the optimal soluti a Ne theory and decision science tools to ‘on to managerial decision problems, efficiently by business fir cost, In all these cases, the it secks to achieve its goal Boals and constraints may Process is the same. Science. Ee: Nes. Mictoeconomi ision-making units, ness firms, in a free-en, he study of the total oy nption, investment nicroeconomic) thy ‘Onomic theory refers ics is the study: of the such as individual con- terprise system. Macro- Faggregare level of out- 1 and prices fur the economy ory of the firm is the single lacroeconomi economic behavior of individual deci sumers, resource owners, and busy economics, on the other hand, is ¢ put, income, employment, consun mewed as a whole. While the imChapter 1: The Nature and Scope of Managerial Economics & most important clement in managerial economics, the general macroeconomic conditions of the economy (suctt as the level of aggregate demand, rate of infla~ tion, and interest rates) within which the firm operates are also very important. Economic theories seck to predict and explain economic behavior. Feono- mic theories usually begin with a model. This abstracts from the many details surrounding an event and secks to identify a few of the most important determi- nants of the event, For example, the theory of the firm assumes that the firm secks to maximize profits, and on the basis of that it predicts how much of a particu- lar commodity the firm should produce under different forms of market structure or organization, While the firm may have other (multiple) aims, the profit- maximization model accurately predicts the behavior of firms, and, therefore, we accept it. Thus, the methodology of economics {and science in general) is to ac- cept a theory ox model if it predicts accurately and if the predictions follow logically from the assumptions.! Relationship to the Decision Sciences Managerial economics is also closely related to the decision sciences. These uti- lize the tools of mathematical economics and econometrics (see Figure 1-1) to construct and estimate decision models aimed at determining the optimal behav- ior of the firm (i. how the firm can achieve its goals most efficiently). Specifi- cally, mathematical economics is used to formalize (i.e., to express in equational form) the economic models postulated by economic theory. Econometrics then applies statistical tools (particularly regression analysis) to real-world data to estimate the models postulated by economic theory and for forecasting. For example, economic theory postulates that the quantity demanded (0) of a commodity is a function of or depends on the price of the commodity (P), the income of consumers (¥), and the price of related (ie., complementary and sake suture) commodities (Pc and Py, respectively). Assuming constant tastes, we may postulate the following formal (mathematical) model: : * - Q=APY. Pe, Py) (1) By collecting data on Q. P, ¥, Pe, and P, for a particular commodity, we can then estimate the empirical (economessic) relationship, This will permit the hers vec sermine how much Q would change by a change in P.¥. Pq and Pe anne ee cast the future demand for the commodity. This information i esteneal one, for management to achieve the goal or objective of the firm (profit maranenc nrost efficiently. t , ea To conclude, “managerial economics” refers to the application ot economic theory snd decison science tools to Gnd the optimal suloneet sion problems, 1 t0 managerial deci- The Methodalogy af Penitive ty Chicago Press, 195M, and ML How: Peeseamasty Explain (Cambradge, Exghind: Cau in Lstays me Positive Economics Mie The Methudtulogy of Eeamomecs and odge University Press, 1180)Introduction 6 Part One: i Aroas lationship to the Functional Tr wesinees Administration Studies Having defined the subject matter of managerial cone and its function we can now examine the relationship between mgnagerial economies and the functional areas of business administration studies. fhe latter include accounting, finance, marketing, personnel or human resource management, and production, These disciplines study the business environment in which the firm operates and, assuch, they provide the background for managerial decision making. Thus, man- agerial economics can be regarded as an overview course that integrates economic theory, decision sciences, and the functional areas of business administration stud- ies; and it examines how they interact wi achieve its goal most efficiently. } Most students taking managerial economics are like! edge (from other courses) of some of the topics presente utilized in managerial economics. others, the student should pay par Process by which the firm can achi of managerial economics, In short, managerial econo: utilization of economic theory firm can achieve its objective which it operates. If all stud taken courses in microecon th one another as the firm attempts to y to have some knowl- d and tools of analysis While reviewing these topics and studying the cular attention to the overall decision-making lve its objective, since this is the ultimate goal mics is not the study of a number of topics but the and management science tools to examine how a ‘most efficiently within the business environment in lents in’ a managerial economi jomic arid macroecon must also present ial decisions, Case Study 1-4 Decision Making In Business itrategy and Military 81