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PRELIM (03)
(for lectures and discussions only)
Book references and other readings:
1. Managerial Economics 3rd Edition
By Luke M. Froeb, Brian T. McCann, Michael R. Ward, Michael Shor
Copyright 2014 Cengage Learning Asia Pte Ltd
2. Fundamentals of Managerial Economics by Mark Hirschey
Copyright 2009 Cengage Learning
3. Economics (principles, problems, and policies) by Campbell R. McConnell
and Stanley L. Brue
Copyright 2005 by The McGraw-Hill Companies, Inc.

Business Decision Making

General Rule in making a decision.
In making decisions, individual should consider all relevant cost and benefits needed
to come out with profitable decisions. Considerations are only on those costs and
benefits that vary with the consequence of the decision. Those are the relevant costs
and relevant benefits.

Two types of mistakes managers encounter in decision making

1. Sunk-cost fallacy- means that managers consider costs and benefits that do not
vary with consequences of their decision that is making decisions using irrelevant
costs and benefits.
Example:
a. You watch a movie and in the middle of the show you realized than the movie
makes no sense and not worth your time, however you decided to finish the
movie because you want to get back the money’s worth of your paid ticket.
However, either you stay or not the price of the ticket remains the same, as
such the ticket price is not relevant to the decision of finishing or not the
movie.
b. Overhead Cost is independently decided in business, if you are going to
increase output let us say from 1,000 to 1,500 units, you do not have to
consider the manager’s salary in making the decision in increasing the output
since the manager’s salary remain the same either you increase or not your
output. So, overhead cost is irrelevant in that decision.
2. Hidden-cost fallacy- means that the manager ignores relevant costs, those cost
that do vary with the consequences of his decision.
Example.
a. In order to increase sales, salespeople offered sales credit to everyone
without considering credit investigations as such the salespeople did not
 consider the hidden cost of default (non-payment) risks that go with it, which
is a relevant cost in offering sales credit.

Suggested guide in business problems-solving

1. Begin with business problems – putting the particular ahead of abstract
2. Use economic analysis to identify profitable decisions – how to use rational-
behavior concept to identify problems and solutions
3. Find ways to implement them – designing an organization where employees
have enough information to make profitable decisions and the incentive to do so.

Problem solving guide-questions:

1. Who is making the decisions?
2. Do they have enough information to make a good decision;
3. Incentive to do so?

The answers to the above questions will lead to the source of problems and
potential solutions
1. Let someone else make decision, someone with better information or
incentives.
2. Give more information to the current decision maker
3. Change the current decision-maker’s incentives.

The problem-solving guide considers the rational-behavior concept, that means people
act rationally, optimally, and self-interestedly. Rational-behavior concept shows why
people behave the way they do and similarly shows ways how to motivate them to
change. That means to change behavior, changes in self-interest are necessary as
such changes in incentives should be considered.
Example:
An investigative group sent a representative with a perfectly good car into a repair shop
by Repair Car Corp.

The representative then came out of the repair shop with a new muffler and
transmission and of course a bill around 30,000 pesos. The event came out in the press
and consumers start to avoid the repair shop so the Repair Car Corp. revenue declines.

1. Who make the bad decisions? The mechanic recommended the unnecessary
repairs.
2. Does the decision-maker have enough information to make a good decision?
Yes, the mechanic knows whether repairs are necessary or not.
3. Does the mechanic have incentive to make a good decision? NO, the
mechanic is evaluated based on the amount of repair work he does, and receives
bonuses or commissions tied to the amount of repair work.

Costs and Benefits

There are two costs being considered in business operations accounting as such there
are also two measurements of profit.
Cost
To obtain or retain the services of resources for business operations, payment must be
made and that is what economists referred to economic costs.

Economics costs includes both the explicit cost and implicit cost:
A. Explicit costs are those costs found in the accounting records. It is the monetary
payments or cost paid to providers of resources for the use of such resources
which the firm does not own. It is considered a cash transaction.
B. Implicit costs are the opportunity costs of any resources used by the firm that
they already owned.
The firm uses those resources to produce their product rather than selling or
renting it to others to obtain cash.
Opportunity costs are defined as the costs of what the firm gave up or the cost of
an alternative or cost of forgone opportunity.

In an equation, economic cost=explicit cost + implicit cost

Profit
There are two kinds of profit and it is measured differently:

Accounting profit are measured after the deduction of all cost from the total revenue
however it only includes the cost recorded from the accounting book of the firm that
means

Accounting profit= revenue – explicit costs

However, economic profit is measured after deducting all the economic cost from the
total revenue that means it includes both implicit and explicit costs which comprise the
economic costs.

Economic profit = revenue-explicit cost-implicit cost

In business operations all relevant costs must be considered including the costs that
does not appear in the accounting book in order to reach business decisions as well as
to measure profits.

Profits
Profit margin is usually measured in monetary terms (Peso, dollar, yen). It is the price
less all the cost, let us say you have 100 pesos comprising all the cost in producing the
goods and distributing it to the ultimate consumer and a 10 percent was added to the
cost to come out with a price of goods/unit at 110 then you can consider a profit margin
of 10 percent. Profit then is equal to Price minus Cost times Quantity of goods sold,
Profit=(P-C) x Q.

Costs and their relationships

Cost affects output, profit, and pricing as such understanding the relevant and irrelevant
cost in decision making is an important factor that leads to a good and right decision.
Understanding Costs is necessary since what we have are scarce resources with an
alternative use. Efficient allocation of resources leads to high benefits and least cost.

Distinguishing costs in the short-run horizon

Fixed Costs (FC) are cost that remain the same or does not vary with changes in the
amount or level of output example are lands, buildings, machineries.
Variable Costs (VC) are those costs that vary as we change the amount or level of
output that includes fuel, raw materials, labor, transportation services and others.
Total Cost (TC) is the amount of Fixed Cost plus the Variable Cost (TC=FC+VC).
Average Fixed Cost (AFC) = Total Fixed Cost divided by the Quantity (TFC/Q)
Average Variable Cost (AVC)= Total Variable Cost divided by the Quantity (TVC/Q)
Average Total Cost (ATC)= Total Cost divided by the Quantity (TC/Q).
Marginal Cost (MC) is an extra or add up cost for producing additional unit of output
which is computed as Marginal Cost= change in Total Cost divided by the change in
Quantity (MC= change in TC/change in Q)

4th week
Relations of Marginal Cost to Average Total Cost and Average Variable Cost
When the Marginal Cost is less than Average Variable Cost and less than Average
Total Cost, both Average Total Cost and Average Variable Cost are decreasing or
falling. (MC < ATC, AVC means that ATC, AVC are decreasing or falling)
If Marginal Cost is higher than Average Total Cost, the Average Total Cost will rise or
increases. (MC > ATC, ATC then rises or increases.
If Marginal Cost is higher than Average Variable Cost, the Average Variable Cost will
rise or increases. (MC > AVC, then AVC rises or increases.
If Marginal Cost is equal to the Average Variable Cost, Average Variable Cost is on the
minimum amount. (MC=AVC, AVC is at minimum amount or point).
If Marginal Cost is equal to the Average Total Cost, Average Total Cost is on the
minimum amount. (MC=ATC, ATC is at minimum amount or point).
Average Fixed Cost do decline as level of output increases.
As level of output increases, Average Variable Cost decreases then reaches a minimum
point or amount and then increases. Such behavior of AVC is due to the Law of
Diminishing Returns which states that as successive unit of a variable resource are
added to a fixed cost, the additional per unit output for each additional unit of the
variable resource decrease.

In a Long-run horizon, there is no distinction between fixed and variable costs since all
the resources used are variable in nature that include the land, building, raw materials,
machineries, transportation services,
Labor hence all costs are also variable.
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