Managerial Economics :

Introduction to Managerial
Economics
What is economics :
 Economics is a social science. Its basic function is to study how
people –individuals, households,firms & nations maximize their gains
from their limited resources & opportunities.

 Economics is obviously a study of the choice-making behaviour of the

people. In reality, however, choice making is not so simple as it looks
because the economic world is very complex & most economic
decisions have to be taken under the condition of imperfect
knowledge, risk & uncertainty.
Why Study Economics?
 An important reason for studying economics is to learn a
way of thinking.

 Three fundamental concepts:

 Opportunity cost

 Marginalism, and

 Efficient markets
Opportunity Cost

 Opportunity cost is the best alternative that we forgo, or

give up, when we make a choice or a decision.

 Nearly all decisions involve trade-offs.

Marginalism

 In weighing the costs and benefits of a decision, it is

important to weigh only the costs and benefits that arise
from the decision.
Marginalism
 For example, when a firm decides whether to produce
additional output, it considers only the additional (or
marginal cost), not the sunk cost.

 Sunk costs are costs that cannot be avoided, regardless

of what is done in the future, because they have already
been incurred.
Efficient Markets
 An efficient market is one in which profit opportunities are
eliminated almost instantaneously.

 There is no free lunch! Profit opportunities are rare

because, at any one time, there are many people searching
for them.
More Reasons to Study Economics
 The study of economics is an essential part of the study of
society.

 Economic decisions often have enormous consequences.

 During the Industrial Revolution, new manufacturing

technologies and improved transportation gave rise to
the modern factory system.
More Reasons to Study Economics
 An understanding of economics is essential to an
understanding of global affairs.

 Voting decisions also require a basic understanding of

economics.
The Method of Economics

 Positive economics studies economic behavior without

making judgments. It describes what exists and how it
works.
The Method of Economics

 Normative economics, also called policy economics,

analyzes outcomes of economic behavior, evaluates them
as good or bad, and may prescribe courses of action.
The Method of Economics

 Positive economics includes:

 Descriptive economics, which involves the compilation

of data that describe phenomena and facts.

 Economic theory, which involves building models of

behavior.
 An economic theory is a general statement of cause

and effect, action and reaction.

Define managerial economics :

 Managerial economics is the discipline that deals with the

application of economic concepts, theories &
methodologies to the practical problems of business/firms
in order to formulate rational managerial decisions for
solving those problems.
Definitions Contd…….

 According to Mansfeild,” Managerial economics is

concerned with the application of economic concepts &
economics to the problem of formulating rational decision
making.”

 According to Douglas, “ Managerial economics is concerned

with the application of economic principles & methodologies
to the decision-making process within the firm or
organization. It seeks to establish rules & principles to
facilitate the attainment of the desired economic goals of
management.
Why Managerial Economics?

 A powerful “analytical engine”.

 A broader perspective on the firm.
 what is a firm
 what are the firm’s overall objectives?
 what pressures drive the firm towards profit and away
from profit
 The basis for some of the more rigourous analysis of issues
in Marketing and Strategic Management.
Links between Managerial Economics
and Management Science

 Managerial Economics: is often concerned with finding

optimal solutions to decision problems.However, the
primary purpose of using models is to predict how firms will
behave, not to advise them what ought to do. Managers are
assumed to find the optimal solutions for themselves and that
is how predictions are made.
 Management science: is essentially concerned with
techniques for the improvement of decision-making and
hence it is essentially normative;firms are not assumed to
find the optimal solutions for themselves. They are found by
the researchers who then present them as prescriptions for
what the firm should do.
Relationship between Managerial
Economics and Related Disciplines
Management
Decision Problems

Economic Concepts Decision Sciences

Managerial
Economics

Optimal Solutions to Managerial

Decision Problems
Management Decision Problems

 Product Price and Output

 Make or Buy
 Production Technique
 Stock Levels
 Advertising Media and Intensity
 Labor Hiring and Training
 Investment and Financing
Economic Concepts

Framework for Decisions

 Theory of Consumer Behaviour

 Theory of the Firm

 Theory of Market Structure and Pricing

Decision Sciences

Tools and Techniques of Analysis

 Numerical Analysis

 Statistical Estimation

 Forecasting

 Game Theory

 Optimization

 Simulation
Managerial Economics

 Use of Economic Concepts and Decision

Science Methodology to Solve Managerial
Decision Problems
THE GOALS OF A FIRM
Economic Goals:
Maximizing or Satisficing
1. Profit
2. Market share
3. Revenue growth
4. Return on investment
5. Technology
6. Customer satisfaction
7. Shareholder value
THE GOALS OF A FIRM contd…….
Non-economic Objectives:

 “A good place for our employees to work”

 “Provide good products/services to our customers”

 “Act as a good
Optimal Decision:

Given the goal(s) that the firm is pursuing, the optimal

decision in managerial economics is one that brings the
firm closest to this goal.
Making decisions and processing information are
the two primary tasks of managers :

Examples:

 Whether or not to close down a branch of the firm?

 Whether or not a store or restaurant should stay open
more hours a day?
 How a hospital can treat more patients without a
decrease in patient care?
Role of Managers Contd……….

 How a government agency can be reorganized to be

more efficient?

 Whether to install an in-house computer rather than pay

for outside computing services?
Why Managers need to know
economics :
 Economics contributes a great deal towards the
performance of managerial duties & responsibilities.

 All other qualifications being the same, managers with a

working knowledge with economics can perform their
functions more efficiently than those without it.
 The basic function of the managers of a business firm is to
achieve the objective of the firm to the maximum possible
extent with the limited resources placed at their disposal.
Contd……..
 All these, as well as many other managerial
decisions require the use of basic economics.

 Economic theory helps decision makers to know what

information is necessary in order to make the decision
and how to process and use that information.
Questions that managers must
answer:
 Should our firm be in this business?
 If so, what price and output levels achieve our goals?
 How can we maintain a competitive advantage over our
competitors?
 Cost-leader?

 Product Differentiation?

 Market Niche?

 Outsourcing, alliances, mergers, acquisitions?

 International Dimensions?
Questions that managers must
answer:
 What are the economic conditions in a particular
market?
 Market Structure?

 Supply and Demand Conditions?

 Technology?

 Government Regulations?

 International Dimensions?

 Future Conditions?

 Macroeconomic Factors?
DMs Optimize

We should emphasize that practically in all managerial

decisions the task of the manager is the same!

Namely, each goal involves an optimization problem.

Contd………
The manager attempts either to maximize or minimize some
objective function, frequently subject to some
constraint(s).

And, for all goals that involve an optimization problem, the

same general economic principles apply!
The Scope of Economics

 Microeconomics is the branch of economics that

examines the behavior of individual decision-making units
—that is, business firms and households.

 Macroeconomics is the branch of economics that

examines the behavior of economic aggregates— income,
output, employment, and so on—on a national scale.
 industries services wealth Number of employees
Microeco and   Wages in in a firm
business
nomics Price of the auto  
How much medical industry
steel care Minimum
How many Price of wages
offices gasoline Executive
  Food prices salaries
How many Apartment poverty
cars rents

Macroeco National Aggregate National Employment and un

nomics production / price level income employment in the
output   Total wages economy
Total Consumer and salaries Total number of jobs
industrial prices Total Unemployment
output Producer corporate Rate
Gross prices profits
domestic
Rate of
product
inflation
Growth of
output
Business Objectives
and Basic Models of the Firm
Objectives:
1. the assumptions of the neo-classical (or profit-
maximising) model of the firm and the limitations
of the model
2. the differences between the profit-maximising
model and the managerial models of the firm
3. the differences between the profit-maximising
model and the behavioural model of the firm
The Assumptions of the Neo-classical
Model of the Firm

 The firm is a profit-maximiser - it optimises

 The firm can be treated in a holistic way

 There is perfect certainty

Contd……….

Assumption 1:

 The firm is a profit-maximiser: it is assumed to make as

much profit as possible.

 This means that the model is an ‘optimising’ model: the

firm attempts to achieve the best possible performance,
rather than simply seeking “feasible” performance which
meets some set of minimum criteria.
The profit-maxing assumption can be
interpreted in two ways:

1. Maximisation of profit in the short-run

i.e. the firm has a given set of plant and equipment and makes as
much profit as it can with that
2. Long-run profit maximisation
i.e. maximise the wealth of the shareholders
In most situations these are consistent with each other. Shareholder
wealth is maximised by selecting the most profitable set of plant
and equipment and then operating it in the most profitable way.
But there may be exceptions - making maximum short term
profit might trigger entry or government intervention
Contd………..

Assumption 2:

It is a holistic model: the firm is a single entity which has

objectives of its own and which can be said to take
decisions.
contd ……….
Assumption 3:

It assumes perfect certainty. Cost and demand conditions are

perfectly known.
The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 STEP BY STEP TO THE MODEL

P1

Demand: Average Revenue

P2

Q1 Q2 Quantity Produced
The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 STEP BY STEP TO THE MODEL
$

Demand: Average Revenue

Quantity
Produced

Marginal Revenue
 The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 WHAT IS THE EQUILIBRIUM?
Marginal Cost

Profit
maximising
price Demand: Average Revenue

Profit Quantity
Marginal
Produced
maximising Revenue
output
The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output which gives
the biggest difference between revenue and costs.
 MORE DETAIL ON THE EQUILIBRIUM

Marginal Cost

Average Cost
Profit
maximising
price Demand: Average Revenue

Quantity Produced
Profit
Marginal Revenue
maximising
output
What Can We Do With This Model?
 Comparative Statics
 begin with an initial equilibrium position - the starting point

 change something

 identify the new equilibrium, e.g:

 When demand increases?

 When costs rise?

 When a fixed cost increases?

 This is the main purpose of the model -what it was designed to do

 Normative prescriptions
 it will cost me $30 per unit to supply something which will give me $20 per unit

in revenue- should I do it?

 I must pay $20 billion to set up in my industry. Should I charge higher prices to

get that money back?

 Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit
what will it do/what should it do?
 The assumptions of profit-maximisation has
been criticised in a number of ways; so we
have:

 The “Managerial School”

 The “Behavioural School”

“Managerial” Criticisms of the Profit-
Maximising Model
 Berle and Means (1932)

 firms are owned by shareholders but controlled by

managers

 owners’ and managers’ interests are different

 managers have discretion to use the firm’s resources in

their own interests
The Managerial School argues that:
1. Ownership and control are in the hands of different groups of people.
2. The interests of owners (shareholders) and Controllers (managers) are
different.
3. Managers have the power to let their interests over-ride those of the
shareholders.
4. Therefore firms are run in the interests of the managers.
In place of the profit-maximising model, the managerial school substitute a
variety of alternatives - sometimes referred to as managerial discretion
models
Sales-revenue maximising (Baumol) Managerial utility maximising
(Williamson)
Managerial Discretion Models of
the Firm

 Baumol’s Sales Revenue Maximising Model

 managers’ rewards seem to be more closely linked to

size than to profit

 therefore, firms aim to maximise sales revenue

 but subject to a profit constraint

Baumol’s Model
TR
$
TC

Profit

Level of
Output
Comparison of Baumol’s Model with
the Profit-Maximising:
 A. The unconstrained version
 Price?

 Output?

 Profit?

 B. The constrained version

 depends where the constraint is

 note what happens if the constraint is so tight that

maximum profit is required

Comparative Statics of
Baumol’s Model

 What if demand rises?

 What if fixed costs change?

 What if variable costs change?

Behavioural Model of the Firm [Simon (1959),
Cyert and March (1963)]

 the firm hardly exists; it consists of a group of people with

multiple objectives
 decision-makers exhibit “satisficing” behaviour;
organisational slack/X-inefficiency
 problem-oriented search using rules of thumb, which are a
function of the past experience of the firm and the people
within it
 organisational learning: meeting all objectives; then
raising aspiration levels. If cannot meet; then reducing
aspiration levels
The Behavioural Approach

 the firm does not exist - it is a set of shifting coalitions of

individuals
 individuals and groups do not maximise - they “satisfice”
 information about the environment is very limited
 organisations do not have objectives, only people have
objectives”
The Behavioural Approach

 If all aspirations are being met - everyone is satisfied - do

nothing

 But then aspiration levels will rise until someone is not

satisfied

 Then rules of thumb used to find solutions to “the

problem”
The Behavioural Approach

 Aspiration levels, which adjust according to experience

 Problem-oriented ‘rules of thumb’ based on past
experience
 A dynamic model
 not “holistic”
 not “deterministic”
 not optimising
A comparison of alternative
models of the firm
Profit-max Managerial Behavioural

Objective Profit-
maximising
Ownership Same
management

Decision- Optimising
making

Environment Certainty

Holistic? Yes
Which Approach is Most Useful?

 Behavioural approach is a more accurate description of

what happens inside the firm.
 But it tells us almost nothing about how the firm will
respond to changes in the environment.
 To use it to make predictions about how the firm will react
to changes in the environment we need to know everything
about the individual firm.
 However, if shareholders are a powerful group and their
aspiration level requires making maximum profit the firm
will again behave in the same way as a profit-maxi miser.
In Conclusion?

 The behavioural approach is a useful complement to the

profit-maximising and managerial approaches, not a
substitute for them.