MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter 1

INTRODUCTION
 OBJECTIVES

• Provide a guide to making good managerial decisions.

• Use formal models to analyze the effects of managerial
decisions on measures of a firm’s success.
• Use these models to shed light on business concepts
• cost, demand, profit, competition, pricing,
compensation, market entry strategy, and auction
strategy.
• All these concepts are under the control of managers, and
they determine fi rm performance.
 MANAGERIAL ECONOMICS

• Differs from microeconomics

• The focus in microeconomics is at the firm level and
often at the market level.
• Microeconomics is descriptive
• Managerial economics is prescriptive.
• Is an integrative course
• Brings the various functional areas of business together
in a single analytical framework
 MANAGERIAL ECONOMICS

• Exhibits economies of scope

• Integrates material from other disciplines
• Reinforces and enhances understanding of those
subjects
• Managerial economics recognizes the complexity of the
managerial world---most integrative of the functional
business classes.
• Helps students learn integrative mind-set that is essential
for good management,
• Long-term vs short-term mentality
 THEORY OF THE FIRM

• Managers work within a larger organization and ultimately

determine its performance.
• To understand the behavioral world of managers, we must
account for the behavior of firms.
• Firms controlled by managers
• Although management styles differ greatly in the millions of
firms across the globe, managers primarily choose actions
they believe will increase the values of their organizations.
• So in our theory of the firm, the goals of managers focus
on increasing this value.
 THEORY OF THE FIRM

• There are many ways to create value in an organization.

• For example, to a microcredit organization with a double
bottom line, value from its lending practices might consist
of a profit measure and the gains to a local
• community’s economy.
• Our models must account for behavior across a great
number of firms
• We take the view that managers in profit-oriented
organizations try to increase the net present value of
expected future cash flows.
 THE THEORY OF THE FIRM

• Managerial Objective
• Make choices that increase the value of the firm.
• The value of the firm is defined as the present value of
future profits.
 THE THEORY OF THE FIRM

• Managerial Choices
• Influence total revenue by managing demand
• Influence total cost by managing production
• Influence the relevant interest rate by managing
finances and risk
• Managerial Constraints
• Available technologies
• Resource scarcity
• Legal or contractual limitations
 MANAGERIAL CONSTRAINTS

• For example, managers may be bound to pay wages

exceeding a certain level because of minimum wage laws
• Also, they must pay taxes in accord with federal, state, and
local laws.
• Further, managers must comply with contracts with
customers and suppliers—or take the legal consequences.
• A wide variety of laws (ranging from environmental laws to
antitrust laws to tax laws) limit what managers can do, and
contracts and other legal agreements further constrain their
actions.
 WHAT IS PROFIT?

• Firm value is largely a function of profit.

• Unlike in accounting, in managerial economics we measure
profit after taking account of the capital and labor provided
by the owners.
• For example, suppose a manager quits her position at a
large firm to create a small start-up business.
• She receives no salary even though she puts in long hours
trying to establish her business.
 WHAT IS PROFIT?

• If she worked these hours for her previous firm, she would
have earned $65,000.
• And if she had invested the capital she used to begin her
business in some alternative investment, she could have
earned $24,000.
• Let’s say in 2012 her start-up firm earned an accounting
profit of $100,000. Her fi rm’s profit in the managerial
economics world is $100,000 - $65,000 - $24,000 =
$11,000 rather than the $100,000 shown in accounting
statements.
 WHAT IS PROFIT?

• The differences between the profit concepts used by the

accountant and the economist reflect a difference in focus.
• The accountant is concerned with controlling the firm’s
day-to-day operations, detecting fraud or embezzlement,
satisfying tax and other laws, and producing records for
various interested groups. The economist is concerned
with decision making and rational choice among strategies.
• Although most of a firm’s financial statements conform to
the accountant’s and not the managerial economist’s
concept of profit, the latter is more relevant for managerial
decisions.
 WHAT IS PROFIT?

• Two Measures of Profit

• Accounting Profit
• Historical costs
• Legal compliance
• Reporting requirements
• Economic Profit
• Market value
• Opportunity, or implicit cost
• More useful measure for managerial decision making
 PROFIT

• Measures the quality of managers’ decision-making skills

• Encourages good management decisions by linkage with
incentives
 SOURCES OF PROFIT

• Innovation
• Producing products that are better than existing
products in terms of functionality, technology, and style
• Risk Taking
• Future outcomes and their likelihoods are unknown, as
are the reactions of rivals.
• Exploiting Market Inefficiencies
• Building barriers to entry, employing sophisticated
pricing strategies, diversifying, and making good
strategic production decisions
 THE PRINCIPAL–AGENT PROBLEM

• Although managerial economists generally assume that

managers want to maximize profit (and hence firm value,
as defi ned in equation (1.1)), they recognize additional
goals.
• Some goals may enhance the firm’s long-term value, like
building market share or establishing a brand name.
• Other managerial goals have less to do with firm value and
more to do with increasing managerial compensation.
• The model recognizes preferences of firm owners and
managers sometimes diverge.
 THE PRINCIPAL–AGENT PROBLEM

• Separation of ownership and control

• The principals are the owners.
• They want managers to maximize the value of the firm.
• The agents are the managers.
• They want more compensation and less accountability.
• The divergence in goals is the principal–agent problem.
• Managers are agents who work for the firm’s owners, who
are shareholders or principals.
• The principal–agent problem centers on whether managers
may pursue their own objectives at a cost to the owners.
 THE PRINCIPAL-AGENT PROBLEM

• To deal with this problem, owners often use contracts to

converge their preferences and those of their agents.
• For example, owners may give managers a financial stake
in future success.
• Many corporations use stock option plans, whereby
managers can purchase shares of common stock at less
than market price.
• These plans give managers incentives to increase firm
profit and comply with owners’ interest.
 MORAL HAZARD

• Moral hazard exists when people behave

differently when they are not subject to the risks
associated with their behavior.
• Managers who do not maximize the value of the
firm may do so because they do not suffer as a
result of their behavior.
 SOLUTION: MORAL HAZARD

• Devise methods that lead to convergence of the

interests of the firm’s owners and its managers
• Examples: stock option plans or bonuses linked to
profits
 DEMAND AND SUPPLY: A FIRST LOOK

• To understand behavior in any society, we must have a

working knowledge of its institutions.
• The managerial world revolves around markets. Any
manager must understand basic market
• principles in order to anticipate behavior.
• We first give an overview of markets and then examine
both the demand and supply sides in greater detail
• A market exists when there is economic exchange; that is,
multiple parties enter binding contracts.
 DEMAND AND SUPPLY: A FIRST LOOK

• Market
• A group of firms and individuals that interact with each
other to buy or sell a good
• Part of an economy’s infrastructure
• A social institution that exists to facilitate economic
exchange
• Relies on binding, enforceable contracts
 DEMAND SIDE OF A MARKET

• Every market consists of demanders and suppliers. A

manager needs to know how potential customers value a
product or service and must estimate the quantity of goods
demanded at various prices.
• One goal of managers is to maximize firm value. The ability
to focus on profit requires a thorough knowledge of
demand, especially the behavior of revenue as price
changes.
• Total revenue is equal to the number of units sold (Q)
multiplied by the price (P) at which they were sold
(TR = P * Q).
 THE DEMAND SIDE OF THE MARKET

• Demand Function
• Quantity demanded relative to price, holding other
possible influences constant
• Negative slope
• Period of time
• Shifts in demand
 THE DEMAND SIDE OF THE MARKET

• Other Influences (held constant)

• Income
• Prices of substitutes and complements
• Advertising expenditures
• Product quality
• Government fiat
 THE DEMAND SIDE OF THE MARKET

• Total Revenue Function

• A firm’s total revenue (TR) for a given time period is
equal to the price charged (P) times the quantity sold
(Q) during that time period.
• TR = P x Q
• The demand function reflects the effect of changes in P
on quantity demanded (Q) per time period and, hence,
the effect of changes in P on TR.
THE MARKET DEMAND CURVE FOR COPPER,
WORLD MARKET

Managerial Economics, 8e
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 MARKET DEMAND CURVE FOR COPPER

• The demand curve shows the global quantity of copper

demanded at all prices. Any demand curve pertains to a
particular period of time, and the shape and position of the
demand curve can depend on the period length.
• The demand curve for copper slopes downward to the
right. In mathematical terms, we say it has a negative
slope; that is, the quantity of copper demanded increases
as the price falls.
• This is true for most commodities: They almost always
slope downward to the right.
 MARKET DEMAND CURVE

• Any demand curve is based on the assumption that other

influences like tastes and incomes are held constant.
Changes in any of these factors are likely to shift the
position of a commodity’s demand curve.
• So if consumers’ tastes shift toward goods that use
considerable copper or if consumers’ incomes increase
(and they thus buy more goods using copper), the demand
curve for copper will shift to the right.
• In other words, holding the price of copper constant, more
copper is demanded at any price.
 THE SUPPLY SIDE OF A MARKET

• Supply Function
• Quantity supplied relative to price, holding other
possible influences constant
• Positive slope
• Period of time
• Shifts in supply
• Other influences (held constant)
• Technology
• Cost of production inputs (Land, Labor, Capital)
THE MARKET SUPPLY CURVE FOR COPPER,
WORLD MARKET

Managerial Economics, 8e
Copyright @ W.W. & Company 2013
 MARKET SUPPLY CURVE

• Note the supply curve slopes upward to the right. In

mathematical terms, we say it has a positive slope; in other
words, the quantity of copper supplied increases as the
price rises. Higher prices provide an incentive to suppliers
to produce more copper to sell.
• Any supply curve is based on the assumption that
production technology is held constant. If lower-cost
production technology is developed, then managers will be
willing to sell more units at any price.
• That is, technological change often causes a supply curve
to shift to the right.
 MARKET SUPPLY CURVE

• The supply curve for a product is affected by the cost of

production inputs (labor, capital, and land).
• When costs of inputs decrease, managers realize lower
production costs and are willing to supply a given amount
at a lower price.
• So decreases in the cost of inputs cause supply curves to
shift to the right.
• If input costs increase, managers are willing to supply a
given amount only at a higher price (because their costs
are higher). Hence the supply curve shifts to the left.
 EQUILIBRIUM PRICE

• Disequilibrium
• Price is too high
• Excess supply
• Surplus
• Causes price to fall
• Price is too low
• Excess demand
• Shortage
• Causes price to rise
 EQUILIBRIUM PRICE

• Equilibrium Price
• Quantity demanded is equal to quantity supplied.
• Price is stable.
• The market is in balance because everyone who wants
to purchase the good can, and every seller who wants
to sell the good can.
EQUILIBRIUM PRICE OF COPPER, WORLD
MARKET

Managerial Economics, 8e
Copyright @ W.W. & Company 2013
 ACTUAL PRICE

• Invisible Hand
• No governmental agency is needed to induce producers
to drop or increase their prices.
• If actual price is above equilibrium price, there will be
a surplus that puts downward pressure on the actual
price.
 ACTUAL PRICE

• If actual price is below equilibrium price, there will be a

shortage that puts upward pressure on the actual price.
• If actual price is equal to equilibrium price, then there will
be neither a shortage nor a surplus and price will be stable.
 WHAT IF THE DEMAND CURVE SHIFTS?

• Increase in Demand
• Represented by a rightward or upward shift in the
demand curve
• Result of a change that makes buyers willing to
purchase a larger quantity of a good at the current price
and/or to pay a higher price for the current quantity
• Will create a shortage and cause the equilibrium price to
increase
 WHAT IF THE DEMAND CURVE SHIFTS?

• Decrease in Demand
• Represented by a leftward or downward shift in the
demand curve
• Result of a change that makes buyers purchase a
smaller quantity of a good at the current price and/or
continue to buy the current quantity only if the price is
reduced
• Will create a surplus and cause the equilibrium price to
decrease
EFFECTS OF LEFTWARD AND RIGHTWARD SHIFTS OF THE
DEMAND CURVE ON THE EQUILIBRIUM PRICE OF COPPER

Managerial Economics, 8e
Copyright @ W.W. & Company 2013
 WHAT IF THE DEMAND CURVE SHIFTS

• Increase in Supply
• Represented by a rightward or downward shift in the
supply curve
• Result of a change that makes sellers willing to offer a
larger quantity of a good at the current price and/or to
offer the current quantity at a lower price
• Will create a surplus and cause the equilibrium price to
decrease
 WHAT IF THE DEMAND CURVE SHIFTS

• Decrease in Supply
• Represented by a leftward or upward shift in the supply
curve
• Result of a change that makes sellers willing to offer a
smaller quantity of a good at the current price and/or to
offer the current quantity at a higher price
• Will create a shortage and cause the equilibrium price to
increase
EFFECTS OF LEFTWARD AND RIGHTWARD SHIFTS OF THE
SUPPLY CURVE ON THE EQUILIBRIUM PRICE OF COPPER

Managerial Economics, 8e
Copyright @ W.W. & Company 2013
 LIFE DURING A MARKET MOVEMENT

• In early spring 2008, shifting demand and supply curves

were impacting every country.
• The global food supply was in disequilibrium, and it
appeared that the world was in a panic.
• During one week in early spring 2008, major governments
worldwide used their sovereign powers to restrict trade in
basic foods.
LIFE DURING A MARKET MOVEMENT
 LIFE DURING A MARKET MOVEMENT

• Acceleration of prices across major food groups.

• This is a shift in the demand curve.
• This rightward shift in the demand curve for food was
attributed to several factors.
• One theory was that Thomas Malthus’s mathematical
doomsday machine was finally reaching fruition. The world
population continues to expand, while agricultural acreage
continues to shrink.
• Many governments in developing countries have focused
efforts on economic development rather than agriculture.
 LIFE DURING A MARKET MOVEMENT

• A UN report shows the annual growth in agricultural

productivity slowed to 1% by 2002.
• A growing middle class in large developing countries like
China and India consumes more food.
• Finally, the increased use of food stock, like corn, for the
production of ethanol fuel has taken such products out of
the food market.
• Also, more individuals are leaving rural areas (farms) in
developing countries and moving to urban areas. These
trends are apt to the supply curve to the left and the
demand curve to the right—upward pressure on prices
 DISCUSSION

• 1. Several factors are mentioned as contributing to disequilibrium in

global food markets. Among them are emotions (panic), government
restrictions on trade, the Malthusian specter of population growth
outpacing food production, slowing productivity growth in the
agricultural sector, rising incomes, and the production of ethanol.
Which of these are supply factors and which are demand factors? How
does each influence market price?

• 2. The market price for crude oil fluctuated widely during 2008. What
supply and demand factors contributed to these fluctuations? Is the
petroleum market subject to any of the same factors cited as
influencing agricultural markets?
 HOMEWORK

• Problems 3, 4, 6, 7, 9