AN INTRODUCTION TO MANAGERIAL

ECONOMICS AND THEORIES OF FIRM

 Syllabus of this Unit  Learning Objectives

a. Concept , nature and scope of managerial On completion of this unit, students will be able to:
economics,
• understand the concept and scope of managerial
b. Business profit and economic profit. economics
c. Theories of firm: Profit maximization, Sales • explain the role of managerial economics in the
revenue maximization,
business decision making
• describe about the business profit and economic profit
• analyse various theories of firm like Profit
Maximization,, Sales Revenue Maximization,
 Introduction
Economics is the study of how individuals and societies choose to utilise
scarce resources to satisfy their unlimited wants. These wants encompass all
the goods and services that individuals desire including food, clothing,
shelter, and anything that enhances the quality of human life.
 Concept of Managerial Economics
• Although the systematic study of economics was started from 18th century,
the history of development of managerial economics is not so long. It was
born during the 1950s.
• Managerial economics applies economic theories and methods to business
and managerial decision making.
 Definition of Managerial Economics
• Managerial economics is the branch of economics which deals with the
application of economic theories and methods for business and managerial
decision making of a firm.
• Managerial economics is, thus, a part of economic knowledge and
economic theories which is used as a tool of analysing business problems
for rational decision making. Managerial economics is also called
business economics or economics of firm.
Definition of Managerial Economics cont.
• According to Edwin Mansfield, "Managerial economics is concerned with application of economic
concepts and economic analysis to the problem of formulating rational economic decision."
• According to Joel Dean, “The purpose of managerial economics is to show how economic analysis
can be used in formulating business policies.”
• In the words of Dominick Salvatore, "Managerial economics refers to the applications of
economic theory and tool of analysis of decision science to examine how an organization can
achieve its aim or objective most efficiently."
• According to J.L. Pappas and Hirschey M., "Managerial economics is the application of
economic theory and methodology to business administration practice. More specifically,
managerial economics is the use of tools and techniques of economic analysis to analyse and solve
managerial problems."
Definition of Managerial Economics cont.
From the above definitions, we can draw following conclusion:
• Managerial economics is a branch of economics.
• The term managerial economics can be used in place of business economics.
• Managerial economics integrates the economic theories with business practices.
• Managerial economics is the science of decision making.
• Managerial economics has both descriptive and prescriptive roles.
• Managerial economics predicts the consequences of decisions made by the firms.
 Nature of managerial economics
• Microeconomics in nature
• Normative in nature
• Narrow scope
• Multi disciplinary
• Use of macroeconomics
• Integration of economic theory and business practice
 Scope of managerial economics
• Demand analysis and demand forecasting
• Cost and production analysis
• Pricing decision
• Profit management
• Capital management(use n allocation of capital)
• External problems (political, social & macro economic problems)
 Role/ Importance/ Uses of Managerial
Economics in Business Decision Making
The major role or importance or uses of managerial economics can be
explained as follows:
1. Foundation of business decision making
2. Estimating economics relationship
3. Useful to understand business environment
4. Useful for pricing decision
5. Prediction of relevant economic quantities
 Concept of Profit
Profit is reward of the entrepreneur, in the same sense as wage is reward to the
labour; rent is reward to the land and interest is reward to the capital. It is paid
for effort, skill, risk and innovations of the entrepreneur.
• According to C.H. Petersen and W.C. Lewis, "Profit is defined as the
revenue minus cost."
• According to Edwin Mansfield, "When economists speak up profit over
and above what the owner's labour and capital employed in the business
could earn elsewhere."
 Business Profit and Economic Profit
Concept of Explicit Cost, Implicit Cost and Economic Cost
Explicit cost: Explicit cost is defined as the payment made by a firm for the
use of inputs purchased or hired from outside or others. In other words, it is
the cost of inputs which requires on expense of money by the firm.
Implicit cost: Implicit cost is defined as the value of factors or inputs owned
and used by the firm or the entrepreneur on its own production process.
Economic Cost: Economic cost is the sum of implicit and explicit cost.
Business Profit and Economic Profit cont.
Business Profit: Business profit is the excess of total revenue over
the explicit cost or accounting cost. In the business sense, business
profit is the excess of total revenue over the total cost of
production. Business profit is also known as the accounting profit.
Business Profit (Accounting Profit) = Total Revenue –
Explicit Cost = Total Revenue – Accounting Cost
Business Profit and Economic Profit cont.
Economic Profit: Economic profit is the excess of total revenue over the economic
cost. Economic cost is the sum of implicit cost and explicit cost. It means that economic
cost includes both visible cost and invisible cost.
Economic Profit = Business Profit – Implicit Cost
Or
Economic Profit = Total Revenue – Economic Cost
= Total Revenue – (Implicit Cost + Explicit Cost)
= Total Revenue – Implicit Cost – Explicit Cost
 Theories of Firm
A firm is an organization that combines and organizes resources for the purpose of
producing goods and services. In other words, it is an independent unit producing goods and
service for sale. Firms exist because they are useful in the process of producing and
distributing goods and services. The objectives and theories of the firm are discussed below.
• Profit Maximization Objective/ Theory of Firm
• Value Maximization Theory / Model
• Sales Revenue Maximization Theory or Objective of the Firm
• Williamson’s Model of Managerial Discretion
 Profit Maximization Objective/
Theory of Firm
The profit maximization objective or theory of firm was developed by classical economists. They
regarded profit maximization as the most important objective of the firm. The attempt of an
entrepreneur to maximize profit is regarded as the rational behaviour.
Assumptions
• The firm has only one objective, i.e. profit maximization.
• Only one commodity is produced by the firm.
• There is existence of imperfect competition in the market.
• The investor himself is manager of the firm.
• The entrepreneur is rational.
 Profit Maximization Objective/
Theory of Firm cont.
There are two approaches to explain the profit maximization objective of the firm which are
explained below.
1. Total Revenue and Total Cost Approach (TR-TC Approach)
Profit is the difference between total revenue and total cost. Profit is maximized when
difference between total revenue (TR) and total cost (TC) is maximum. Symbolically,
 = TR – TC
where
 = Profit
TR = Total revenue

TC = Total cost
 Figure 1-1: Total Revenue and Total Cost Approach
(TR-TC Approach)

Profit Maximization Y
Objective/
TC
Theory of Firm cont. Loss

Cost and Revenue

M B

TR  TC approach can be explained TR

Maximum
by the help of given Figure 1-1: Loss
Profit
A N
E

Profit
X
O Q1 Q2 Q3 Loss
Loss 
Quantity
 Profit Maximization Objective/
Theory of Firm cont.
2. Marginal Revenue and Marginal Cost Approach (MR-MC Approach)
According to the marginal revenue and marginal cost approach, the firm attains equilibrium or
maximizes profit when following two conditions are fulfilled:
i. MR = MC
ii. MC must intersect MR from below (slope of MC > slope of MR).
 Figure 1-3: Marginal Revenue and Marginal Cost
Approach (MR  MC Approach)

Profit Maximization Y
Objective/
Theory of Firm cont.

Cost, Revenue
MC

and Profit
The MR-MC approach can be explained by B
P AC
the help of Figure 1-2. Profit A
C
E M
In the figure, AR
TR = OQBP
MR
TC = OQAC X
O Q
Profit () = TR – TC
Quantity
= OQBP – OQAC
= ABPC
 Sales Revenue Maximization Theory or
Objective of the Firm
The sales revenue maximization model was developed by W.J. Baumol in 1958. This
theory is an important alternative theory of firm's behaviour. According to this theory, firms
seek to maximize sales revenue rather than maximizing profit. Baumol also argues that
firms need to earn minimum profit in order to spend on expansion plans and provide
dividend to the shareholders.
Rational for Sales Revenue Maximization
• The reasons which explain rational for sales revenue maximization objective are as
follows:
• There is evidence that salaries and other slack earnings (payment above minimum
necessary) of top managers are correlated more closely with sales than profits.
 Sales Revenue Maximization Theory or
Objective of the Firm cont…
• Personal problems can be handled more satisfactorily when sales are growing.
• Larger sales growing over time given prestige to the managers, while large profits go
into the pockets of shareholders.
• Managers find profit maximization a difficult objective to fulfil consistently over time
and at the same level. Profit may fluctuate with changing conditions.
• Large and growing sales strengthen the power of the firm to adopt the competitive
tactics.
• Increased sales revenue increase competitive capacity of managers in the market.
 Sales Revenue Maximization Theory or
Objective of the Firm cont.
Assumptions
• The sales revenue maximization objective is based on the following assumptions:
• The time horizon of a firm is a single period.
• During this time period, the firm attempts to maximize the total sales revenue subject to
profit constraint.
• Firms earn minimum profit to keep shareholders happy and prevent the fall in share
price.
• The market is imperfectly competitive.
• The demand curve is downward slopping and average cost curves are U-shaped.
 Figure 1-3: Sales Revenue Maximization Model

Y
Profit Maximization
Objective/

Revenue, Cost and Profit

G
Theory of Firm cont. R2 TC
R1 M TR

The sales revenue maximization

model can be explained by the help of N

A
B 4 (Profit under profit maximization)
Figure 1-3. 3 (Operative profit constraint)
2 (Optimum profit constraint)
C D 1 (Non-operative profit constraint)
X
O Q 1 Q 2 Q3

Quantity
 Sales Revenue Maximization Theory or
Objective of the Firm cont.
This model or theory can be explained under the two cases: sales revenue maximization
without profit constraint and sales revenue maximization with profit constraint.
Case 1: Sales Revenue Maximization without Profit Constraint
If there is no profit constraint or shareholders of the firm do not demand any type of profit, the
manager will produce and sell OQ3 quantity of output. At this output, total revenue is OR2
which is the maximum revenue and total profit is CQ3.
 Sales Revenue Maximization Theory or
Objective of the Firm cont.
Case 2: Sales Revenue Maximization with Profit Constraint
Under the profit constraint case, there are three situations which are as follows:
i. If minimum profit constraint imposed by shareholders is 2, the manager will sell OQ3
output, where total revenue is maximum. This is known as the optimum profit constraint.
ii. If minimum profit constraint imposed by shareholders is 3, the manager will sell OQ2
output. This is known as the operative profit constraint.
iii. If minimum profit constraint is 1, the manager will sell OQ3 output. This is known as the
non-operative profit constraint.
 Sales Revenue Maximization Theory or
Objective of the Firm cont.
Criticisms/ Comments/ Limitations
The criticisms or limitations of sales revenue maximization theory developed by W.J. Baumol
are as follows:
1. Hypothesis cannot be tested
2. No differences between sales revenue maximization and profit maximization
3. Relationship between firm and industry
4. Core problem of uncertainty
5. Implicit assumption
6. Logic of social welfare is not true
EXERCISE 1
Two former MBA students worked in the world Bank at a salary Rs. 30,00,000 each for one year
after they graduated. After a year they decided to quit their job and started a research institute.
They used Rs. 15,00,000 to overheads (i.e. computer, furniture, etc.) For the next year, they took
Rs. 150,00,000 in revenue each year and paid five research assistants Rs. 10,00,000 annually
each and rented an office for Rs. 10,00,000 per year with miscellaneous expenses Rs. 5,00,000
per year.
a. Define accounting cost and economic cost.
b. Compute accounting profit and economic profit. Should they remain in research institute
after the year if they are indifferent between working for themselves or other in a similar
capacity?
SOLUTION
b. Calculation of Accounting Profit and Economic Profit
Particular Amount (Rs.) Amount (Rs.)
Total revenue (TR)   150,00,000
Less: Explicit costs/Accounting costs    
Overhead costs 15,00,000  
Wages and Salaries of previous job 50,00,000  
Rent 10,00,000  
Miscellaneous Expenses 5,00,000 80,00,000
Business/Accounting Profit   70,00,000
Less: Implicit cost/ Opportunity cost (Salary) 60,00,000 60,00,000
Economic Profit   10,00,000

Since, economic profit is positive, they should remain in the research institute.
Alternative Method
Given
Total revenue (TR) = Rs. 15000000 Overhead costs = Rs. 1500000
Wages and salaries = Rs. 5000000 Rent = Rs. 1000000
Miscellaneous expenses = Rs. 500000
Explicit cost /Accounting cost = Overhead cost + Wages and Salaries + Rent +
Miscellaneous Expenses
= 1500000 + 5000000 + 1000000 + 500000
= Rs. 8000000
Accounting/Business profit = Total Revenue  Explicit /Accounting cost
= 15000000  8000000
= Rs. 7000000
Implicit cost (Opportunity cost) = Salary of the previous job
= Rs. 6000000
Economic profit = Accounting /Business profit  Implicit cost
= 7000000  6000000
= Rs. 1000000
Since, economic profit is positive, they should remain in the research institute.
Thank You