The Fundamentals of

Managerial Economics

Dr. Abdullah M. Al-Ansi

 Chapter Objectives
After completing this chapter, you will be able to:
• LO1 Summarize how goals, constraints, incentives, and market rivalry affect
economic decisions.
• LO2 Distinguish economic versus accounting profits and costs.
• LO3 Explain the role of profits in a market economy.
• LO4 Apply the five forces framework to analyze the sustainability of an industry’s
profits.
• LO5 Apply present value analysis to make decisions and value assets.
• LO6 Apply marginal analysis to determine the optimal level of a managerial
Control variable.
• LO7 Identify and apply seven principles of effective managerial decision making.
Many students taking managerial economics ask:

Why I should I study economics?

Will it tell me what the stock market will do tomorrow?
Will it tell me where to invest my money or how to get rich.
 The Manager
• A person who directs resources to achieve a stated goal.

(1) direct the efforts of others

(2) purchase inputs to be used in the production of goods and services
(3) are in charge of making other decisions, such as product price or quality

 The science of making decisions in

the presence of scare resources.
 Nature of Scarcity

• Decisions are important because scarcity implies that by making one

choice, you give up another.
• Economic decisions thus involve the allocation of scarce resources,
and a manager’s task is to allocate resources so as to best meet the
manager’s goals.
• Time is one of the scarcest resources of all.
 Managerial Economics Defined

• The study of how to direct scarce resources in the way that most
efficiently achieves a managerial goal.
• The key to making sound decisions is to know what information is
needed to make an informed decision and then to collect and process
the data.
THE ECONOMICS OF EFFECTIVE MANAGEMENT

In particular, an effective manager must

(1) identify goals and constraints,
(2) recognize the nature and importance of profits,
(3) understand incentives,
(4) understand markets,
(5) recognize the time value of money,
(6) use marginal analysis, and
(7) make data-driven decisions.
 Economic versus Accounting Profits

• The overall goal of most firms is to maximize profits or the firm’s

value.
• Accounting Profits: The total amount of money taken in from sales
(total revenue, or price times quantity sold) minus the dollar cost of
producing goods or services.
• Economic Profits (p): The difference between total revenue and total
opportunity cost.
• opportunity cost : The explicit cost of a resource plus the implicit cost
of giving up its best alternative use.
Illustration:
The Five Forces Framework and Industry Profitability
 Understand Incentives

• Incentives affect how resources are used and how hard workers work.
• No reward for working hard? and incurs no penalty if he fails to make
sound managerial decisions?
 Understand Markets
1. Consumer-Producer Rivalry.
- Consumers attempt to negotiate or locate low prices.
- Producers attempt to negotiate high prices.
2. Consumer-Consumer Rivalry.
- When limited quantities of goods are available, consumers will compete with
one another for the right to purchase the available goods.
- An example: auction.
3. Producer-Producer Rivalry.
- Given that consumers are scarce, producers compete with one another
for the right to service the customers available.
4. Government and the Market
 Recognize the Time Value of Money
• Time value of money: The fact that $1 today is worth more than $1
received in the future.
• Present Value (PV): The amount that would have to be invested today
at the prevailing interest rate to generate the given future value.
• Formula (Present Value). The present value (PV) of a future value (FV)
received n years in the future is:
 Example:

• What is the present value of $100.00 in 10 years if the interest rate is

at 7 percent?

• if you could invest $1.00 today at a guaranteed interest rate of 10

percent, one year from now $1.00 would be worth $1.00 × 1.1 =
$1.10.
• Formula (Present Value of a Stream). When the interest rate is i, the
present value of a stream of future payments of FV1, FV2, . . . , FVn is:
 Formula (Net Present Value)
net present value (NPV)
• The present value of the income stream generated by a project minus
the current cost of the project.
• Suppose that by sinking C0 dollars into a project today, a firm will generate
income of FV1 one year in the future, FV2 two years in the future, and so on for n
years. If the interest rate is i, the net present value of the project is:
 Present Value of Indefinitely Lived Assets
• Some decisions generate cash flows that continue indefinitely. For instance,
consider an asset that generates a cash flow of CF0 today, CF1 one year from
today, CF2 two years from today, and so on for an indefinite period of time. If the
interest rate is i, the value of the asset is given by the present value of these cash
flows:

• When cash flow is zero (CF0 = 0)

 value of a firm

The value of the firm immediately after its current profits have been paid out as dividends
 Use Marginal Analysis

• Marginal analysis:
States that optimal managerial decisions involve
comparing the marginal benefits of a decision with
the marginal costs.

• N(Q) = B(Q) − C(Q),

Discrete Decisions
• Marginal Benefit (MB): The change in total benefits arising from a
change in the managerial control variable Q.
• Marginal (incremental) Cost (MC): The change in total costs arising
from a change in the managerial control variable Q.
• The marginal net benefits of Q—MNB(Q)—are the change in net
benefits that arise from a one-unit change in Q.

• MNB(Q) = MB(Q) − MC(Q)

Marginal Benefit (MB): Marginal Cost (MC):

MB = DB / DQ
MB = marginal Benefit MC = DC / DQ
TB = total Benefit MC = marginal cost
Q = output TC = total cost
D = change Q = output
when net benefits are maximized, MB = MC.
 Continuous Decisions

Determining the Optimal Level of a Control Variable: The Continuous Case

Homework 1

• Questions: 3,4,6, 9
• Pages 31,32