Admas University

School of Post Graduate Studies

Managerial Economics for 1st Year Post Graduate

Project Management Students
By

Semeneh Bessie (PhD), Associate Professor of

Economics

Email: semeneh2003@gmail.com
 CHAPTER ONE

The Nature and Scope of Managerial

Economics
 Chapter Outline

 Definition of Managerial Economics

 Theory of the Firm

 Profit

 Role of Business in Society

The Definition and Scope of Managerial Economics

 Managerial economics applies economic theory and

methods to business and administrative decision making.
 It prescribes rules for improving managerial decisions.
 It also helps managers recognize how economic forces affect
organizations.
 And it also describes the economic consequences of managerial
behavior.
 It links economic concepts with quantitative methods to develop
vital tools for managerial decision making.
 Managerial economics identifies ways to efficiently achieve
goals.(pricing and production decisions)
The Nature Of Managerial Decision Making
 The Economic Theory

Ø  Relationship to Economic Theory:

 The organization can solve its management decision problems by

application of economic theory and the tools of decision science.

 Economic Theory: refers to microeconomics and
macroeconomics. Economic theories seek to predict and explain
economic behaviour based on a model.
Microeconomics:
 This subject is the study of the economic behaviour of

individuals decision-making units such as individual consumers,

resources owners and business firm in the free enterprise system.
Macroeconomics:
 On the other hand, this subject is the study of the total or

aggregate level of output, income, employment, consumption,

investment and prices for the economy viewed as a whole.
 Decision Sciences
Mathematical Economics and Econometrics
 Mathematical Economics especially is used to

formalize (i.e. express in equational form) the

economic model postulated by economic theory.

 Econometrics applies statistical tools (i.e. regression

analysis) to real world data to estimate the models
postulated by economic theory and for forecasting.
 Definition of Managerial Economics

 Managerial economics is very closely related to the decision sciences. These use
the tools of mathematical economics and econometrics to construct and
estimate decision models aimed at determining the optimal behavior of the firm
(i.e. how the firm can achieve its goals most efficiently).
 Douglas - “Managerial economics is .. the application of economic principles
and methodologies to the decision-making process within the firm or
organization.”
 Pappas & Hirschey - “Managerial economics applies economic theory and
methods to business and administrative decision-making.”
 Salvatore - “Managerial economics refers to the application of economic theory
and the tools of analysis of decision science to examine how an organisation can
achieve its objectives most effectively.”
 Howard Davies and Pun-Lee Lam - “It is the application of economic analysis to
business problems; it has its origin in theoretical microeconomics.”
 Definition Continued

These Definitions Cover a Number of Different Approaches

 1. Analysis based on the theory of the firm
 2. Analysis based upon management sciences
 3. Analysis based upon micro-economics

 Managerial economics is related to, but not the same as

management science and Micro-economics.

 The meaning of the definitions can be best examined with aid

of figure below:
 How Is Managerial Economics Useful?

 What is the purpose of economic analysis?

 Why do we want to apply economic analysis to business
problems?
 Evaluating Choice Alternatives
 Identify ways to efficiently achieve goals.
 Specify pricing and production strategies.
 Provide production and marketing rules to help maximize
net profits.
 Making the Best Decision
 Managerial economics can be used to efficiently meet
management objectives.
 Managerial economics can be used to understand logic of
company, consumer, and government decisions.
 THEORY OF THE FIRM
 The theory of firm assumes that the firm seeks to
maximize profits and minimize cost and on the basis
of that it predicts how much of a particular
commodity the firm should produce under different
forms of market structure or organization.
 Combines and organizes resources for the purpose of producing
goods and/or services for sale.
 Internalizes transactions, reducing transactions costs
 Primary goal is to maximize the wealth or value of the firm.
 THEORY OF THE FIRM Cont…

 Firms are major economic institutions

in market economies.
 They come in all shapes and sizes, but

have the following common

characteristics:
 Owners.

 Managers.

 Objectives.
 THEORY OF THE FIRM Cont…

 A pool of resources (labor, physical capital, financial capital and

learned skills and competences) to be allocated roles by managers.

 Administrative or organizational structures through which

production is organized.

 Performance assessment by owners, managers and other

stakeholders.

 These are termed shareholders and they are able to determine the
objectives and activities of the firm.
 THEORY OF THE FIRM Cont…

 Expected Value Maximization

 Owner-managers maximize short-run profits.
 Primary goal is long-term expected value maximization.

 Constraints and the Theory of the Firm

 Resource constraints.
 Social constraints

 Limitations of the Theory of the Firm

 Alternative theory adds perspective.
 Competition forces efficiency.
 Hostile takeovers threaten inefficient managers.
 Managerial Decision Problems

 Managerial decision problems arise in any organization (i.e. non-profit

organization such as a hospital or a university or government agency),
when they seek to achieve some goal or objective subject to limitations on
the availability of essential inputs and in the face of legal constraints.
 Case of Hospital:
 A hospital may seek to treat as patients as possible at an adequate medical
standard with its limited physical resources (i.e. physicians, technicians,
nurses, equipment, beds etc.) and budget.

Case of University:
 The goal of a state university may provide an adequate education to as
student as possible subject to the physical and financial constraints it faces.
 Managerial Decision Problems cont…

Case of government agency

 Similarly, a government agency may investigate to provide
a particular service to as many people as possible the
lowest feasible cost.
 In all these cases, the relevant organizations face management
decision problems as it seek to accomplish their own goals or
objective subject to the constraint they face.  

 It is important to note that the goals and constraints may differ

from case to case, however the basic decision-making process
is the same.
 Application Cont...
 We can estimate this empirical relationship by
collecting data on the variables mentioned in the
equation above.

 This will permit the firm to determine how much Q

would change in P, Y, PC and PS and to forecast the
future demand for the commodity.

 This information is essential in order for management

to achieve the goal or objective of the firm (profit
maximization) most efficiently.
 Firms exist because it would be very inefficient and costly for
entrepreneurs to enter into and enforce contracts with workers and
owners of capital, land and the other resources for each separate step
of production and distribution process. Instead, entrepreneurs enter
into long term and broader contracts with labor to perform a number
of tasks for a specific wages and fringe benefit.
Value of the Firm
The present value of all expected future profits
1 2 n n
t
PV  1
 2
  n
 t
(1  r ) (1  r ) (1  r ) t 1 (1  r )

n
t n
TRt  TCt
Value of Firm   t
 t
t 1 (1  r ) t 1 (1  r )
 Alternative Theories

 Sales maximization
 Adequate rate of profit
 Management utility maximization
 Principle-agent problem
 Satisfying behavior

 The theory of firm has also been criticized as being much narrow and
unrealistic. For this reason, broader theories of the firm have been
proposed.
 The most prominent among these are models postulate that the
primary objective of the firm is the maximization of sales, the
maximization of management utility and satisfying behavior.
 Sales Maximization

According to the model, managers of modern corporations seek to

maximize sales after an adequate rate of profit has been earned to
satisfy stockholder ( this model introduced by William Baumol).
Management utility maximization
 The model (introduced by Oliver Williamson) postulates that with

the advent of the modern corporation and resulting separation of

management from ownership.
 Managers are more interested in maximizing their utility measured

in terms of their compensation (i.e. salaries, stock options etc.), the

size of their staff, extent of control over the corporation, lavish
offices etc. than maximizing corporate profits. This referred to as
the Principle-agent problem.
 Satisfying behavior

 This stems from the great complexity of running the

large modern corporation- a task often complicated
by uncertainty and a lack of adequate data.

 Manager are not able to maximize profits but can

only strive for some satisfactory goal in terms of
sales, growth, market share and so on. This situation
is called satisficing behaivour.
 Definitions of Profit

 Business Profit: Total revenue minus the explicit or

accounting costs of production.

 Economic Profit: Total revenue minus the explicit

and implicit costs of production.

 Opportunity Cost: Implicit value of a resource in its

best alternative use.
 The Explicit and Implicit costs
o The explicit or accounting costs: are the actual
out of pocket expenditures of the firm to
purchase or hire inputs it requires in
production. (i.e. wages to hire labour, interest
on borrowed capital, rent on land and
buildings and the expenditure on raw
materials).
o The Implicit costs: refers to the value of the
inputs owned and used by the firm in its own
production processes.
 Theories of Profit

 Risk-Bearing Theories of Profit

 Frictional Theory of Profit

- Profit stems from disturbances from long-run equilibrium

-Normal return adjusted for risk or zero economic profit

- Energy crises in 1970s-large profit by providing

insulation materials

- Decline in oil prices in mid 1980s- losses are incurred

 Theories of Profit Cont…

 Monopoly Theory of Profit

 Innovation Theory of Profit
- Profit is the reward for the introduction of a
successful innovation
- e.g Steven Job, the founder of the Apple comp.
Company became a millonaire in 1977
- successful innovation encourage the flow of
technology as well as profit
 Managerial Efficiency Theory of Profit
 Function of Profit

 Profit is a signal that guides the allocation of society’s

resources.
 High profits in an industry are a signal that buyers

want more of what the industry produces.

 Low (or negative) profits in an industry are a signal

that buyers want less of what the industry produces.

Business Ethics
 Identifies types of behavior that businesses and their
employees should not engage in.
 Source of guidance that goes beyond enforceable laws.
 The Changing Environment of Managerial Economics

 Globalization of Economic Activity

 Goods and Services
 Capital
 Technology
 Skilled Labor
 How does globalization differ from colonization ?

 ‘’Since the collapse of the USSR, the dynamics of

empire has changed.

 The World is now more multi polar and mercantile,

with China and Europe emerging to compete against
the US.

 Empire is more driven by multinational corporations,

whose interests transcend those of any particular
nation-state.’’
 Theory of firm-Value of the firm-PV
Example 1

 Q1. The owner of a firm expects to receive a profit

of $ 100 in each of the next three years and to be
able to sell the firm at the end of the third year for
$ 700. The owner believes that the appropriate
discount rate for the firm is 10 percent per year.
 Calculate (a) the value of the firm (PV) (b) the

value of the firm when a discount rate of 20

percent (c) what is the effect on the value of the
PVfirm
of using  a higher n
discount
 rate.
 1
1
 2
2
 
n
n
 t
t
(1  r ) (1  r ) (1  r )
t 1 (1  r )
 Solution:
  
 Theory of firm-Value of the firm
Example 2 for the trade-off between profit and costs
 Q2. The costs of attending a state college for one year
are $ 2,000 for tuition, $ 1,500 for the room, $1,000
for meals, and $500 for books and supplies. As an
alternative the student could earn $13,000 by getting
a job instead of going to college and in adddition,
earn 8 percent interest by saving the money not spent
on attending.
 Calculate (a) the explicit cost (b) the implicit costs
(c) the total economic costs that the student faces by
attending the college for one year.
 Answer 2 for the trade-off between profit and costs -
Value of the firm
(a) Expenses is the explicit costs- the expenses are $ 2,000
for tuition, $ 1,500 for the room, $ 1,000 for meals,
and $ 500 for books and supplies– total amout$ 5,000
per year .
(b) The Implicit costs are the sum of $ 13,000 and 8% 0f $
5,000 is $ 400- total amout$ 13,400 for the year.
(c) The total economic cost =the explicit costs + the
implicit costs= $ 5,000 +$ 13,400= $ 18,400
 Theory of firm-Value of the firm
Example 3 for the trade-off between profit and costs
 A person managing a dry- cleaning store for $ 30,000 per
year decides to open a new one. The revenues of the store
during the first year of operation are $ 100,000 and the
expenses are $ 10,000 for supplies, $ 35,000 for salaries, $
8,000 for rent, and $ 2,000 for utilities. The person also used
$5,000 for interest on a bank loan. Assume that income and
business taxes are zero and the repayment of the principal of
the loan does not start before three years (suppose r=10%).
 Calculate (a) the explicit cost (b) the implicit costs (c) the
business profit, (d) the Economic profit (e) normal return on
investment and also (f) indicate whether the person should
open the dry-cleaning store.
 Answer 3 for the trade-off between profit and costs -Value of the firm
(a) Expenses is the explicit costs- the expenses are $ 10,000 for
supplies, $ 35,000 for salaries, $ 8,000 for rent, and $ 2,000 for
utilities as well as interest $ 5,000 – total amout is $ 60,000.
 (b) The Implicit costs are the entrepreneeur’s foregone salary- $
30,000.
 (c) the business profit= total revenues - the explicit costs = $
100,000 - $ 60,000= $ 40,000
 (d) the Economic profit= total revenues – (the explicit costs +
Implicit costs) = 100,000 – ($ 60,000 + $ 30,000) = $ 10,000
 (e) normal return on investment = The Implicit costs =$ 30,000.
 (f) PV=10,000/1+0.10)....or roughly we can say that The person
would earn economic profit $ 10,000 per year, therefore, the
person should

open

the store..
  n
PV  1

(1  r )1
 2

(1  r ) 2
  n

(1  r ) n
  (1  r )
t 1
t
t