Managerial Economics

Instructor: Maharouf Oyolola

 Chapter 1
The nature and Scope of
managerial economics
 OUTLINE OF THE LECTURE
• Managerial economics
• -Microeconomics
• -Macroeconomics
• -Decision Science ( Mathematical
economics and Econometrics)
• Theory of the firm
• Economic and Business Profits
• Business Ethics
What is Managerial Economics?
• It refers to the application of economic theory
and the tools of analysis of decision science to
examine how an organization can achieve its
aims or objectives most efficiently
• Managerial economics extracts from economic
theory (particularly microeconomics) those
concepts and techniques that enable the
decision maker to allocate efficiently the
resources of the organization
• The field of managerial economics has
experienced rapid growth over the past
three decades.
• This growth reflects a realization that
managers can use economic theory to
make decisions consistent with the goals
of the organization.
• Managerial problems arise in any
organization that seeks to achieve some
goals or objectives subject to some
constraints
How can Managerial Economics be
used by managers?
• Managerial economics can be used by a
goal-oriented manager in two ways:
• (1) Given an existing economic
environment, the principles of managerial
economics provide a framework for
evaluating whether resources are being
allocated efficiently within a firm.
• (2) These principles help managers
respond to various economic signals.
 Example 1
• A hospital may seek to treat as many
patients as possible at an “adequate”
medical standard with its limited physical
resources (physicians, technicians,
nurses, equipment, beds) and budget.
• What is the problem of the manager in this
example?
• (1) objective of the hospital
• Treat as many patients as possible at an
adequate medical standard
• (2) Constraints
• -Limited physical resources
• -Budget
 Example 2
• What is the goal of a state university?

• (1) Objective
• Provide an adequate education to as
many students as possible
• (2) Constraints
• - budget constraint
• -physical constraint
 Relationship to Economics
• Economic theory refers to Microeconomics
and Macroeconomics.
 What is economics?
• Economics is the study of how society allocates
scarce resources and goods
• Resources are the inputs that society uses to
produce goods.
• Inputs: land, labor and capital (physical and
financial)
• Goods include products such as food, clothing
and housing as well as services such as those
provided by doctors, police officers and barbers
• Society needs are unlimited but resources
are scarce or limited
• The term market refers to an arrangement
that allows people to trade with one
another
 Microeconomics
• It is concerned with the study of the
market system on a small scale.
• Microeconomics looks at the individual
markets that make up the market system
and is concerned with the choices made
by small economic units such as individual
consumers, individual firms, or individual
government agencies.
 Examples
• .The study of the computer industry
• The study of the consumer buying
behavior
 Macroeconomics
• It is concerned with the study of the market
system on a large scale
• Macroeconomics considers the aggregate
performance of all markets in the market system
and is concerned with the choices made by the
large subsectors of economy- the household
sector, which includes all consumers; the
business sector, which includes all firms; and the
government sector, which includes all
government agencies.
Why do we study Macroeconomics
in Managerial Economics?
• The state of the economy has an impact
on each economic agent.
• For instance, a recession or an expansion
will have an impact on the buying behavior
of firms. Therefore, it will affect the
demand and supply of firms operating in
different industries.
 Examples
• Total level of employment in a country
• Total consumption in the economy
• Gross Domestic Product
• Total level of investment
• Although the (microeconomic) theory of the firm
is the single most important element in
managerial economics, the general
macroeconomic conditions of the economy
(such as the level of aggregate demand, rate of
inflation, and interest rate) within which the firm
operates are also very important.
• For instance, if the economy is going through a
recession, it is going to affect the buying
behavior of consumers. Therefore, many firms
operating within the country will suffer
• Managerial economics should be thought
of as applied microeconomics. That is,
managerial economics is an application of
the part of microeconomics focusing on
those topics of great interest to managers.
These topics include demand, production,
cost, pricing, market structure, and
government regulation.
 II. Relationship to Decision Science(
Mathematical economics and Econometrics

Economic Theory ( Micro and Macro)

• Managerial econ.

Decision Science ( Mathematical

Economics and Econometrics)
• Managerial Economics uses the tools of
Mathematical Economics and
Econometrics to construct and estimate
decision models aimed at determining the
Optimal behavior of the firm.
 Mathematical Economics
• Is used to formalize (i.e. to express in
equational form) the economic models
postulated by economic theory.
 Econometrics
• A collection of statistical techniques
available for testing economic theories by
empirically measuring relationships
among economic variables
 Example
• Economic theory postulates that the
quantity demanded (Q) of a commodity is
a function of or depends on the price of
the commodity (P), the income of
consumers (Y), and the price of related
(i.e. complementary and substitute)
commodities (Pc and Ps, respectively).
Assuming constant tastes
• Q=F(P, Y, Pc, Ps)
• Collecting data on Q, P, Y, Pc and Ps for a
particular commodity, we can then
estimate the empirical (econometric)
relationship.
• The estimation of a demand function using
econometric techniques involves the following
steps:
• -Identification of the variables
• -Collection of the data
• -Formulation of the demand model
• -Estimation of the parameters of the model
• -Development of forecasts (estimates) based on
the model.
 Relationship to The functional areas of
business administration studies( Finance,
Accounting, Marketing, Management…)
• Managerial Economics can be regarded
as an overview course that integrates
economic theory, decision sciences, and
the functional areas of Business
Administration studies
• It also examines how they interact with
one another as the firm attempts to
achieve its goals most effectively.
• Managerial Economics is the use of
economic theory and management
science tools to examine how a firm can
achieve its objective most efficiently within
the Business environment in which it
operates
 The Decision-making process in
managerial economics follows 5 steps
• (1) Establish the objective of the firm or
organization
• (2) Define the problem or obstacles that
the firm or organization faces in trying to
achieve its objective.
• (3) Identify the range of possible solutions
• (4) Select the best solution available
• (5) Implement that decision
 Theory of the firm
• A Firm is an organization that
combines and organizes
resources for the purpose of
producing goods and/or services
for sale.
 There are millions of firms in the United
States

• These include:
• Proprietorships: firms owned by one
individual
• Partnership: firms owned two or more
individuals
• Corporations: owned by stockholders
 The Objective and Value of the
Firm
• The Theory of the firm postulates that the
primary goal of the firm is to maximize the
wealth or value of the firm.
• Firms maximize current or short-term
profits. They, however, are often observed
to sacrifice short-term profits for the sake
of increasing future or long-term profits.
 Present value analysis
• Many transactions involve making or
receiving cash payments at various future
dates.
• In all of these cases, concepts relating to
the time value of money are required to
make sound decisions.
 Present value analysis
• Understanding the following terms is essential for
applying time value of money principles:
• Annuity: a series of payments per period for a specified
length of time. For example, the repayment of a loan by
making forty-eight monthly payments of $200 each is a
form of annuity.
• Amount: a specified number of dollars to be paid or
received on a specified date.

• Present value: the value today of an amount or an

annuity, taking into consideration that interest can be
earned.
 Present value of an amount
• The basic equation for the present value
of an amount S is
 1 
PV =S  n 
(1 +i ) 
The bracketed term is the present value of $1 in n periods if the
interest rate is i percent
Example of the present value of an
amount
• What is the present value of $100,000 to
be received at the end of ten years if the
interest rate is 10 percent?
 1 
PV = 100000  10 
 (1.10) 
PV= $38,550
 Present value of an annuity
• An annuity is defined as a series of
periodic equal payments.
• Examples of annuity: retirement pension,
the repayment schedule of a mortgage
loan.
• An annuity that is paid forever is called a
perpetuity.
 Value of the Firm
• It is given by the Present value of all
expected future profits of the firm.
• Future profits must be discounted to the
present because a dollar of profit in the
future is worth less than a dollar of profit
today.
• Maximize: PV(π)= 1π +r
+
1 π 2
(1 +r )
+.... +
2
πn
(1 +r ) n
 Value of the Firm
• The present value of all future profits also
can interpreted as the value of the firm.
That is, it is what a willing buyer would pay
for the business.
Constraints on the operation of the
firm
• Profit maximization is constrained by the
limited information available to the
manager.
• In general, constraints on managerial
decisions involve legal, moral, contractual,
financial and technological considerations.
 Legal constraints
• Legal constraints include the array of federal,
state, and local laws that must be obeyed by all
citizens, both individual and corporate.
• Areas where managers seem to be having some
legal difficulty include environmental laws,
especially those relating to pollution and the
disposal of hazardous wastes, and employment
laws, including wrongful termination and sexual
harassment matters.
Constraints on the operation of the
firm
• Objective of the Firm: maximize profit
• However, it might face many constraints:
• - limitations of availability of essential
inputs: for instance, the firm might not be
able to hire as many skilled workers as it
wants, especially in the short-run.
• -The firm might not be able to acquire all
the raw materials it demands. Example: oil
• (More on Next page)
• - Size of the factory and warehouse space
• -The quantity of capital funds available for
a given project.
• Compliance with government regulations
• Example: The minimum wage law
• health and safety standards
• The existence of these constraints
restricts the range of possibilities or
freedom of actions of the firm and limits
the value of the firm to a level that is lower
than in the absence of such constraints
(unconstrained optimization).
Limitations of the theory of the firm
• The theory of the firm has been criticized for
being too unrealistic. Thus, broader theories
have been proposed:
• (1) The theory of the sales maximization: Which
is the most prominent among these new theories
was introduced by William Baumol. According to
the theory, managers of modern corporations
seek to maximize sales after an adequate rate of
profit has been earned to satisfy stockholders
• (2) The theory of management utility
maximization was introduced by Oliver
Williamson.
• The separation of management from ownership
in many modern corporations leads to the issue
of moral hazard ( when one party detains more
information than the other). For instance, the
manager of a corporation who deals with the
daily operations of the enterprise has more
information than the owner. Therefore, the issue
of moral hazard arises.
• The theory assumes that managers are
more interested in maximizing their utility
or satisfaction, measured in terms of their
compensation (salaries, fringe benefits,
stock options…) or incentives, the size of
their staff, extent of control over
corporation, lavish offices…, than in
maximizing corporate profits. This is
referred to as the principal-agent problem.
 Principal-agent problem
• The agent (manager) may be more
interested in maximizing his/her benefits
than maximizing the principal’s (the
owner’s) interest.

• The issue of principal-agent is resolved by

tying the manager’s reward to the firm’s
performance.
 The nature and Function of Profits

• Business profits versus Economic profits

• Business Profit= Total revenue – explicit

cost or accounting cost
• Explicit cost: are the actual out-of-pocket
expenditures of the firm to purchase or
hire the inputs it requires in production.
 Example of Explicit costs
• Wages to hire labor
• Interest on borrowed capital
• Rent on land and buildings
• Expenditures on borrowed capital
• Expenditures on raw materials
• Economic profit= total revenue- explicit
cost-implicit cost

• Implicit costs refers to the value of the

inputs owned and used by the firm in its
own production processes
 Implicit costs
• Implicit costs are not included in the
accounting statements but must be
included in any rational decision-making
framework.
 Example of implicit cost
• Salary that the entrepreneur could earn
from working for someone else in a similar
capacity.

• While the concept of business profit may

be useful for accounting and tax purposes,
it is the concept of economic profit that
must be used in order to reach correct
investment decisions.
 Example
• Suppose that a firm reports a business profit of
$30,000 during a year, but the entrepreneur
could have earned $35,000 by managing
another firm and $10,000 by lending out his
capital to another firm facing similar.
• Business profit = $30,000
• Economic profit= Business profit-implicit cost
• Economic profit= $30,000-45,000
• =-$15,000
 Example 2
• Consider an individual who has an MBA
degree and is considering investing
$200,000 in a retail store that she would
manage. The projected income statement
for a year as prepared by an accountant is
as shown:
 The accounting income statement

Sales $90,000

Less: Cost of goods sold -40,000

Gross profit $50,000

Less: Advertising ($10,000)

Depreciation 10,000

Utilities 3,000

Property tax 2,000

Miscellaneous expenses 5,000 30,000

Net accounting profit $20,000

 Example 2
• There are two major implicit costs in this problem:
• First, the owner has $200,000 invested in the business.
Suppose the best alternative use for this money is a
bank account paying a 5% interest rate. Therefore, this
investment would return $10,000 annually.
• Second, the implicit cost includes the manager’s time
and talent. The annual wage return on an MBA degree
from a reasonably good business school may be
$40,000 per year.
• Economic profit= accounting profit - 40,000 -10,000
• = $-30,000
Accounting income statement with
economic profit
• See file in Microsoft Excel
 BUSINESS ETHNIC
• Business ethics seeks to proscribe behavior
that businesses, firm managers, and
managers, and workers should not engage
in.
• It is clear and uncontroversial that firms and
their workers should not engage in unlawful
acts, such as selling harmful and defective
products, and ignorance of the law cannot be
used as a justification for unlawful actions.
 Problems (chapter 1)
• In-class problems:
• Problem #3 page 28
• Problem #5 page 29
• Problem #8 page 29
• Written assignment
Problem #15 page 30