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Introduction

OVERVIEW
Managerial economics is the application of economic theory and quantitative methods to nd solutions to managerial decision-making problems. In general, economic theory is the study of how individuals and societies choose to utilize scarce productive resources (land, labor, capital and entrepreneurial ability) to satisfy virtually unlimited wants. Managerial economics might best be described as applied microeconomics. As an applied discipline, managerial economics integrates economic theory with the techniques of quantitative analysis, including mathematical economics, optimization analysis, regression analysis, forecasting, linear programming, and risk analysis. Managerial economics attempts to demonstrate how the optimality conditions postulated in economic theory can be applied to real world business situations to optimize rms organizational objectives. The study of economics is divided into two broad subcategories: Macroeconomics and microeconomics. Macroeconomics is the study of entire economies and economic systems. In general, the topics covered in macroeconomics are concerned with the economic environment within which rm managers operate. Macroeconomic analysis focuses on variables which are generally outside the control of the manager, but which are of considerable importance when making economic decisions at the level of the individual, rm, or industry. Macroeconomics also examines the role of government in inuencing these economic aggregates to achieve some socially desirable objective through the use of monetary and scal policies.

Managerial Economics: Theory and Practice

Copyright 2003 by Academic Press. All rights of reproduction in any form reserved.

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Introduction

Microeconomics is the study of the behavior and interaction of consumers, producers, and government. Microeconomics deals with such topics as prot maximization, utility maximization, revenue or sales maximization, product pricing, input utilization, production efciency, market structure, capital budgeting, environmental protection, governmental regulation, and so on. Unlike macroeconomics, microeconomics is concerned with factors that are directly or indirectly under the control of management, such as product quantity, quality, pricing, input utilization, and advertising expenditures. Managerial economics may be described as applied microeconomic. Managerial economics explicitly recognizes that a rms organizational objectives, usually prot maximization, are subject to one or more operating constraints, such as the size of the rms operating budget, shareholders expected rate of return on investment, etc. The dominant organizational objective of rms in free market economies is prot maximization. The assumption of prot maximization has come under repeated criticism. Many economists have argued that this behavioral assertion is too simplistic to describe the complex nature and managerial thought processes of the modern large corporation. Other theories emphasize different aspects of the operations of the modern, large corporation. Despite these attempts, no other theory of rm behavior has been able to provide a satisfactory alternative to the broader assumption of prot maximization. Total economic prot maximization involves maximizing the positive difference between total revenue and total economic cost. Total revenue is dened as the price of a product times the number of units sold. Total economic prot takes considers all relevant economic costs associated with the production of a good or a service, including both explicit and implicit costs. Total economic prot is distinguished from accounting prot, which is the difference between total revenue and total explicit costs. Another important concept is normal prot, which refers to the minimum payment necessary to keep the rms factors of production from being transferred to some other activity. Economic prot refers to prot in excess of these normal returns. Noneconomic organizational objectives tend to emphasize such intangibles as good citizenship, product quality, employee goodwill, etc. Other organizational objectives, such as earning an adequate rate of return on investment, or attaining some minimum acceptable rate of sales, prot, market share, asset growth, and so on, is the result of satiscing behavior on the part of senior management. Satiscing behavior is predicated on the belief that it is not possible for senior management to know when prots are maximized because of the complexities and uncertainties associated with running a large corporation. Finally, shareholder-wealth maximization involves maximizing the value of a companys stock by maximizing the present value of the rms net cash inows at the appropriate discount rate.

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Multiple Choice Questions

MULTIPLE CHOICE QUESTIONS

1.1 Economics is the study of: A. How societies best serve the wants and needs of individuals. B. How individuals and societies best utilize scarce resources. C. The three economics questions of what, how, and for whom. D. How productive resources are used to produce specic goods and services. E. None of the above. Scarcity refers to: A. The condition where the availability of productive resources is insufcient to satisfy the wants and needs of individuals and society. B. The situation in which the quantity demanded of a good or service exceeds the quantity supplied. C. The economys inability to create jobs for all those who are willing and able to work. D. Inefcient production. Production efciency: A. Occurs when consumers derive the greatest utility from the purchase of goods and services. B. Answers the three basic economic questions of what, how, and for whom. C. Refers to least cost production technology. D. None of the above. Which of the following represent scarce productive resources? A. Land, technology, labor, organizational skills. B. Land, labor, investment, managerial ability. C. Land, capital, natural resources, executive skills. D. Land, labor, capital, entrepreneurial ability. Opportunity cost is: A. The total value of foregone goods and services. B. The total value of producing a particular good or service. C. The highest-valued alternative foregone whenever a choice is made. D. Total explicit cost of production.

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1.3

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1.6

Introduction

The eld of economics that is most relevant to the managerial decision making process is: A. Macroeconomics. B. Microeconomics. C. Labor economics. D. International economics. E. Capitalism. Macroeconomics deals with: A. The behavior of individual consumers. B. The actions of government agencies. C. The economy as a whole. D. The managerial decision-making process. Microeconomic theory focuses on: A. The operations of economic systems. B. The role of nancial intermediaries in the regulation of the money supply. C. Markets and the system of prices. D. Full employment, ination, and economic growth. Managerial economics is best described as: A. Applied microeconomics. B. The application of quantitative methods to microeconomic theory to nd optimal solutions to managerial decision-making problems. C. The study of how managers organize scarce productive resources to efciently achieve the objectives of the rm. D. All of the above are correct.

1.7

1.8

1.9

1.10 The primary objective of the rm is to: A. Maximize total sales revenue. B. Minimize the total cost of production. C. Maximize managers perquisites. D. Maximize the stream of prots and shareholder value. 1.11 The prot motive is important because: A. It is the signaling mechanism for the dynamic reallocation of societys scarce productive resources. B. It encourages unethical behavior by shareholders. C. It discourages monopolistic markets. D. It promotes the equitable distribution of income in an economy.

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Multiple Choice Questions

1.12 Economic theory is used to: A. Reduce uncertainty. B. Make predictions. C. Enable managers to efciently achieve the rms objectives. D. All of the above. 1.13 Ceteris paribus means: A. Buyer beware. B. Other things remaining unchanged. C. After the fact, therefore because of the fact. D. Among other things. 1.14 Descriptive economics: A. Attempts to predict the outcomes of specic management decisions. B. Attempts to interpret observed phenomena and to formulate theories about possible cause and effect relationships. C. Is subjective in nature because it attempts to explain the way things ought to be. D. None of the above. 1.15 Quantitative methods: A. Refer to the tools and techniques of economic analysis. B. Include optimization analysis and statistical methods. C. Include game theory and capital budgeting. D. All of the above. 1.16 Pure capitalism: A. Is characterized by a blend of public and private ownership of productive resources. B. Is characterized by exclusive private ownership of productive resources and the use of markets to allocate goods and services. C. Is characterized by centralized decision making to allocate scarce productive resources. D. Is quite common among countries in North America and Western Europe. 1.17 Markets: A. Are the basic coordinating mechanisms of capitalism. B. A mechanism through which the free choices of individuals are recorded and communicated. C. Allow buyers and sellers to communicate indirectly through prices. D. All of the above.

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Introduction

1.18 Market processes: A. Rely on the intervention of government regulators to answer three basic economic questions. B. Summarize the interaction of supply and demand to answer the three basic economic questions. C. Are only possible with barter transactions. D. Use custom and tradition to answer the three basic economic questions. 1.19 In economics, the term efciency may refer to: A. Corporate and managerial efciency. B. Production and consumption efciency. C. Temporal and spatial efciency. D. All of the above. 1.20 Economic prot is: A. Total revenue minus total cost. B. Total economic revenue minus total economic cost. C. Total revenue minus total economic cost. D. Total revenue minus total explicit cost. E. Total economic revenue minus total cost. 1.21 Total economic costs is: A. Total out-of-pocket expenses. B. The sum of all identiable explicit costs. C. Total explicit and total implicit costs. D. Total accounting costs. 1.22 Accounting cost differ from economic cost because: A. Accounting costs are always greater than economic costs. B. Economic costs include all relevant opportunity costs while accounting costs only include out-of-pocket expenses. C. Accounting costs include implicit costs while economic costs do not. D. Accounting costs include explicit costs while economic costs do not. 1.23 Accounting prot is: A. Total revenue minus total explicit cost. B. Total revenue minus total implicit cost. C. Total revenue minus total economic cost. D. Total revenue minus total cost.

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Multiple Choice Questions

1.24 A rm that earns zero accounting prot: A. Is earning positive economic prot. B. Is also earning zero economic prot. C. Is earning an above-normal rate of return. D. Is earning negative economic prot. 1.25 Normal prot: A. Refers to the level of prots required to keep a rm engaged in a particular activity. B. Is a rate of return that covers the total opportunity costs of the resources sued by a rm. C. Represents the rate of return on the next best alternative investment of equivalent risk. D. The accounting prot earned when economic prot is zero. E. All of the above. 1.26 When a rm just earns a normal prot, then: A. Accounting prot is zero. B. Operating prot is zero. C. Economic prot is zero. D. Economic prot is positive. 1.27 Roscoe owns a shoe store in Frenchtown, New Jersey. Roscoes total revenue last year was $250,000. Roscoes total cost, including his annual salary of $50,000, was $220,000. A large department store wants to hire Roscoe for $75,000 to manage its footwear operations. The opportunity cost to Roscoe of running his own shoe store is: A. $25,000. B. $50,000. C. $75,000. D. There is no opportunity cost since Roscoes annual salary is an explicit cost. 1.28 Roscoe owns a shoe store in Frenchtown, New Jersey. Roscoes total revenue last year was $250,000. Roscoes total cost, including his annual salary of $50,000, was $220,000. A large department store wants to hire Roscoe for $75,000 to manage its footwear operations. Roscoes accounting prot was: A. $5,000. B. $30,000. C. $80,000. D. $105,000. E. $170,000.

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Introduction

1.29 Roscoe owns a shoe store in Frenchtown, New Jersey. Roscoes total revenue last year was $250,000. Roscoes total cost, including his annual salary of $50,000, was $220,000. A large department store wants to hire Roscoe for $75,000 to manage its footwear operations. Roscoes economic prot was: A. $5,000. B. $30,000. C. $80,000. D. $105,000. E. $170,000. 1.30 Roscoe owns a shoe store in Frenchtown, New Jersey. Roscoes total revenue last year was $250,000. Roscoes total cost, including his annual salary of $50,000, was $220,000. A large department store wants to hire Roscoe for $75,000 to manage its footwear operations. Roscoes normal prot was: A. $30,000. B. $80,000. C. $105,000. D. $170,000. E. Cannot be determined from the information provided. 1.31 The principal-agent problem refers to: A. The relationship between the rms owner and manager. B. The relationship between the rms manager and worker. C. Problems that arises when there are inadequate incentives for agents to put forth their best efforts for principals. D. All of the above. 1.32 The principal-agent problem arises when: A. Managers have a vested interest in the success of a company, but workers do not. B. Workers have a vested interest in the success of a company, but managers do not. C. When managers or workers do not have a vested interest in the success of a company. D. None of the above. 1.33 One possible solutions to the owner-manager principal agent problem include: A. Time clocks and spot checks. B. An incentive contract that links manager compensation to performance. C. Higher salaries and perquisites. D. Both B and C are correct.

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Shorter Problems

1.34 Satiscing behavior: A. Is a theory put forward by Herbert Simon suggesting that managers attempt to maximize executive salaries and perquisites subject to some minimally acceptable (to the shareholder) rate of return on investment. B. Implies that managers attempt to satisfy shareholder expectations by maximizing the rms valuation ratio, which is dened as the ratio of the stock market value of the rm to its highest possible value. C. Implies that the objective of the rm is to satisfy shareholder expectations by maximizing the rms market share. D. Is similar to theory of manager-utility maximization put forth by Oliver Williamson. E. Both A and D are correct.

SHORTER PROBLEMS
1.1 A rm earned $500,000 in operating prots. The rms total revenues and total economic costs were $750,000 and $250,000, respectively. What is the rms normal prot? Researchers at the Goodpastor Company have analyzed two capital investment projects (Projects 1 and 2) which are expected to generate the following prot (p) streams:
Prot Streams for Projects 1 and 2 ($ thousands) Period (t) 1 2 3 4 5 Total pA $200 300 400 450 525 $1,875 pB $550 500 400 300 100 $1,850

1.2

Which project should Goodpastor adopt if the discount rate is 8 percent? 1.3 Jessie quit her $35,000 per year job and purchased a building that was previously rented by the owner of a coin-operated laundry for $2,000 per month. Last year, Jessie was told by her accountant that she earned a prot of $100,000. How much was Jessies economic prot?

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LONGER PROBLEMS
1.1

Introduction

A rm is considering three capital investment projects that generate the following net income over the next four years: p1,1 = $150; p1,2 = $200; p1,3 = $300; p1,4 = $400 p2,1 = $400; p2,2 = $300; p2,3 = $200; p2,4 = $100 p3,1 = $225; p3,2 = $200; p3,3 = $200; p3,4 = $400 where pi,j represents the net income of the ith capital investment project production in the jth year. A. Suppose that the objective of the rm is to maximize total yearly net incomes. Which project will the rm select? B. Suppose that the objective of the rm is to maximize the present value of the stream of net incomes. Which project will the rm select if the discount rate is 10 percent?

1.2

Fatty Wingfoot owns a stationery story. Last year, Fattys total sales revenues amounted to $175,000, employee labor costs were $80,000, the cost of supplies were $20,000, $15,000 went for rent, $2,500 for utilities, and $4,000 for interest payments on a bank loan. Before opening his own business, Fatty earned $60,000 as a store manager for Tacks, a large business-supplies chain. A. Calculate Fattys total explicit costs. B. Calculate Fattys total implicit costs. C. What is Fattys accounting prot? D. What is Fattys economic prot? Jack Sprat is the owner of Bandit, a company that manufactures toy slot machines. Before starting his own business, Jack worked for Slots, a company that produces toy roulette wheels. Jacks salary while working for Slots was $150,000 per year. In addition, in order to start his own business, Jack closed a $1,500,000 certicate of deposit on which he was earning 5 percent annually. Last year, Bandits total revenues and expenditures were: Revenues Cost of goods sold Cost of labor Advertising Insurance Rent Miscellaneous expenses $6,750,000 2,500,000 750,000 150,000 100,000 500,000 250,000

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Answers to Multiple Choice Questions

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A. B. C. D.

Calculate Bandits total explicit costs. Calculate Bandits total implicit costs. Calculate the rms accounting prot. Calculate Jacks economic prot.

1.4 A rm has estimated the following total revenues and expenditures for the next scal year: Sales revenues Cost of raw materials Wages and salaries Advertising Insurance Rent Miscellaneous $10,000,000 7,500,000 500,000 50,000 100,000 250,000 75,000

A. Calculate the rms accounting prot. B. The company is considering purchasing and moving its operations to another building. The cost of the building is $3,000,000. The rm plans to nance the purchase of the building with a bank loan. The interest rate on the loan is 7.5 percent. If the rm goes through with its plan, what will be the rms accounting prot? What will be the rms economic prot?

ANSWERS TO MULTIPLE CHOICE QUESTIONS

1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 1.15 1.16 1.17 B. A. C. D. C. B. C. C. B. D. A. D. B. B. D. B. D. 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 1.26 1.27 1.28 1.29 1.30 1.31 1.32 1.33 1.34 B. B. C. C. B. A. D. E. C. A. B. A. E. D. C. B. E.

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SOLUTIONS TO SHORTER PROBLEMS
1.1 1.2

Introduction

pN = pO - TR + TC = $500,000 - $750,000 + $250,000 = $0 PV(p1) = 200/(1.08)1 + 300/(1.08)2 + 400/(1.08)3 + 450/(1.08)4 + 525/(1.08)5 = $1,447.99 PV(p2) = 550/(1.08)1 + 500/(1.08)2 + 400/(1.08)3 + 300/(1.08)4 + 100/(1.08)5 = $1,544.03 Goodpastor should invest in Project 2. p = TR - TCexplicit - TCimplicit = pA - TCimplicit = 100,000 - (35,000 + 12 2,000) = $41,000

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SOLUTIONS TO LONGER PROBLEMS

1.1 A. p1,1 + p1,2 + p1,3 + p1,4 = $1,050 p2,1 + p2,2 + p2,3 + p2,4 = $1,000 p3,1 + p3,2 + p3,3 + p3,4 = $1,025 The rm will select the rst capital investment project since it generates the greatest total yearly net incomes. B. PV(p1) = S[pt/(1 + i)t] = $150/1.1 + $200/(1.1)2 + $300/(1.1)3 + $400/(1.1)4 = $800.25 PV(p2) = S[pt/(1 + i)t] = $400/1.1 + $300/(1.1)2 + $200/(1.1)3 + $100/(1.1)4 = $830.13 PV(p3) = S[pt/(1 + i)t] = $225/1.1 + $200/(1.1)2 + $200/(1.1)3 + $400/(1.1)4 = $773.31 The rm will select the second capital investment project since it results in the highest present value of the net income streams. A. Total explicit costs = Labor + Supplies + Rent + Utilities + Interest = $80,000 + $20,000 + $15,000 + $2,500 + $4,000 = $121,500

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Solutions to Longer Problems

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B. C. D.

Total implicit costs = Fattys Tacks salary = $60,000 Accounting prot = Total revenue - Total explicit costs = $175,000 - $121,500 = $53,500 Economic prot = Total revenue - Total economic costs = Total revenue - (Total explicit costs + Total implicit costs) = $175,000 - ($121,500 + $60,000) = -$6,500 A. TCexplicit = Cost of goods sold + Labor + Advertising + Insurance + Rent + Misc. = $2,500,000 + $750,000 + $150,000 + $100,000 + $500,000 + $250,000 = $4,250,000 B. TCimplicit = Foregone salary + Foregone interest income = $150,000 + $75,000 = $225,000 C. pA = TR - TCexplicit = $6,750,000 - $4,250,000 = $2,500,000 D. p = TR - TCexplicit - TCimplicit = $6,750,000 - $4,250,000 - $225,000 = $2,275,000 A. pA = TR - TCexplicit = TR - (Raw materials + Wages and salaries + Advertising + Insurance + Rent Miscellaneous) = 10,000,000 - (7,500,000 + 500,000 + 50,000 + 100,000 + 250,000 + 75,000) = 10,000,000 - 8,475,000 = $1,525,000 B. If the rm purchases the building, then expenditures on rent will decline by $250,000. On the other hand, the rm will be obligated to make interest payments of $225,000. There will be a net decline in total explicit costs of $25,000. As a result, the rms accounting prots will increase to $1,550,000. The effect on the rms economic prot will depend on how much rental income the rm could have earned from the new building. If the new building can earn a rental income of $250,000, then the rms economic prot will not be affected. On the other hand, if the rm could have rented the building for an amount greater than $250,000, then the rms economic prot will fall. If the rm could have rented the building for an amount less than $250,000, then the rms economic prot will increase.

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