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Afework Getachew Kassa,PhD

Managerial decisions are an important cog in the
working wheel of an organisation. The success or
failure of a business is contingent upon the
decisions taken by managers.
Increasing complexity in the business world has
spewed forth greater challenges for managers.
Decisions pertinent to production and marketing of
goods are shaped with a view of the world both
inside as well as outside the economy.
Rapid changes in technology, greater focus on innovation in
products as well as processes that command influence over
marketing and sales techniques have contributed to the
escalating complexity in the business environment.

This complex environment is coupled with a global market

where input and product prices have a propensity to
fluctuate and remain volatile.

These factors work in tandem to increase the difficulty in

precisely evaluating and determining the outcome of a
business decision. Such evanescent environments give rise
to a pressing need for sound economic analysis prior to
making decisions.
Definition: Economics is the study of how
individuals and societies choose to utilize
scarce resources to satisfy virtually unlimited
Definition: Scarcity describes the condition in
which the availability of resources is
insufficient to satisfy the wants and needs of
individuals and society.
Individuals and societies cannot have everything
that is desired because most goods and services
must be produced with scarce productive

Because productive resources are scarce, the

amounts of goods and services produced from
these ingredients must also be finite in supply.

The concept of scarcity is summarized in the

economic admonition that there is no “free
Goods, services, and productive resources that are
scarce have a positive price. Positive prices reflect
the competitive interplay between the supply of
and demand for scarce resources and

A commodity with a positive price is referred to as

an economic good.
Commodities that have a zero price because they
are relatively unlimited in supply are called free
Is air a free good?
Many students would assert that it is, but what is
the price of a clean environment? Inhabitants of
most advanced industrialized societies have
decided that a cleaner environment is a socially
desirable objective.
Environmental regulations to control the disposal of
industrial waste and higher taxes to finance
publicly mandated environmental protection
programs, which are passed along to the
consumer in the form of higher product prices,
make it clear that clean air and clean water are
not free.
What are these scarce productive resources?
Productive resources, sometimes called factors
of production or productive inputs, are
classified into one of four broad categories:
land, labor, capital, and entrepreneurial

Land generally refers to all natural resources.

Included in this category are wildlife, minerals,
timber, water, air, oil and gas deposits, arable
land, and mountain scenery.
Land generally refers to all natural resources.
Included in this category are wildlife, minerals,
timber, water, air, oil and gas deposits, arable
land, and mountain scenery.
Labor refers to the physical and intellectual abilities
of people to produce goods and services. Of
course, not all workers are the same; that is,
labor is not homogeneous.
Different individuals have different physical and
intellectual attributes. These differences may be
inherent, or they may be acquired through
education and training
Capital refers to manufactured commodities that are used to
produce goods and services for final consumption.
Machinery, office buildings, equipment, warehouse space,
tools, roads, bridges, research and development, factories,
and so forth are all a part of a nation’s capital stock.
Economic capital is different from financial capital, which
refers to such things as stocks, bonds, certificates of
deposits, savings accounts, and cash.
It should be noted, however, that financial capital is typically
used to finance a firm’s acquisition of economic capital.
Thus, there is an obvious linkage between an investor’s return
on economic capital and the financial asset used to
underwrite it.
Entrepreneurial ability refers to the ability to
recognize profitable opportunities, and the
willingness and ability to assume the risk
associated with marshalling and organizing land,
labor, and capital to produce the goods and
services that are most in demand by consumers.
People who exhibit this ability are called
In market economies, the value of land, labor, and
capital is directly determined through the
interaction of supply and demand. This is not the
case for entrepreneurial ability. The return to the
entrepreneur is called profit.
The concepts of scarcity and choice are central to the
discipline of economics. These concepts are used to
explain the behaviour of both producers and
It is important to understand, however, that in the face of
scarcity whenever the decision is made to follow one
course of action, a simultaneous decision is made to
forgo some other course of action.
When a high school graduate decides to attend college or
university, a simultaneous decision is made to forgo
entering the work force and earning an income
Scarcity necessitates trade-offs, which is
sacrificed when a choice is made in the next
best alternative.

It is the path that we would have taken had our

actual choice not been open to us.
Definition: Opportunity cost is the highest
valued alternative forgone whenever a choice
is made.


Scarcity, and the manner in which individuals

and society make choices, are fundamental to
the study of economics.

To examine these important issues, the field of

economics is divided into two broad subfields:
macroeconomics and microeconomics.
As the name implies, macroeconomics looks at the
big picture.
Macroeconomics is the study of entire economies
and economic systems and specifically considers
such broad economic aggregates as gross
domestic product, economic growth, national
income, employment, unemployment, inflation,
and international trade.
In general, the topics covered in macroeconomics
are concerned with the economic environment
within which firm managers operate.
For the most part, macroeconomics focuses on
the variables over which the managerial
decision maker has little or no control but may
be of considerable importance in the making
of economic decisions at the micro level of the
individual, firm, or industry.
Definition: Macroeconomics is the study of
aggregate economic behaviour.
????Macroeconomic issues are beyond the
control of managers. Then, why would it be
essential for managerial decision makers to be
aware and knowledgeable of such macro
By contrast, microeconomics is the study of the
behaviour and interaction of individual economic
agents. These economic agents represent
individual firms, consumers, and governments.

Microeconomics deals with such topics as profit

maximization, utility maximization, revenue or
sales maximization, production efficiency, market
structure, capital budgeting, environmental
protection, and governmental regulation.
Definition: Microeconomics is the study of
individual economic behaviour.
The discipline of managerial economics deals with
aspects of economics and tools of analysis, which are
employed by business enterprises for decision-making.
Decision-making can be delineated as a process where a
particular course of action is chosen from a number of
alternatives. This demands an unclouded perception of
the technical and environmental conditions, which are
integral to decision making.
The decision maker must possess a thorough knowledge
of aspects of economic theory and its tools of analysis.
Almost any business decision can be analysed with managerial economics
techniques. However, the most frequent applications of these
techniques are as follows:

• Risk analysis: Various models are used to quantify risk and asymmetric
information and to employ them in decision rules to manage risk.
• Production analysis: Microeconomic techniques are used to analyse
production efficiency, optimum factor allocation, costs and economies
of scale. They are also utilised to estimate the firm's cost function.
• Pricing analysis: Microeconomic techniques are employed to examine
various pricing decisions. This involves transfer pricing, joint product
pricing, price discrimination, price elasticity estimations and choice of
the optimal pricing method.
• Capital budgeting: Investment theory is used to scrutinise a firm's
capital purchasing decisions.
The tenets of managerial economics have been derived
from quantitative techniques such as regression
analysis, correlation and Lagrangian calculus (linear).

An omniscient and unifying theme found in managerial

economics is the attempt to achieve optimal results
from business decisions, while taking into account the
firm's objectives, constraints imposed by scarcity and
so on.
A paradigm of such optmisation is the use of operations
research and programming.

Managerial economics is thereby a study of application of

managerial skills in economics.
Characteristics of ME
1. Microeconomics: It studies the problems and principles
of an individual business firm or an individual industry.
It aids the management in forecasting and evaluating
the trends of the market.

2. Normative economics: It is concerned with varied

corrective measures that a management undertakes
under various circumstances. It deals with goal
determination, goal development and achievement of
these goals. Future planning, policy-making, decision-
making and optimal utilisation of available resources,
come under the banner of managerial economics.
Characteristics of ME

3. Pragmatic: Managerial economics is pragmatic. In pure

micro-economic theory, analysis is performed, based
on certain exceptions, which are far from reality.
However, in managerial economics, managerial issues
are resolved daily and difficult issues of economic
theory are kept at bay.

4. Uses theory of firm: Managerial economics employs

economic concepts and principles, which are known as
the theory of Firm or 'Economics of the Firm'. Thus, its
scope is narrower than that of pure economic theory.
Characteristics of ME
5. Takes the help of macroeconomics: Managerial economics
incorporates certain aspects of macroeconomic theory.
These are essential to comprehending the circumstances
and environments that envelop the working conditions of
an individual firm or an industry.
Knowledge of macroeconomic issues such as business cycles,
taxation policies, industrial policy of the government, price
and distribution policies, wage policies and antimonopoly
policies and so on, is integral to the successful functioning
of a business enterprise.
6. Aims at helping the management: Managerial economics
aims at supporting the management in taking corrective
decisions and charting plans and policies for future.
Characteristics of ME
7. A scientific art: Science is a system of rules and
principles engendered for attaining given ends.
Scientific methods have been credited as the optimal
path to achieving one's goals.
Managerial economics has been also called a scientific
art because it helps the management in the best and
efficient utilisation of scarce economic resources.
It considers production costs, demand, price, profit, risk
etc. It assists the management in singling out the most
feasible alternative. Managerial economics facilitates
good and result oriented decisions under conditions of
Characteristics of ME
8. Prescriptive rather than descriptive:
Managerial economics is a normative and
applied discipline.

It suggests the application of economic

principles with regard to policy formulation,
decision-making and future planning. It not
only describes the goals of an organisation but
also prescribes the means of achieving these
Scope of ME
The scope of managerial economics includes
following subjects:
1. Theory of demand
2. Theory of production
3. Theory of exchange or price theory
4. Theory of profit
5. Theory of capital and investment.
Importance of managerial economics
Spencer and Siegelman have described the
importance of managerial economics in a
business and industrial enterprise as follows:

• Reconciling traditional theoretical concepts to the

actual business behaviour and conditions
• Estimating economic relationships
• Predicting relevant economic quantities
• Understanding significant external forces
• Basis of business policies
The Principal-Agent Problem
A distinguishing characteristic of the large corporation is
that it is not owner operated. The responsibility for
day-to-day operations is delegated to managers who
serve as agents for shareholders.
Since the owners cannot closely monitor the manager’s
performance, how then shall the manager be
compelled to put forth his or her “best” effort on
behalf of the owners?
If a manager is paid a fixed salary, a fundamental
incentive problem emerges. If the firm performs
poorly, there will be uncertainty over whether this was
due to circumstances outside the manager’s control
was the result of poor management.
The Principal-Agent Problem....
Suppose that company profits are directly related to
the manager’s efforts. Even if the fault lay with a
goldbricking manager, this person can always
claim that things would have been worse had it
not been for his or her herculean efforts on
behalf of the shareholders.
With absentee ownership, there is no way to verify
this claim. It is simply not possible to know for
certain why the company performed poorly.
When owners are disconnected from the day-to-
day operations of the firm, the result is the
owner–manager/principal–agent problem.
The Principal-Agent Problem....

Definition: The owner–manager/principal–agent

problem arises when managers do not share
in the success of the day-to-day operations of
the firm. When managers do not have a stake
in company’s performance, some managers
will have an incentive to substitute leisure for
a diligent work effort.
The Principal-Agent Problem....

Will the offer of a higher salary compel the manager to work


The answer is no for the same reason that the manager did
not work hard in the first place. Since the owners are not
present to monitor the manager’s performance, there will
be no incentive to substitute work for leisure.

A fixed-salary contract provides no penalty for goofing off.

One solution to the principal–agent problem would be to
make the manager a stakeholder by offering the manager
an incentive contract
The Principal-Agent Problem....
An incentive contract links manager compensation
to performance. Incentive contracts may include
such features as profit sharing, stock options, and
performance bonuses, which provide the
manager with incentives to perform in the best
interest of the owners.

Definition: An incentive contract between owner

and manager is one in which the manager is
provided with incentives to perform in the best
interest of the owner.
The Principal-Agent Problem....
Suppose, for example, that in addition to a salary of
$200,000 the manager is offered 10% of the
firm’s profits. The sum of the manager’s salary
and a percentage of profits is the manager’s gross

This profit-sharing contract transforms the manager

into a stakeholder. The manager’s compensation
is directly related to the company’s performance.
It is in the manager’s best interest to work in the
best interest of the owners.
The Principal-Agent Problem....
Another incentive is the manager’s own reputation.
Managers are well aware that their current position
may not be their last.
The ability of managers to move to other more
responsible and lucrative positions depends
crucially on demonstrated managerial skills in
previous employments.
An effective manager invests considerable time,
effort, and energy in the supervision of workers
and organization of production
The Principal-Agent Problem....
The value of this investment will be captured in the
manager’s reputation, which may ultimately be
sold in the market at a premium.
Thus, even if the manager is not made a
stakeholder in the firm’s success through profit
sharing, stock options, or performance bonuses,
the manager may nonetheless choose to do a
good job as a way of laying the groundwork for
future rewarding opportunities.

Job security also serves as incentive.


Definition: The manager–worker/principal–agent

problem arises when workers do not have a
vested interest in a firm’ success. Without a stake
in the company’s performance, there will be an
incentive for some workers not to put forth their
best efforts.

Profit and revenue sharing, piecework, time clocks,

and spot checks are some incentives for workers.
Economic profit Vs Accounting profit
To use a certain set of resources to produce a good
or service means that certain alternative
production possibilities were forgone.
Costs in economics have to do with forgoing the
opportunity to produce alternative goods and
services. The economic, or opportunity, cost of
any resource in producing some good or service is
its value or worth in its next best alternative use.
Given the notion of opportunity costs, economic
costs are the payments a firm must make, or
incomes it must provide, to resource suppliers to
attract these resources away from alternative
lines of production
Economic profit Vs Accounting profit.....
Economic costs (TC) include all relevant opportunity costs.
These payments or incomes may be either explicit,
“out-of-pocket” or cash expenditures, or implicit.

Implicit costs represent the value of resources used in the

production process for which no direct payment is
This value is generally taken to be the money earnings of
resources in their next best alternative employment.
When a computer software programmer quits his or
her job to open consulting firm, the forgone salary is
an example of an implicit cost.
Economic profit Vs Accounting profit.....
These relationships may be summarized as follows:

Problem : Aderajew operates a small shop specializing in party favors.

He owns the building and supplies all his own labor and money capital.
Thus, Aderajew incurs no explicit rental or wage costs. Before starting his
own business Aderajew earned birr 1,000 per month by renting out the
store and earned birr 2,500 per month as a store manager for a large
department store chain. Because Aderajew uses his own money capital,
he also sacrificed birr 1,000 per month in interest earned on Treasury
bonds. Aderajew’s monthly revenues from operating his shop are birr
10,000 and his total monthly expenses for labor and supplies amounted to
birr 6,000. Calculate Aderajew’s monthly accounting and economic
Economic profit Vs Accounting profit.....

Total accounting profit is calculated as follows:
• Total revenue birr 10,000
• Total explicit costs 6,000
• Accounting profit birr 4,000
Andrew’s accounting profit appears to be a healthy
birr 4,000 per month.

However, if we take into account Aderajew’s implicit

costs, the story is quite different
Economic profit Vs Accounting profit.....
Total economic profit is calculated as follows:
• Total revenue birr 10,000
• Total explicit costs 6,000
• Forgone rent 1,000
• Forgone salary 2,500
• Forgone interest income 1,000
• Total implicit costs 4,500
• Total economic costs 10,500
• Economic profit (loss) birr (500)

Economic profits are equal to total revenue less total

economic costs, which is the sum of explicit and implicit
costs. Accounting profits, on the other hand, are equal to
total revenue less total explicit costs.
Economic profit Vs Accounting profit.....
Problem :
Adam is the owner of a small grocery store in a busy
section of Kasanchis Addis Ababa. Adam’s annual
revenue is birr 200,000 and his total explicit cost (Adam
pays himself an annual salary of birr 30,000) is birr
180,000 per year. A supermarket chain wants to hire
Adam as its general manager for birr 60,000 per year.
a. What is the opportunity cost to Adam of owning and
managing the grocery store?
b. What is Adam’s accounting profit?
c. What is Adam’s economic profit?
Summary Questions
?? What is the concern of economics in general?
?? How is the concept of opportunity cost related with
?? Macroeconomics Vs Microeconomics.
?? What is managerial economics? How is it helpful to
?? Discuss the characteristics of ME.
?? Discuss the scope of ME.
?? What is the principal agent problem?
?? Differentiate B/N economic and accounting cost/profit