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Managerial Economics

IntroductionManagerial Economics:

1. Describes the economic forces that shape the internal and external environments of a business firm.

2. Prescribes rules for managerial decision-making that furthers the objective of the firm.

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A Decision-Making ModelObjectives

Define the problem

Alternative Solutions

Evaluation

Implement andmonitor the

decision

Organizationaland input

constraints

Social constraints

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Objective of the Firm Not market share Not growth Not revenue Not empire building Not name recognition Not state-of-the-art technology

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What’s the objective of the firm?

The objective of the firm is to maximize the value of the firm.

Value of the firm is the true measure of business success (of course, from a for-profit perspective.)

Two questions:

1. How is the “value of the firm” defined and measured?

2. How do managers go about adding value to the firm?

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Managerial Economics

Q1- What’s the value of the firm?“The present value of the firm’s future net earnings.”

1 2 n

V = [--------] + [ --------] + . . . + [ -------- ] (1+r)1 (1+r)2 (1+r)n

t

= [ ------- ] , t = 1, 2, ... , N (1+r)t

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Managerial Economics

Q2 - How should a manager go about adding value?

A good map or a travel guide to the “curious land of the Econ” should help.

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Managerial Economics

A Useful Map

Profit = Total Rev - Total Cost

= P . Qd - AC . Qs

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Theories of Profits

(Why are profits necessary?) Risk-Bearing Theory of Profit - Profits (normal

profits) are necessary to compensate for the risk that entrepreneurs take with their capital and efforts

Dynamic Equilibrium (Frictional) Theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.

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Theories of Profits Monopoly Theory - Profits are the result of

some firm’s ability to dominate the market Innovation Theory - Extraordinary profits

are the rewards for successful innovations Managerial Efficiency Theory -

Extraordinary profits can result from exceptionally managerial skills of well-managed firms.

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Managerial Actions Controllable factors (internal environment):

Productions Technology Marketing Mix Employment Policies Investment Strategies Capital structure

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Managerial Actions

Non-Controllable factors(external environment): Level of Economic activities Economic Regulations Unions Global Business conditions BOP and Exchange rate changes

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Terminology Issues

The Marginality analysis Economic Profits Accounting Profits Cash flows

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The Principle of Marginality $

1 2 3 4

MC

MB

Hospital Days

$1,000

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The Principle of Opportunity Cost

Costs are opportunities sacrificed. To be precise, the opportunity cost of a choice or decision is measured by the highest valued alternative that will be given up.

Cost is not always the monetary expense Cost is often implicit rather than explicit

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Significance of the Opportunity Cost

Concept Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services)

Reported on the firms income statement Economic profits = Net revenue –

Opportunities Costs Economic profits and opportunity costs are

critical to decision making

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More examples of useful concepts The principal-agent or the agency

problems: Moral hazard

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What’s Managerial Economics?

Managerial economics is not a separate management discipline

Rather, it is a logical and useful tool for framing and solving management problems.

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Outline for this Course

Microeconomics Way of Thinking

Sellers, Production, Costs

Markets and Pricing

Consumers, Value and Demand

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What will we learn? useful economic principles for sound economic

decision-making in a management context. the basics of the demand side of the market

and which factors influence the buyers’ behavior.

the fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs.

how firms’ costs and buyers’ demand together determine the firm’s price and net profit.