Nature and Scope of Managerial Economics (Chapter 1 Hirschey)

INTRODUCTION

Definition of Managerial Economics

• Application of economic tools and techniques to business and administrative decision-making; another term for the title of this course, namely economic analysis for agribusiness and management.

• Helps decision-makers recognize how economic forces affect organizations and describes the economic consequences of managerial behavior. How? By linking economic concepts and quantitative methods to develop tools for managerial decision-making.

• Simply put, managerial economics uses economic concepts and quantitative methods to solve managerial problems.

• We place emphasis on the practical application of economic analysis to managerial decision problems; the primary virtue of managerial economics lies in its usefulness.

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Economic concepts:

influence which products to produce, which costs to consider, and the prices to charge;

necessitates the collection, organization, and analysis of information.

Emphasis is placed on microeconomic topics, although macroeconomic relations have implications for managerial decision-making as well.

ECONOMIC CONCEPTS

1) Optimization techniques (calculus-based and

linear programming)2) Statistical relations3) Demand analysis and estimation (through

regression)4) Forces of demand and supply5) Forecasting of firm activities (sales, production,

demand, prices)6) Risk analysis

Economic decision-making requires the following:

Firms are useful for producing and distributing

goods and services Motivation for firms:

profit maximization or expected value maximization; free enterprise depends upon profits and the profit motive

Expected value of maximization: optimization of profits in light of uncertainty and

time value of money.

FIRMS

 

VALUE OF THE FIRM

n

tttt

iTCTR

1 )1( firm of Value

+

…

Suppose that Chevron Corporation makes

projections of profits (expected profits) over the next five years: 2011 = $18,690 million 2012 = $15,560 million 2013 = $14,935 million 2014 = $20,125 million 2015 = $24,585 million

EXAMPLE: VALUE OF THE FIRM

Let the discount rate be equal to three percent.

Calculate the value of Chevron Corporation today.

Value of the firm ( in millions) =

Value of the firm discounted back to the present = $_____________ million

EXAMPLE, CONT.

85,653

Expected value maximization relates to the

various functional departments of the firm; also illustrates the value of forecasting TR: marketing department, primary

responsibility for promotion and sales TC: production department, primary

responsibility for costs i: finance department, primary

responsibility for the acquisition of capital and hence the discount factor i.

EXPECTED VALUE MAXIMIZATION

The determination of TR and TC is a non-trivial

and often complex task.

Suppose that a firm produces only one product. TRt = PtQt-1 requires the notion of a demand

function TCt = fixed costst + variable costst

Variable costs are a function of Q TCt = f(Qt) Even more complex situation if a firm produces

more than one product.

TOTAL REVENUE AND TOTAL COSTS

Skilled labor Raw materials Energy Specialized machinery Warehouse space Amount of investment funds available for a particular

project or activity Legal /contractual restrictions

Consequently, optimization techniques with constraints are important in decision-making Linear programming Calculus-based optimization

FIRM FACES CONSTRAINTS

Business Profit:

= TR – TC the residual of sales revenue minus the explicit

costs of doing business. Economic Profit:

= business profit minus the implicit costs of capital and any other owner-provided inputs

reflects the opportunity cost for the effort of the owner-entrepreneur.

PROFIT MEASUREMENT

Opportunity Costs:

Owner-provided inputs are a notable part of business profits, especially among small businesses.

Profit Margin: = business profit (net income)/sales, Expressed as a percent

PROFIT MEASUREMENT

In 2007, the sales revenue of the American

Express Company was $27,136 million. The Business profit or net income for this firm was $3,729 million. What was the profit margin for the American Express Company?

Profit Margin =

EXAMPLE: PROFIT MARGIN

b

Return on Equity(ROE)

business profit (net income)/equity Expressed as a percent

Equity total assets – total liabilities = net worth=equity

EQUITY

In 2007, the net income for Microsoft

Corporation was $11,909 million. The equity (or net worth) of this firm was $36,708 million. What is the ROE for Microsoft Corporation?

ROE =

EXAMPLE: ROE