Man eco-session 1

The Nature & scope of Man EcoDr. Prema Basargekar

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright 2007 by Oxford University Press, Inc. (Adapted by OUP India, 2008) Slide 2

Define managerial economics How Is Managerial Economics Useful? Economics and Managerial Decision Making Theory of the Firm Profit Measurement Theory of profit Why Do Profits Vary among Firms? Role of Business in Society


“Economics studies human behaviour as a relationship between ends and scarce means which have alternative uses”- Lionel Robbins

Economics is “the study of the behavior of human beings in producing, distributing and consuming material goods and services in a world of scarce resources.” (McConnell, 1993)


Management is the discipline of organizing and allocating a firm’s scarce resources to achieve its desired objectives. Involves the ability to organize and administer various tasks in pursuit of certain objectives.

Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources.


Business decision process is becoming more & more complex due to

a.Change in ownership patternb.Change in scale of operationc.Change in business environment

Making appropriate business decision requires clear understanding of market conditions of product, inputs & financial markets which require application of economic concepts, theories & tools.


The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently.◦ applications of economic theory◦ quantitative methods◦ statistical methods◦ computational methods


Microeconomics◦ Study of the economic behavior of individual

decision-making units.◦ Relevance to Managerial Economics

Macroeconomics◦ Study of the total or aggregate level of output,

income, employment, consumption, investment, and prices for the economy viewed as a whole.


Mathematical Economics◦ Expresses and analyzes economic models using

the tools of mathematics. Econometrics

◦ Employs statistical methods to estimate and test economic models using empirical data.


Economic Models◦ Abstract from details◦ Focus on most important determinants of

economic behavior – cause and effect Evaluating Economic Models

◦ A model is accepted if it predicts accurately and if the predictions follow logically from the assumptions.


Combines and organizes resources for the purpose of producing goods and/or services for sale.

Internalizes transactions, reducing transactions costs.

Economic theory assumes that the primary goal of managers is to maximize the value of the firm.


Value of the firm is the present value of the firm’s expected future cash flows.

If the cash flows or future expected profits are discounted back to the present value, we get the present value of the firm.

Discounting is required because profits earned in the future are less valuable than profits earned presently.


The present value of all expected future profits

1 21 2

1(1 ) (1 ) (1 ) (1 )

nn tn t

t

PVr r r r

1 1(1 ) (1 )

n nt t tt t

t t

TR TCValueof Firm

r r


Present value of Rs. 100 at the discount rate of 5% would be

First year – 100/(1+0.05) = 95.24 Second year – 100/(1+0.05)2 = 90.70

If discounting rate is 10 % Then 100/(1+0.10) = 90.90 100/ (1+0.10)2 = 82.64


The manager of automated Products is contemplating the purchase of a new machine that will cost Rs. 3,00,000 and has a useful life of five years. The machine will yield (year-end) cost reduction to Automated Products of Rs. 50,000 in year 1, Rs. 60,000 in year 2, Rs. 75,000 in year 3 and Rs. 90,000 in year 4 and year 5.

What is the present value of the cost savings of the machine if the interest rate is 8 % ? Should the manager purchase the machine?


By spending Rs. 3,00,000 today on a new machine, the firm will reduce costs by Rs. 3,65,000. However the present value is

PV = 50,000/1.08 + 60,000/ 1.082 + 75,000/1.083 + 90,000/1.084 + 90,000/1.085

= 2,84,679 NPV = PV – Cost = 2,84,679 – 3,00,000 = - 15,321 Since NPV is negative, the manager should not purchase

the machine. She can earn more by investing the same amount at 8 % in any financial asset.


Scarcity of Inputs: Skilled labour, specific raw material, funds

Legal Constraints: Govt rules & regulations, licenses, permissions, wage laws, health & safety standards, pollution emission standards, etc.

Constrained Optimization: within these constraints firms have maximise wealth or its value.


Sales maximization◦ Adequate rate of profit – ◦ Dichotomy bet. Ownership & Mgt.◦ After adequate rate of profit◦ Reasons: salary, loans, dev indicators related to

sales; strengthening competitive spirit Management utility maximization

◦ Principle-agent problem Satisficing behavior – complexity &uncertainty make decision

complicated Mangers have to satisfy variety of people like

Labour, shareholders, customers, financiers, authorities, etc


Business Profit: Total revenue minus the explicit or accounting costs of production.

Economic Profit: Total revenue minus the explicit and implicit costs of production.

Opportunity Cost: Implicit value of a resource in its best alternative use.


Find out accounting & economic profit. A. A manager working at the salary of Rs.

30,000/pm leaves his job & starts his own firm. He uses his own capital of Rs.4,00,000/ which he had kept in fixed deposit at 10%p.a. He pays Rs. 10,000/ pm to 2 workers each. He pays Rs. 30,000/- as rent pm. His total revenue from sales is Rs. 7,00,000/-.


Explicit cost: Salary: (10,000 * 2) * 12 = 2,40,000 Rent : 30,000 * 12 = 3,60,000 Total explicit cost = 6,00,000 Accounting profit = 7,00,000 – 6,00,000 = 1,00,000 Implicit cost: Salary forgone: 30,000 * 12 = 3,60,000 Interest forgone: 4,00,000 * 0.1 = 40,000 Total implicit cost = 4,00,000 Total cost (Implicit + Explicit) 6,00,000 + 4,00,000 Economic profit = 7,00,000 – 10,00,000 = - 3,00,000


Risk-Bearing Theories of Profit Frictional Theory of Profit Monopoly Theory of Profit Innovation Theory of Profit Managerial Efficiency Theory of Profit


Risk-Bearing Theories of Profit: above normal returns (economic profits) are required to get to cover for risk. The greater the risk; the greater shd be the returns

Frictional Theory of Profit: Profits arise due to friction or disturbances from long-run equilibrium where firms tend to earn only normal profits.


Monopoly Theory of Profit: Monopolist can control the supply & can continue to make profits even in the long run.: economies of scale, control over crucial input, legal protection, mergers, takeovers, etc.

Innovation Theory of Profit: Profit is a reward for successful innovation.: new commodity, new method of prod, new market, new inputs, new way of organization

Managerial Efficiency Theory of Profit: Firms that are more efficient than the average would earn above normal returns and economic profit.


Profit is a signal that guides the allocation of society’s resources.

High profits in an industry are a signal that buyers want more of what the industry produces.

Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.


Concepts learnt: Managerial economics Theory of firm Time value of money Discounting principle Constrained optimization Business & accounting profit Economic profit Theories of profits

Man eco-session 1

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