Managerial Economics Lect 1 & 2

8/8/2019 Managerial Economics Lect 1 & 2

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Managerial Economics :


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Introduction to ManagerialEconomics


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What is economics :

Economics is a social science. Its basic function is to study howpeople individuals, households,firms & nations maximize their gains

from their limited resources & opportunities.

Economics is obviously a study of the choice-making behaviour of thepeople. In reality, however, choice making is not so simple as it looksbecause the economic world is very complex & most economicdecisions have to be taken under the condition of imperfect

knowledge, risk & uncertainty.


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Why Study Economics? An important reason for studying economics is to learn a

way of thinking.

Three fundamental concepts:

Opportunity cost

Marginalism, and

Efficient markets


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Opportunity Cost

Opportunity cost is the best alternative that we forgo, or

give up, when we make a choice or a decision.

Nearly all decisions involve trade-offs.


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Marginalism

In weighing the costs and benefits of a decision, it isimportant to weigh only the costs and benefits that arise

from the decision.


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Marginalism

For example, when a firm decides whether to produce

additional output, it considers only the additional (or

marginal cost), not the sunk cost.

Sunk costs are costs that cannot be avoided, regardless

of what is done in the future, because they have already

been incurred.


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Efficient Markets

An efficient market is one in which profit opportunities are

eliminated almost instantaneously.

There is no free lunch! Profit opportunities are rare

because, at any one time, there are many people searching

for them.


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More Reasons to Study Economics The study of economics is an essential part of the study of

society.

Economic decisions often have enormous consequences.

During the Industrial Revolution, new manufacturingtechnologies and improved transportation gave rise tothe modern factory system.


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More Reasons to Study Economics

An understanding of economics is essential to an

understanding of global affairs.

Voting decisions also require a basic understanding of

economics.


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The Method of Economics

Positive economics studies economic behavior withoutmaking judgments. It describes what exists and how it

works.


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Normative economics, also called policy economics,

analyzes outcomes of economic behavior, evaluates them

as good or bad, and may prescribe courses of action.


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Positive economics includes:

Descriptive economics, which involves the compilationof data that describe phenomena and facts.

Economic theory, which involves building models of

behavior.

An economic theory is a general statement of causeand effect, action and reaction.


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Define managerial economics :

Managerial economics is the discipline that deals with theapplication of economic concepts, theories &

methodologies to the practical problems of business/firms

in order to formulate rational managerial decisions for

solving those problems.


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Definitions Contd.

According to Mansfeild, Managerial economics is

concerned with the application of economic concepts &economics to the problem of formulating rational decisionmaking.

According to Douglas, Managerial economics is

concerned with the application of economic principles &methodologies to the decision-making process within thefirm or organization. It seeks to establish rules & principlesto facilitate the attainment of the desired economic goals ofmanagement.


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Why Managerial Economics?

A powerful analytical engine.

A broader perspective on the firm. what is a firm

what are the firms overall objectives?

what pressures drive the firm towards profit and away

from profit The basis for some of the more rigourous analysis of issues

in Marketing and Strategic Management.


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Links between Managerial Economics

and Management Science

Managerial Economics: is often concerned with findingoptimal solutions to decision problems.However, the

primary purpose of using models is to predict how firms

will behave, not to advise them what ought to do.Managers are assumed to find the optimal solutions forthemselves and that is how predictions are made.

Management science: is essentially concerned with

techniques for the improvement of decision-making andhence it is essentially normative;firms are not assumed tofind the optimal solutions for themselves. They are found

by the researchers who then present them as prescriptionsfor what the firm should do.


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Relationship between Managerial

Economics and Related Disciplines

Management

Decision Problems

Economic Concepts

ManagerialEconomics

Optimal Solutions to Managerial

Decision Problems

Decision Sciences

Management

Decision Problems

Economic Concepts

ManagerialEconomics

Optimal Solutions to Managerial

Decision Problems

Decision Sciences


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Management Decision Problems

Product Price and Output

Make or Buy Production Technique

Stock Levels

Advertising Media and Intensity

Labor Hiring and Training Investment and Financing


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Economic Concepts

Framework for Decisions

Theory of Consumer Behaviour

Theory of the Firm

Theory of Market Structure and Pricing


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Decision Sciences

Tools and Techniques ofAnalysis

Numerical Analysis Statistical Estimation

Forecasting

Game Theory

Optimization

Simulation


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Managerial Economics

Use of Economic Concepts and Decision

Science Methodology to Solve Managerial

Decision Problems


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THE GOALS OFAFIRM

Economic Goals:

Maximizing or Satisficing

1. Profit

2. Market share

3. Revenue growth

4. Return on investment

5. Technology

6. Customer satisfaction

7. Shareholder value


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THE GOALS OFAFIRM contd.

Non-economicObjectives:

A good place for our employees to work

Provide good products/services to our customers

Act as a good


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Optimal Decision:

Given the goal(s) that the firm is pursuing, the optimaldecision in managerial economics is one that brings the

firm closest to this goal.


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Making decisions and processing information are

the two primary tasks of managers :

Examples:

Whether or not to close down a branch of the firm?Whether or not a store or restaurant should stay open

more hours a day?

How a hospital can treat more patients without a

decrease in patient care?


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Role of Managers Contd.

How a government agency can be reorganized to bemore efficient?

Whether to install an in-house computer rather than pay

for outside computing services?


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Why Managers need to know

economics : Economics contributes a great deal towards the

performance of managerial duties & responsibilities.

All other qualifications being the same, managers with a

working knowledge with economics can perform their

functions more efficiently than those without it.

The basic function of the managers of a business firm is toachieve the objective of the firm to the maximum possible

extent with the limited resources placed at their disposal.


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Contd.. All these, as well as many other managerial

decisions require the use of basic economics.

Economic theory helps decision makers to know what

information is necessary in order to make the decision

and how to process and use that information.


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Questions that managers must

answer:j Should our firm be in this business?

j If so, what price and output levels achieve our goals?

j

How can we maintain a competitive advantage over ourcompetitors?

Cost-leader?

Product Differentiation?

Market Niche?

Outsourcing, alliances, mergers, acquisitions?

International Dimensions?


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Questions that managers must

answer:j What are the economic conditions in a particular

market?

Market Structure? Supply and Demand Conditions?

Technology?

Government Regulations?

International Dimensions? Future Conditions?

Macroeconomic Factors?


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DMs Optimize

We should emphasize that practically in all managerial

decisions the task of the manager is the same!

Namely, each goal involves an optimization problem.


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ContdThe manager attempts either to maximize or minimize some

objective function, frequently subject to some

constraint(s).

And, for all goals that involve an optimization problem, the

same general economic principles apply!


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The Scope of Economics

Microeconomics is the branch of economics that

examines the behavior of individual decision-makingunitsthat is, business firms and households.

Macroeconomics is the branch of economics that

examines the behavior of economic aggregates income,output, employment, and so onon a national scale.

n us r es serv ces lth


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Microeco

nomics

n us r es

and

business

How much

steel

How many

offices

How many

cars

serv ces

Price of

medical

care

Price of

gasolineFood prices

Apartment

rents

wealth

Wages in

the auto

industry

Minimum

wages

Executivesalaries

poverty

Number of employees

in a firm

Macroeco

nomics

National

production

/outputTotal

industrial

output

Gross

domestic

product

Growth of

output

Aggregate

price level

Consumer

prices

Producer

prices

Rate of

inflation

National

income

Total wagesand salaries

Total

corporate

profits

Employment and un

employment in the

economyTotal number of jobs

Unemployment

Rate


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BusinessObjectives

and Basic Models of the Firm

Objectives:

1. the assumptions of the neo-classical (or profit-maximising) model of the firm and the limitationsof the model

2. the differences between the profit-maximisingmodel and the managerial models of the firm

3. the differences between the profit-maximisingmodel and the behavioural model of the firm


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The Assumptions of the Neo-classical

Model of the Firm

The firm is a profit-maximiser - it optimises

The firm can be treated in a holistic way

There is perfect certainty


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Contd.

Assumption 1:

The firm is a profit-maximiser: it is assumed to make as

much profit as possible.

This means that the model is an optimising model: thefirm attempts to achieve the best possible performance,

rather than simply seeking feasible performance which

meets some set of minimum criteria.


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The profit-maxing assumption can be

interpreted in two ways:

1. Maximisation of profit in the short-run

i.e. the firm has a given set of plant and equipment and makes

as much profit as it can with that2. Long-run profit maximisation

i.e. maximise the wealth of the shareholders

In most situations these are consistent with each other.

Shareholder wealth is maximised by selecting the mostprofitable set of plant and equipment and then operating itin the most profitable way. But there may be exceptions -making maximum short term profit might trigger entry orgovernment intervention


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Contd..

Assumption 2:

It is a holistic model: the firm is a single entity which has

objectives of its own and which can be said to take

decisions.


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contd .

Assumption 3:

It assumes perfect certainty. Cost and demand conditions are

perfectly known.


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The Basic Model of the Firm The neo-classical model

The firm aims to maximise profit by choosing the level of output

which gives the biggest difference between revenue and costs.

STEP BY STEP TO THE MODEL

P1

Demand: Average Revenue

Quantity Produced

P2

Q1 Q2

$


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STEP BY STEP TO THE MODEL


Marginal Revenue

Quantity

Produced

$


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WHAT IS THE EQUILIBRIUM?

Profit

maximising

price

Marginal Cost


Quantity

ProducedMarginal

Revenue

Profit

maximising

output


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The firm aims to maximise profit by choosing the level of output which gives

the biggest difference between revenue and costs.

MORE DETAIL ON THE EQUILIBRIUM

Profit

maximising

price

Profit

maximising

output

Marginal Revenue

Quantity Produced


Average Cost

Marginal Cost


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What Can We Do WithThis Model?

Comparative Statics

begin with an initial equilibrium position - the starting point

change something

identify the new equilibrium, e.g: When demand increases?

When costs rise?

When a fixed cost increases?

This is the main purpose of the model -what it was designed to do

Normative prescriptions it will cost me $30 per unit to supply something which will give

me $20 per unit in revenue- should I do it?

I must pay $20 billion to set up in my industry. Should I chargehigher prices to get that money back?

Positive and Normative are linked by if? IF the aim of the firm is tomaximise profit what will it do/what should it do?


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The assumptions ofprofit-maximisation has

been criticised in a number of ways; so we

have:

The Managerial School

The Behavioural School


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Managerial Criticisms of the Profit-

Maximising Model

Berle and Means (1932)

firms are owned by shareholders but controlled bymanagers

owners and managers interests are different

managers have discretion to use the firms resources in

their own interests


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The Managerial School argues that:

1. Ownership and control are in the hands of different groups of people.

2. The interests of owners (shareholders) and Controllers (managers) aredifferent.

3. Managers have the power to let their interests over-ride those of theshareholders.

4. Therefore firms are run in the interests of the managers.

In place of the profit-maximising model, the managerial school substitutea variety of alternatives - sometimes referred to as managerialdiscretion models

Sales-revenue maximising (Baumol)Managerial utility maximising (Williamson)


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Managerial Discretion Models of

the Firm

Baumols Sales Revenue Maximising Model managers rewards seem to be more closely linked to

size than to profit

therefore, firms aim to maximise sales revenue

but subject to a profit constraint


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Baumols ModelTR

TC

Profit

Level of

Output

$


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A. The unconstrained version

Price?

Output? Profit?

B. The constrained version

depends where the constraint is note what happens if the constraint is so tight that

maximum profit is required

Comparison ofBaumols Model with

the Profit-Maximising:


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Comparative Statics of

Baumols Model

What if demand rises?

What if fixed costs change?

What if variable costs change?


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Behavioural Model of the Firm [Simon (1959),

Cyert and March (1963)]

the firm hardly exists; it consists of a group of people withmultiple objectives

decision-makers exhibit satisficing behaviour;organisational slack/X-inefficiency

problem-oriented search using rules of thumb, which are afunction of the past experience of the firm and the people

within it organisational learning: meeting all objectives; then

raising aspiration levels. If cannot meet; then reducingaspiration levels


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The Behavioural Approach

the firm does not exist - it is a set of shifting coalitions of

individuals individuals and groups do not maximise - they satisfice

information about the environment is very limited

organisations do not have objectives, only people have

objectives


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If all aspirations are being met - everyone is satisfied - do

nothing

But then aspiration levels will rise until someone is not

satisfied

Then rules of thumb used to find solutions to the

problem


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Aspiration levels, which adjust according to experience

Problem-oriented rules of thumb based on pastexperience

A dynamic model

not holistic

not deterministic not optimising


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A comparison of alternative

models of the firmProfit-max Managerial Behavioural

Objective P it-maximising

Owners ipmanagement

Same

Decision-making

Optimising

Environment Certainty

Holistic? Yes


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WhichApproach is Most Useful?

Behavioural approach is a more accurate description ofwhat happens inside the firm.

But it tells us almost nothing about how the firm willrespond to changes in the environment.

To use it to make predictions about how the firm will reactto changes in the environment we need to know everythingabout the individual firm.

However, if shareholders are a powerful group and theiraspiration level requires making maximum profit the firmwill again behave in the same way as a profit-maxi miser.


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In Conclusion?

The behavioural approach is a useful complement to theprofit-maximising and managerial approaches, not a

substitute for them.

Documents

Managerial Economics Lect 1 & 2