UNIVESITI UTARA MALAYSIA
SCHOOL OF ECONOMICS, FINANCE
AND BANKING, UUM COB
MASTER OF BUSINESS ADMINISTRATION
SEEG5013 MANAGERIAL
ECONOMICS
Chapter 1
Introduction & Goals of the Firm
What is Managerial Economics?
 The Decision-Making Model and the
Responsibilities of Management
 The Role of Profits?
 The Principal-Agent Problem
 Shareholder Wealth Maximization and
the Real Option Value
 Objectives in the Public Sector and
Not-for-Profit Organizations
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What is Managerial Economics?
The application of microeconomics to
problems faced by decision makers in the
private, public, and not-for-profit sectors.
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Even questions of how best to abate nitrous
oxide by coal-fired Power Plants involves
economic issues of finding efficient, least cost
solutions.
Managerial economics deals with
microeconomic reasoning on real world
problems such as pricing decisions,
selecting the best strategy in different
competitive environments, and making
efficient choices.
Responsibility of Management
 Managers solve problems before they become a crisis
 Managers select strategies to try to assure the success of
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the firm
Managers create an organizational culture attune to the
mission of the organization
Senior management establish a vision for the firm
Managers motivate and promote teamwork
Managers promote the profitability of the firm
And many managers see it in their long-run interest to
promote sustainability of their enterprise in their
environment.
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Managers who fail at these responsibilities are reviled, be they be
mangers of BP, Enron, or Bernie Madoff
To Expand Capacity or Not?
An example of a simplified decision problem
 Should Honda or Toyota expand its capacity in North
America? In part, it must consider current and future
demand and what other firms are likely to do.
 Capacity for making cars is a long term project, so these
firms should think in terms of the present value (PV) of
future profits.
 Objective Function:
 Max PV of profits {S1(New), S2(Used)}
 where S1(New) is expand capacity with new facilities and
S2(Used) to purchase used facilities from GM.
 Decision Rule:
 Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
 Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
 If equal profits, then flip a coin
 If negative profits for both, then don’t expand at all
The Role of Profits?
 Economic Profit is the difference between
total revenues and total economic cost
(Economic cost includes the “normal” rate of
return on capital contributions by the firm’s
partners).
 We’d expect high profit areas to attract
investment
 We’d expect low profit areas to lose investment
 Shouldn’t
then all industries
earn the same profit eventually?
Theories of Why Profit Varies
Across Industries
1. RISK-BEARING Theory of Profit
2. TEMPORARY DISQUILIBRIUM Theory
of Profit
3. MONOPOLY Theory of Profit
4. INNOVATION Theory of Profit
5. MANAGERIAL EFFICIENCY Theory of
Profit
What is Managerial Economics?
Douglas - “Managerial economics is .. the
application of economic principles and
methodologies to the decision-making process
within the firm or organization.”
Pappas & Hirschey - “Managerial economics
applies economic theory and methods to business
and administrative decision-making.”
Salvatore - “Managerial economics refers to the
application of economic theory and the tools of
analysis of decision science to examine how an
organisation can achieve its objectives most
effectively.”
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What is Managerial Economics?
Howard Davies and Pun-Lee Lam “It is the application of economic
analysis to business problems; it has its
origin in theoretical microeconomics.”
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Managerial Economics Defined
 The application of economic theory (eg.
demand theory, production theory, cost
theory, market structure) and the tools of
decision science (eg. mathematics and
regression analysis) to examine how an
organization can achieve its aims or
objectives most efficiently.
How Is Managerial Economics Useful?
 Evaluating Choice Alternatives
 Identify ways to efficiently achieve goals.
 Specify pricing and production strategies.
 Provide production and marketing rules to help
maximize net profits.
 Making the Best Decision
 Managerial economics can be used to efficiently
meet management objectives.
 Managerial economics can be used to
understand logic of company, consumer, and
government decisions.
ECONOMIC ANALYSIS AND
DECISIONS
1. Demand Analysis
2. Production and Cost Analysis
Product, Pricing, and Output
Decisions
4. Capital Expenditure Analysis
ECONOMIC, POLITICAL, AND SOCIAL
ENVIRONMENT
1. Business Conditions (Trends, Cycles, and
Seasonal Effects)
2. Factor Market Conditions (Capital, Labour,
and Raw Materials)
3. Competitors’ Reactions and Tactical
Response
4. Orgabization architecture and Regulatory
Risk
Cash Flows
Firm Value
(Shareholders’ Wealth)
Evaluating Choice Alternatives
Managerial Economics identifies ways to
efficiently achieve goals. For example,
 To identify pricing and production strategies
to help small business meet short run
objective such as rapid growth.
 Provides production and marketing rules that
permit the company to maximize net profits
once it has achieve growth or market share
objectives.
Evaluating Choice Alternatives
 Managerial economics has applications in
both profit and not-for-profit sectors
For example, an administrator of a nonprofit
hospital strives to provide the best medical
care possible given limited staff, equipment,
and related resources. Using the tools and
concepts of managerial economics, the
administrator can determine the optimal
allocation of these limited resources.
Making the best decision
To make a good decision, managers must understand the economic
environment in which they operate. For example,
 A grocery retailer may offer consumers a highly price-sensitive
product, such as rice, at an extremely low markup over cost – say, 1
percent to 2 percent – while offering less price-sensitive products,
such nonprescription drugs, at markups of as high as 40 percent
over cost. (Discuss : HYPERMARKET VS SUPERMARKET; MAS
VS AIR ASIA; PASARAYA PELADANG VS PACIFIC etc.)
 Similarly, managerial economics reveals that car import quotas
reduce the availability of substitutes for domestically produced cars,
and create the possibility of monopoly profits for domestic
manufacturers.
 It does not explain whether imposing quotas is good public policy
(benefits for consumers, lower income group, environment etc.); that
is a decision involving broader political considerations. Managerial
economics only describes the predictable economic consequences
of such actions. (draw diagram govt. intervention - QUOTAS; impact
of changes in EXCHANGE RATE).
Theory of the Firm
 Expected Value Maximization
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Owner-managers maximize short-run profits.
Primary goal is long-term expected value
maximization.
 Constraints and the Theory of the Firm
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Resource constraints.
Social constraints
 Limitations of the Theory of the Firm
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Alternative theory adds perspective.
Competition forces efficiency.
Hostile takeovers threaten inefficient managers.
The firm connect suppliers, investors, workers, and
management in a joint effort to serve customers.
Value of the Firm
 The value of the firm is the present value of
the firm’s expected future net cash flows.
 If cash flows are equated to profits for
simplicity, the value of the firm today, or its
present value, is the value of expected profits
, discounted back to the present at an
appropriate interest rate. (?? Why we have to
do discounting?).
Value of the Firm
The present value of all expected future profits
Shareholder Wealth Maximization [1.1]
t = REVENUE – COST = TRt – TCt = PtQt – VtQt - Ft
 Value of the Firm = the present value of discounted future cash
flows, both from current operations but also those that might be.
V0∙(shares outstanding) = 1/(1+ke)1 +2/(1+ke)2 + … + Real Option
Value
or
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V0∙(shares outstanding) = (t ) / (1+ke)t + Real Option Value
t=1
 The real option value of the firm comes from the flexibility that the
firm has to find added cost savings or new revenue possibilities that
have not yet come to pass, but could in the future because of
following their current business plans.
 V0 is the current value of a share of stock.
 Whatever lowers perceived risk of the firm (ke) will raise firm value.
 Whatever raises the profits of the firm, raises firm value
Profit Measurement
 Business Versus Economic Profit
 Business (accounting) profit reflects
explicit costs and revenues.
 Economic profit.
Profit above a risk-adjusted normal
return.
 Considers cash and noncash items.
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 Variability of Business Profits
 Business profits vary widely.
Relationship between profits, total
revenues and total costs.
 The ‘value of firms’ equation can be used to examine
how the expected value maximization model relates
to a firm’s various functional department.
 The marketing department often has primary
responsibility for product promotion and sales (TR);
 The production department has primary responsibility
for product development costs (TC); and
 The finance department has primary responsibility for
acquiring capital and, hence, for the discount factor
(r) in the denominator.
Why every department important?
 The marketing department can help reduce costs
associated with a given level of output by influencing
customer order size and timing (TR = p x q).
 The production department can stimulate sales by
improving quality (discuss ISO and quality control).
 Other departments, for example – accounting, human
resources, and transportation, provide information
that are useful for sales growth (TR) and cost control
(TC).
Constraints and the Theory of the Firm
 Managerial decisions are often made in light of
constraints imposed by technology, resource scarcity,
contractual obligations, and regulations.
 Managers often face limitations on the amount of
investment funds available for a particular project or
activity.
 Decisions can also be constrained by contractual
requirements. For example, contracts sometimes
require that a minimum level of output be produced to
meet delivery requirements.
 In most situation, output must also meet quality
requirements.
Definitions of Profit
 Business Profit: Total revenue minus the
explicit or accounting costs of production.
 Economic Profit: Total revenue minus the
explicit and implicit costs of production (i.e.
the implicit (non-cash) costs of capital and
other owner provided inputs, used by the
firm).
 Opportunity Cost: Implicit value of a resource
in its best alternative use.
Role of Profits in the Economy
 Economic profits play an important role in a market
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based economy.
Above-normal profits serve as valuable signal that firm or
industry output should be increased.
Entry by new competitors often occurs quickly during
high profit periods.
Just as above-normal profits provide a signal for
expansion and entry, below-normal profits provide a
signal for contraction and exit.
Above-normal profits can also constitute an important
reward for innovation and efficiency, just as below-normal
profits can serve as a penalty for stagnation and
inefficiency.
Function of 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.
Why Firms Exist?
 Firms exist by public consent to serve social
needs.
 Maximization of sosial welfare requires
answering the following important questions:
 What combination of goods and services
should be produced?
 How to produce?
 How to distribute goods and services?
Why Do Profits Vary Among
Firms?
Disequilibrium Profit Theories
 Rapid
growth in revenues.
 Rapid decline in costs.
Compensatory Profit Theories
Better,
faster, or cheaper than
the competition is profitable.
Role of Business in Society
 Why Firms Exist
 Business is useful in satisfying
consumer wants.
 Business contributes to social welfare
 Social Responsibility of Business
 Serve customers.
 Provide employment opportunities.
 Obey laws and regulations.
 To make good economic decisions, managers
need to be able to forecast & estimate
relationships
 Will be forecasting demand (both Pt & Qt)
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applies to for-profit corporations
non-profit organizations
Hospital Administrators forecast patients
 University Administrator forecast
enrollment
 Regression analysis, time series methods, and
qualitative forecasting methods used for
forecasting
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Agency Problems
 Modern corporations allow firm
managers to have no ownership
participation, or only limited
participation in the profitability of the
firm.
 Shareholders may want profits, but
managers may wish to relax.
 The shareholders are principals,
whereas the managers are agents.
 The Principal-Agent Problem
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Shareholders (principals) want profit
Managers (agents) want leisure & security
Conflicting motivations between these groups
are called agency problems.
 Examples
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KKR’s takeover of RJR Nabisco to refocus on
wealth-maximization
The LBO by O.M. Scott (a lawn fertilizer
company) from ITT (a conglomerate) improved
Scott’s performance
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
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Public Goods are goods that can be consumed or used by
more than one person at the same time with no extra cost
(like a flood control or national defense).
 Sometimes governments produce public goods. Other
times, they are exclusive to one person (like a free meal).
 Instead of profit, NFP organizations may have as their
goals:
1. Maximization of the quantity of output, subject to a
breakeven constraint.
2. Maximization of the utility (happiness) of NFP
administrators.
3. Maximization of cash flows.
4. Maximization of the utility of contributors to the NFP
organization.
 Which goal a NFP manager selects affects
decisions made.
A
food shelter manager may decide to
maximize the utility of contributors by
selecting only "healthy foods"
 Public sector managers are performance
monitored.
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V.A. hospital administrators are rewarded by
reducing the cost per bed over a year. Hence, they
become efficient with respect to costs.
The "friendliness" of the hospital staff is harder to
measure, so friendliness will tend not be a high
priority of the public sector manager.
The Changing Environment of
Managerial Economics
 Globalization of Economic Activity
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Goods and Services
Capital
Technology
Skilled Labor
 Technological Change
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Telecommunications Advances
The Internet and the World Wide Web
These Definitions Cover a Number of
Different Approaches
1. Analysis based on the theory of the
firm
2. Analysis based upon management
sciences
3. Analysis based upon industrial
economics
Related to, but not the same as management
science and industrial economics.
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The Process of Model-building
 The economics ‘method’
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‘illicit relationships with beautiful models’
 The steps: the hypothetical-deductive approach
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make assumptions about behaviour
work out the consequences of those assumptions
make predictions
test the predictions against the evidence
PREDICTIONS SUPPORTED? The model is accepted as a
good explanation (for the moment)
PREDICTIONS REFUTED? Go back and re-work the whole
process
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Definitions
&
assumptions
Theoretical
analysis
If predictions
not supported by
data, model is
amended or
discarded
Predictions
Predictions
tested
against data
If predictions
borne out by
data, the model
is valid, for
the moment
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Should Assumptions be Realistic?
The assumption of profit-maximising may be
unrealistic or inaccurate
However, what matters is the explanatory or
predictive power of a theory (or model), not the
descriptive realism of its assumptions.
A model built on unrealistic assumptions may
give good predictions.
Assumptions are a necessary simplifying device
Example: Overtaking
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What Is A “Good” Model?
 It allows us to make predictions and set
hypotheses
 The predictions can be tested against the
empirical evidence
 The predictions are supported by the
empirical evidence
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The Use of Economic Models
Positive Economics:Derives useful theories with testable
propositions about WHAT IS.
Normative Economics:Provides the basis for value
judgements on economic
outcomes.WHAT SHOULD BE
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Managerial Economics
 Economics in general takes a ‘positive’ and
predictive approach not prescriptive or
‘normative’
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trying to explain “what is” not what “should be”
the main objective is to understand how a market
economy works
 Not very concerned about the descriptive realism
of assumptions: “I assume X” does not mean “I
believe X to be true”
 Some real tension if the models are used for
prescription
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assume “perfect knowledge”: OK for model-building
cannot say to a manager: “behave AS IF you had perfect
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knowledge”
Economic Analysis
 Comparative Statics
 begin with an initial equilibrium position - the starting point
 change something
 identify the new equilibrium, e.g:in neo-classical model of the firm
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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 charge
higher prices to get that money back?
 Positive and Normative are linked by “if?” IF the aim of the firm
is to maximise profit what will it do/what should it do?
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What is the purpose of economic analysis?
Why do we want to apply economic analysis to business
problems?
For the academic economist: to understand, to make
predictions about firm’s behavior The “positive” approach
to theory: What is?
For the businessperson: “to assist decision-making”, to
provide decision-rules which can be applied The
“normative” approach to theory: What should be?
These purposes are different, they can lead to
misunderstanding, and economists are not always honest
about the limitations of their approach for practical
purposes.
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What are these limitations?
If the aim is prediction, unrealistic
assumptions are acceptable and may be
needed;
for instance, the firm may be assumed to behave “as if” its managers had
perfect knowledge of its environment
If the aim is to produce decision-rules
which can be applied by practising
managers, unrealistic assumptions will
produce decision-rules which are not
operational
for instance, set output and price by MC=MR
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How Can Managerial Economics
Assist Decision-Making?
1. Adopt a general perspective, not a
sample of one
2. Simple models provide stepping stone to
more complexity and realism
3. Thinking logically has value itself and can
expose sloppy thinking
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Why Managerial Economics?
 A powerful “analytical engine”.
 A broader perspective on the firm.
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what is a firm?
what are the firm’s 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 Industrial Economics
In managerial economics, the emphasis is
upon the firm, the environment in which the
firm finds itself, and the decisions which
individual firms have to take.
In industrial economics (or industrial
organization), the emphasis is (or was) upon
the behavior of the whole industry, in which
the firm is simply a component.
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What is Industrial Organization?
It studies how the performance of an
industry is related to its structure, that is,
to the number and size of firms it contains.
It is the study of markets for goods and of
the firms which produce them. It is the
study of industry. It is more concerned
with why markets are structured the way
they are and behave the way they do.
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Questions Asked in Industrial
Organization:
a Why are some markets monopoly-like while others are
competitive?
a How can industry performance and structure be measured or
analyzed?
a How does the performance of individual firms affect the
structure and performance of the industry in which they operate?
a If industry performance seems deficient but remediable, which
government policies are likely to help more than they cost?
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The Structure-Conduct-Performance Paradigm:
Basic Conditions: factors which shape the market of the industry, e.g.
demand, supply, political factors
Structure: attributes which give definition to the supply-side of the market,
e.g. economies of scale, barriers to entry, industry concentration, product
differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior
advertising, innovation.
Performance: a judgement about the results of market behaviour, e.g.
efficiency, profitability, fairness/income distribution, economic growth.
How can the government improve the performance in an industry?
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Basic Conditions
Structure
Government
Policy
Conduct
Performance
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Links between Managerial Economics
and Management Science
Managerial economics: is often concerned with finding optimal
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 for themselves and that is how predictions are
made.
Management science: is essentially concerned with techniques for
the improvement of decision-making and hence it is essentially
normative;firms are not assumed to find the optimal solutions for
themselves. They are found by the researchers who then present
them as prescriptions for what the firm should do.
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