What is managerial economics?

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

Managerial economics is (mostly) applied microeconomics (normative microeconomics)

Managerial economics deals with

“How decisions should be made by managers to achieve the firm’s goals - in particular, how to maximize profit.”

(Also government agencies and nonprofit institutions benefit from knowledge of economics, i.e. efficient recourse allocation is important for them too...)

Relationship between Managerial Economics and Related Discipl ines

Management Decision Problems

Economic Concepts

Managerial Economics

Optimal Solutions to Managerial Decision Problems

Management Decision Problems

Managerial Economics

Optimal Solutions to Managerial Decision Problems

Decision Sciences

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

Management Decision Problems

Economic Concept s

Manager ial Economics

Opt imal Solut ions t o Managerial Decision Problems

Decision Sciences

Management Decision Problems

Economic Concept s

Manager ial Economics

Opt imal Solut ions t o Managerial Decision Problems

Decision Sciences

Decision SciencesTools and Techniques of Analysis

Numerical Analysis Statistical Estimation Forecasting Game Theory Optimization Simulation

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions t o Manager ial Decision Problems

Decision Sciences

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions t o Manager ial Decision Problems

Decision Sciences

Economic Concepts

Framework for Decisions Theory of Consumer Behaviour Theory of the Firm Theory of Market Structure and Pricing

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions t o Manager ial Decision Problems

Decision Sciences

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions t o Manager ial Decision Problems

Decision Sciences

Managerial Economics Use of Economic Concepts and

Decision Science Methodology to Solve Managerial Decision Problems

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions to Manager ial Decision Problems

Decision Sciences

Management Decision Problems

Economic Concept s

Managerial Economics

Opt imal Solut ions to Manager ial Decision Problems

Decision Sciences

Ch 2 THE GOALS OF A FIRM

Economic Goals:Maximizing or Satisficing1. Profit2. Market share3. Revenue growth4. Return on investment5. Technology6. Customer satisfaction7. Shareholder value

THE GOALS OF A FIRM continued

Non-economic Objectives:1. “A good place for our employees to

work”2. “Provide good products/services to our

customers”3. “Act as a good citizen in our society”

Optimal Decision:

Given the goal(s) that the firm is pursuing, the optimal decision in managerial economics is one that brings the firm closest to this goal.

Roles of Managers: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?

Role of Managers continued

How a government agency can be reorganized to be more efficient?

Whether to install an in-house computer rather than pay for outside computing services?

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.

Questions that managers must answer:

♦ Should our firm be in this business?♦ If so, what price and output levels achieve

our goals?♦ How can we maintain a competitive

advantage over our competitors? Cost-leader? Product Differentiation? Market Niche? Outsourcing, alliances, mergers,

acquisitions? International Dimensions?

Questions that managers must answer:

♦ What are the economic conditions in a particular market?

Market Structure? Supply and Demand Conditions? Technology? Government Regulations? International Dimensions? Future Conditions? Macroeconomic Factors?

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.

The 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!

REVIEW OF SUPPLY AND DEMAND“Economic analysis begins and ends with demand and supply.”

The primary importance of demand and supply is the way they determine prices and quantities sold in the market.

Managers are extremely interested in forecasting future prices and output, both for the goods and services they sell and for the inputs they use.

DEMAND ELASTICITY

Elasticity measures the sensitivity of the quantity demanded to changes in the determinants of demand (supply).

Some elasticity concepts:• price elasticity of demand• elasticity of derived demand• cross-elasticity of demand• income elasticity of demand• elasticity of supply

Determinants of Price Elasticity of Demand

1. The number and availability of substitutes

2. The expenditure on the commodity in relation to the consumer’s budget

3. The durability of the product4. The length of the time period under

consideration5. Consumer’s preferences

Short-Run vs. Long-Run Elasticity

P2P1

PDS5 DS4 DS3 DS2 DS1

fe

dc b

a

DL

QQ1Q2Q3

A long-run demand curve will generally be more elastic than a short-run curve

As the time period lengthens consumers find way to adjust to the price change, via substitution or shifting consumption

Elasticity of Derived Demand

The demand for components of final products is called derived demand

The derived demand curve will be the more inelastic:1. The more essential is the component in

question.2. The more inelastic is the demand for the

final product.3. The smaller is the fraction of total cost

going to this component.4. The more inelastic is the supply curve of

cooperating factors.5. The shorter the time period under

consideration.

The Relationship between Elasticity and Total Revenue

IF DEMAND IS

P ↓ Q ↑ elastic if TR ↑ (relative ∆ Q> relative ∆ P)

P ↓ Q ↑ inelastic if TR ↓ (relative ∆ Q< relative ∆ P)

P ↑ Q ↓ elastic if TR ↓ (relative ∆ Q> relative ∆ P)

P ↑ Q ↓ inelastic if TR ↑ (relative ∆ Q< relative ∆ P)

Demand, Total Revenue, Marginal Revenue, and Elasticity

Pri

ce a

nd

mar

gin

al

reve

nu

e ($

)

Quantity

Tot

al R

even

ue

($)

Quantity0

p0

D E>1E=1

E<1

D

MR

q0

q00

The Cross-Elasticity of Demand

Cross-price elasticity measures the relative responsiveness of the quantity purchased of some good when the price of another good changes, holding the price of the good and money income constant.

It is, therefore, the percentage change in quantity demanded in response to a given percentage change in the price of another good.

B

AX

P

QE

∆∆=

%

%

Cross-elasticity can be either positive or negative. In particular, cross-elasticity is positive for substitutes and negative for complements.

Categories of Income Elasticity

Income elasticity > 1: superior goods Income elasticity > 0, and <1: normal goods Income elasticity < 0: inferior goods

Superior

Normal

Inferior

Q

Y

Applications of Supply and Demand

Interference with the Price Mechanism:

• the effect of a price ceiling• the effect of a price floor• the effect of a subsidy• the incidence of taxes

The Effect of a Price Ceiling on Quantity of Supply and Demand

0

P1

P0

P2

P

Q1 Q0 Q2 Q

D

S

The Effect of a Price Floor on Supply and Demand

W

0

W0

W1

Q1 Q0 Q2 Q

D

S

The Use of Price Supports

Surplus (Q2-Q1) bought Production quota Q3 by the government introduced by the

government

Q0

P0

P1

P

Q1 Q2

D

S

Q0

P1

P

Q1 Q3

D

a) b)

The Incidence of Taxes effect of demand elasticity effect of supply elasticity

Imposition of a Voluntary Export Quota

Shift in Demand as Consumer Tastes Change

Demand Elasticity and Tax IncidenceMore elastic demand shifts the tax burden more to the supplier.

D’

0

P

Q

D

S

D’

0

P

Q

S

S’

Supply Elasticity and Tax Incidence

P

P1P2

P*

Q1 Q2 Q* Q

D

S

S1

S1’

S’

The more elastic the supply, the more heavily consumers will bear the burden of the tax.

Imposition of a Voluntary Export Quota

Q0

P0

P1

P

Q1 Q0

D

S0

S1

Q0

P’

P’’

P

Q’ Q’’

D’

S’

D’’

a)

b) D & S of other cars

D & S of Japanese cars in USA before 1981

The Downward Shift in Beef Demand

Q0

P1

P0

P

Q1 Q0

D1

S0

D0D2

S1

Decrease in the demand of beef will, over time, shift resources out of beef production.