FALL 2014-15

The Nature and Scope of Managerial Economics

byDr Loizos Christou

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Outline: What You Will Learn . . .

Definition of Managerial Economics Examine the Theory of the Firm The Nature of Profits Business Ethics The International Framework of Managerial

Economics Managerial Economics and the Internet

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Managerial Economics Defined

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

The meaning of this definition can be best examined with aid of figure below:

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Managerial Decision Problems

Economic theoryMicroeconomicsMacroeconomics

Decision SciencesMathematical Economics

Econometrics

MANAGERIAL ECONOMICSApplication of economic theory

and decision science tools to solvemanagerial decision problems

OPTIMAL SOLUTION TOMANAGERIAL DECISION PROBLEMS

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Managerial Decision Problems:

Managerial decision problems arise in any organization (i.e. non-profit organization such as a hospital or a university or government agency), when they seek to achieve some goal or objective subject to limitations on the availability of essential inputs and in the face of legal constraints.

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o     

o       Case of Hospital:

A hospital may seek to treat as patients as possible at an adequate medical standard with its limited physical resources (i.e. physicians, technicians, nurses, equipment, beds etc.) and budget.

o       Case of University:

The goal of a state university may provide an adequate education to as student as possible subject to the physical and financial constraints it faces.

o       Case of government agency

Similarly, a government agency may investigate to provide a particular service to as many people as possible the lowest feasible cost.

Managerial Decision Problems:

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In all these cases, the relevant organizations face management decision problems as it seek to accomplish their own goals or objective subject to the constraint they face.  

It is important to note that the goals and constraints may differ from case to case, however the basic decision-making process is the same.

Managerial Decision Problems:

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  Relationship to Economic Theory:The organization can solve its management decision problems by application of economic theory and the tools of decision science.   

Economic Theory refers to microeconomics and macroeconomics. Economic theories seek to predict and explain economic behaviour based on a model.

Economic Theory:

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Microeconomics:

This subject is the study of the economic behaviour of individuals decision-making units such as individual consumers, resources owners and business firm in the free enterprise system.

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     Macroeconomics:

On the other hand, this subject is the study of the total or aggregate level of output, income, employment, consumption, investment and prices for the economy viewed as a whole.

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Microeconomic theory of firm

Although the microeconomic theory of firm is the single most important element in the managerial economics, the general macroeconomic conditions of the economy (i.e. the level of aggregate demand, rate of inflation, and interest rate) in which the firm operates are also very important.

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The theory of firm

The theory of firm assumes that the firm seeks to maximize profits and minimize cost and on the basis of that it predicts how much of a particular commodity the firm should produce under different forms of market structure or organization.

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Theory of the Firm

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

Internalizes transactions, reducing transactions costs.

Primary goal is to maximize the wealth or value of the firm.

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Decision Sciences

Managerial economics is very closely related to the decision sciences. These use the tools of mathematical economics and econometrics to construct and estimate decision models aimed at determining the optimal behavior of the firm (i.e. how the firm can achieve its goals most efficiently).

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  Mathematical Economics and Econometrics

Mathematical Economics especially is used to formalize (i.e. express in equational form) the economic model postulated by economic theory.

Econometrics applies statistical tools (i.e. regression analysis) to real world data to estimate the models postulated by economic theory and for forecasting.

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Application of economic theory and decision science tools to solve managerial decision problems 

Example: Economic theory postulates that the quantity demanded

(Q) of a commodity is a function of the price the commodity (P), the income of consumers (Y), and the price of related (i.e. complementary and substitute) commodities (PC and PS) respectively. So we may postulate the following formal model:

Q= f (P,Y, PC, PS) The Theory says: Qd=f (P, I, PR, T, PE, N) -, +/-, +/-,+, +, + N/I, S/C

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Cont..

We can estimate this empirical relationship by collecting data on the variables mentioned in the equation above. This will permit the firm to determine how much Q would change in P, Y, PC and

PS and to forecast the future demand for the

commodity. This information is essential in order for management to achieve the goal or objective of the firm (profit maximization) most efficiently.

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OPTIMAL SOLUTION TO MANAGERIAL DECISION PROBLEMS:

Theory of the firm

A firm is an organization that Combines and organizes resources for the purpose of producing goods and/or services for sale.

For instance; there are millions of firms in the United States. These include proprietorship (i.e. firms owned by one individual), partnership and corporations (i.e. owned by stockholders). Firms produce more than 80 percent of all good and services consumed in the U.S.A. The remainder is produced by the government and non profit organizations such as private college, hospitals, museums and foundations.

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Internalizes transactions, reducing transactions costs

Firms exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with workers and owners of capital, land and the other resources for each separate step of production and distribution process. Instead, entrepreneurs enter into long term and broader contracts with labor to perform a number of tasks for a specific wages and fringe benefit.

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Internalizes transactions, reducing transactions costs

This kind of contract is much less costly than numerous specific contracts and is highly advantageous both to entrepreneurs and to the workers and the other resource owners. The firm exists in order to save on such transaction costs. By performing many functions within the firm, the firm also saves on sales taxes and avoids price controls and other government regulations that apply only to transactions among firms. This is This is called internalizing transactions. Primary goal is to called internalizing transactions. Primary goal is to maximize the wealth or value of the firm.maximize the wealth or value of the firm.

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Value of the Firm

The present value of all expected future profits

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Alternative Theories

Sales maximization Adequate rate of profit

Management utility maximization Principle-agent problem

Satisficing behavior

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   Alternative Theories

The theory of firm has also been criticized as being much narrow and unrealistic. For this reason, broader theories of the firm have been proposed. The most prominent among these are models postulate that the primary objective of the firm is the maximization of sales, the maximization of management utility and satisfying behavior.

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Sales Maximization

According to the model, managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy stockholder ( this model introduced by William Baumol).

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Management utility maximization

The model (introduced by Oliver Williamson) postulates that with the advent of the modern corporation and resulting separation of management from ownership.

Managers are more interested in maximizing their utility measured in terms of their compensation (i.e. salaries, stock options etc.), the size of their staff, extent of control over the corporation, lavish offices etc. than maximizing corporate profits. This referred to as the Principle-agent problem.

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    Satisficing behavior

This stems from the great complexity of running the large modern corporation- a task often complicated by uncertainty and a lack of adequate data. Manager are not able to maximize profits but can only strive for some satisfactory goal in terms of sales, profit, growth, market share and so on. This situation is called satisficing behaivour.

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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.

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

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The Explicit and Implicit costs

The explicit or accounting costs: are the actual out of pocket expenditures of the firm to purchase or hire inputs it requires in production. (i.e. wages to hire labour, interest on borrowed capital, rent on land and buildings and the expenditure on raw materials).

The Implicit costs: refers to the value of the inputs owned and used by the firm in its own production processes.

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Theories of Profit

Risk-Bearing Theories of Profit Frictional Theory of Profit- Profit stems from disturbances from long-run equilimrium -Normal return adjusted for risk or zero profit - Energy crises in 1970s-large profit by providing insulation materials - Decline in oil prices in mid 1980s- losses are incurred Monopoly Theory of Profit Innovation Theory of Profit

- Profit is the reward for the introduction of a successful innovation- e.g Steven Job, the founder of the Apple comp. Company became a millonaire in 1977- successful innovation encourage the flow of technology as well as profit

Managerial Efficiency Theory of Profit

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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.

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Business Ethics

Identifies types of behavior that businesses and their employees should not engage in.

Source of guidance that goes beyond enforceable laws.

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The Changing Environment of Managerial Economics

Globalization of Economic Activity Goods and Services Capital Technology Skilled Labor

Technological Change

–Telecommunications Advances

–The Internet and the World Wide Web

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Theory of firm-Value of the firm Example for the trade-off between profit and costs

A person managing a dry- cleaning storestable for $ 30,000 per year decides to open a new one. The revenues of the store during the first year of operation are $ 100,000 and the expenses are $ 10,000 for supplies, $ 35,000 for salaries, $ 8,000 for rent, and $ 2,000 for utilities. The person also used $5,000 for interest on a bank loan. Assume that income and business taxes are zero and the repayment of the principal of the loan does not start before three years (suppose r=10%).

Calculate (a) the explicit cost (b) the implicit costs (c) the business profit, (d) the Economic profit (e) normal return on investment and also (f) indicate whether the person should open the dry-cleaning store.

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Example for the trade-off between profit and costs -Value of the firm

(a) Expenses is the explicit costs- the expenses are $ 10,000 for supplies, $ 35,000 for salaries, $ 8,000 for rent, and $ 2,000 for utilities as well as interest $ 5,000 – total amout is $ 60,000.

(b) The Implicit costs are the entrepreneeur’s foregone salary- $ 30,000.

(c) the business profit= total revenues - the explicit costs = $ 100,000 - $ 60,000= $ 40,000

(d) the Economic profit= total revenues – (the explicit costs + Implicit costs) = 100,000 – ($ 60,000 + $ 30,000) = $ 10,000

(e) normal return on investment = The Implicit costs =$ 30,000.

(f) PV=10,000/1+0.10)....or roughly we can say that The person would earn economic profit $ 10,000 per year, therefore, the person should open the store..

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The EndThe End

Thanks