Lecture Notes

On
“ Managerial Economics (MBA 521)

Chapter 1: Introduction

2017
October, ”
By :Girma Tadesse( Ph.D. Candidate)
 Chapter One: Introduction
1.1 What is Managerial Economics?
Managerial economics is the discipline that deals with
the application of economic concepts, theories and
methodologies to the practical problems of business in
order to formulate rational managerial decisions for
solving the problems.
With regard to the problems, there are various
problems related to the decision making process such
as production decisions (what, how much, and how to
produce). Exchange decisions (what price to charge and
to whom to sell) and consumption decisions (what and
how much to consume).
In economics, it is clearly indicated that these
problems along with the scarcity of resources forced
the human being too be concerned on efficient and
effective allocation of scarce resources among
competing ends or objectives by finding an optimal
solution for the problems
 Cont’d
The scarcity of resource particularly in business
environment requires managers to analyze and
evaluate all the available choices and choose an
alternative that optimize the objective of the firm.
Such tasks of a manager become easy with the
practical application of economics concepts
theories and methodologies
Concepts refers to demand, price, production, cost
etc and theories may be explained in consumer
behavior and managerial theories of firms,
optimization either maximization of profit/ values/
sales/ revenue/ size/ management utility or
minimization of cost.
 Cont’d
Methodologies can be described in technique of
statistical estimation, foresting, optimization,
and game theory etc. Thus, managerial
economics play a vital role in managerial
decision making and prescribe specific solutions
to the problem of the firm. Accordingly, it has a
wide scope to deal on the following issues:
• Estimation and analysis of demand for products
• Determination of price of products
• Planning of production and deciding input
combination
• Estimation and analysis of cost of production
• Analysis of market structures and estimation of
profit
• Achieving other objectives of a business
 1.2 Theory of Firm and Its Limitation
In this section, we will discuss the behavioral and
managerial theories of a firm. These theories are
quite based on assumptions and objectives different
from the neo-classical theory of profit maximization,
which is obtaining optimal level of profit.
Accordingly, these theories recognize the distinction
between owners and managers in modern large
corporations. They consider the decision making
process in the firm under conditions of uncertainty as
against the perfect knowledge of cost and demand
conditions in the neo-classical theory of the firm.
The theories have not only the profit maximization
objective but also other multiple objectives of the
firm. Thus, we discuss below some of these theories
of the firm with their limitations.
 Simon’s Satisficing Theory

Simon is the first scholar to propound the behavioral

theory of the firm. According to him, the firm’s
principal objective is not maximizing profits but
satisfying or satisfactory profit.
We must expect the firm’s goal to be not maximizing
profits but attaining a certain level or rate of profit
that the firm aspires by holding a certain share of the
market or a certain level of sales.
The main limitation of this theory is that it does not
specify the target level of profit which a firm aspires
to reach. So it does not define how much is
“satisfactory level” of profit as it differ from one
individual to another individual and one business to
another business.
 Behavioural Theory of Cyert and March

Behavioural theory of Cyert and March in a

modern large multiproduct firm, ownership is
separated from management and the neo-
classical assumption of certainty is rejected.
Thus, a firm is not considered as a single entity
with as single goal of profit maximization by a
single decision maker, called the entrepreneur.
Instead, a modern business firm as a group of
individuals who are engaged in the decision
making process to its multiple goals such as
production, sales, market share, revenue, profit
and growth goals.
Its weakness is that it simply predicts the
behaviour of the firm but does not explain in
detail, for example, how the multiple goals would
be achieved at a time.
 Williamson’s Managerial Discretion Model
Williamson is the first scholar to propound the
managerial theory of the firm and hence develop the
managerial utility maximization model as against
profit maximization.
In large modern firms, shareholders and managers are
two separate groups in which the former aim to
maximize as return on their investment and hence
maximization of profit while the later aim to
maximize manager’s utility which is a function of
three factors: expansion of staff and increase their
salaries, maximizing manager’s slack such as pretty
secretaries, company cars and company phones and
discretionary funds that is an investment fund
remained after paying taxes and dividends to the
shareholders.
:

1.3 Optimization

Optimization deals with the determination of

extreme values which can be maximum or
minimum for the objective variable. The
objective variable may be one or multiple.
For example, the private firm might pursue
profit maximization as single goal or the public
sector firm might aim at minimizing its average
cost of production as the sole goal.
In contrast, the government undertaking might
have twin goals, namely, maximization of profit
and maximization of employment of unskilled
labour. Thus, below we will discuss optimization
problems of the firm.
 Profit Maximization
If a firm’s objective is profit maximization, it would
have the power to control variables such as total
revenue and total cost which are variables related to
profit. With regard to the total cost, it is to mean the
total economic cost which is the sum of implicit and
explicit costs.
Explicit costs are costs directly incurred by the firm
for the purchase of the inputs from the supplier of
inputs where as implicit costs are an indirect costs of
the firm which are related to depreciation of capital
assets, employment of owner-supplied resources and
payments to the owner-manager for his/her services.
Thus, the economic profit is the difference between
the total revenue and the total economic costs. So
the firm maximizes its profit when such difference
comes with a possible maximum value.
 Value Maximization

The value of the firm is the price for which the firm can
be sold and that price is equal to the present value of
the future expected profit of the firm. The value of the
firm is affected by the risk associated with the future
profit so that the value would depends up on the risk
premium, which is a discount rate to compensate
investors for the risk they have faced due to
uncertainty on future profits.
Thus, the value of a firm is computed as the present
value of the future economic profits expected to be
generated by the firm so that the value of the firm
maximizes when the summation of the present value of
the future economic profits over the life time of the
firm becomes at its maximum.
1 2 3 T T
t
Value of the firm   
1  r  1  r  1  r 
2 3
 ...  
1  r  t 1 (1  r )t
T

 t
Where is the economic profit expected in period t, r is the
risk-adjusted discount rate, and T is the number of years in the
life of the firm. The larger the risk associated with the future
profit, the higher the risk adjusted discount rate used to
compute the value of the firm and the lower will be the value of
the firm. The reverse holds true if the risk associated with the
future profits is smaller.
 Profit Maximization Vs Value Maximization
Profit maximization refers to maximization of a single
period profit by considering only the current revenue and
cost conditions where as value maximization refers to
maximization of the present value of future profits
expected to be generated by considering not only the
current revenue and cost conditions but also the future
revenue and cost conditions.
The profit maximization and value maximization become
equivalent and mean to the same thing if the cost and
revenue conditions in one time period are independent of
the revenue and costs in the future time period so a
manager will maximize the value of the firm by making
the decision that maximize profit in every single time
period.
However, if there is some dependency between the
current and future condition of revenue and costs, say the
current production output has an effect on increasing
costs in the future, profit maximization in each (single)
time period will not maximize the value of the firm.
 The Marginal Analysis
 Marginal analysis is an analytical technique used for solving
optimization problem and arrives at optimal decision. Although there
are various maximization or minimization decision to solve the
optimization problems, all optimization problems can be solved using
analytical technique called marginal analysis.
 The marginal analysis involves changing the values(s) of the variables
that determine the objective function (i.e. choice variables) by a small
amount to see if the objective function can be further increased (in the
case of maximization problems) or further decreased (in the case of
minimization problems). The manager continues to make incremental
adjustment on the choice variables until no further improvements are
possible.
 The change on a choice variable also refers to an activity that decision
makers might wish to undertake will generate both benefits and costs.
Consequently, the decision makers will want to obtain a maximum
possible net benefit from the activity where the net benefit (NB)
associated with a specific amount or level of activity (A) is the
difference between the total benefit (TB) and total cost (TC) of the
activity. NB = TB-TC. This net benefit helps to maximize the objective
function.
 Cont’d

Regarding the marginal analysis the marginal benefit

(MB) and the marginal cost (MC) helps to analyze the
optimization problem. MB is a change in total benefit
caused by an incremental change in the level of an
activity and MC is a change in total cost caused by an
incremental change in the level of activity. MB and
MC can be expressed mathematically as:

changein total benefit TB change in total cost TC

MB  MC  
A change in activity A
An optimal level of activity which optimizes the
changein activity

objective function is achieved when MB = MC an

activity must be increase (if MB > MC) or decrease (if
MB < MC) to reach the highest net benefit and thus
optimize the objective function.
 Chapter Two: Demand and Supply
2.1. Demand and Its Determinant
• Demand for a commodity is a consumer’s attitude
towards that commodity. So demand can be defined
as the desire and willingness to buy and the ability
to pay of a consumer for a commodity. But quantity
demanded is the amount of a good or service that a
consumer is willing and able to purchase during a
given time period.
2.1.1. Law of Demand

• The law of demand states the functional

relationships between price and quantity
demanded.
• According to this law, there is an inverse
relationship between price and quantity
demanded of a commodity, other things hold
constant
 2.1.2. Determinants of Demand
• Although price is the important determinant of demand,
there are also various factors which determine demand.
This includes:
1. Price of a commodity: as the law of demand describes,
the relationship between the price of the commodity and
the quantity demanded is inverse. i.e. as one increases the
other decreases and vice versa .
2. Price of related commodities: the two goods are related
either being substituted or complemented each other. The
two goods are said to be substituted if they are independent
in usage but substitute for each other. For such goods
changes in the price of one affects the demand for other in
the same direction. Example, tea & coffee, pepsi and coca.
 Continued….
However, the two goods are said to be
complementary if they goes together in
uses and complement of each other. For
such goods changes in price of one affects
the demand for other in the different
direction. Example, tea & sugar, car & tyre,
camera & film.
3. Income of the consumer: usually people
want to spend more at higher income level
than at lower income level. But for a
detailed analysis of income-demand
relationship the type of good taking into
consideration will result different
outcomes.
 Continued….
a. Necessity or basic goods: these are goods
essentially consumed by the society such as food
grains, vegetables and sugar etc. So the demand
of such goods increases with the increase in
income.
b. Inferior goods: goods which has been given
less value by the society. The demand
for such goods may initially increase with
increase in income up to a certain limit. But it
decreases when income increases beyond that
limit.
c. Normal goods: Normal goods are goods like
clothing and furniture whose demand
increases as income increase.
 Continued…
7. Population- if the size of the population is more,
demand for good will be more. The market demand
for a commodity substantially changes when there is
change in total population keeping other factors
constant.
8. Money circulation- the more the money in
circulation , higher the demand and vise versa.
9. Advertisement and Salesmanship- if the
advertisement is very attractive for a commodity
demand will be more. Similarly, if the salesmanship
and publicity is effective, demand for the commodity
will be more.
 Continued…
d. Prestige or luxury goods: these are goods
demanded for luxury purposes usually by
the rich. Demand for these goods a rise beyond a
certain level of consumer’s income.
Example, Luxury cars and jewelers.
4. Taste and preference of consumers: it also has an
effect on demand of a consumer due to the existence
of different social, cultural, religious values which
changes the taste and
preference of consumers towards a given commodity.
5. Expectation about future price of commodities and
income of consumers: there exist
positive relationship between the expected price and
demand, that is, as the expected price
in the future time increases, the today’s consumers’
consumption (or demand) increases and
vice versa. Also we will obtain the same result in the
case of expected income of the
consumer.
 Continued….
10. Government policy( taxation)
High taxes increase the price & reduce demand while low
taxes will reduce the price and extend the demand.
11. Credit Facilities- the more credit provision, more the
demand for a commodity will be.
 2.2. Supply and Its Determinant
• Supply- refers to the producer’s attitude
towards a commodity to produce and sell a
given commodity at a given price per time
period. So it is the willingness and ability of a
producer to produce and offer a commodity
to the market.
• Supply is what the seller is able and willing to
offer for sale.
2.2.2. Determinants of Supply
1. Cost of inputs: the cost of inputs has an indirect
effect on the supply of a commodity. That is, when the cost of
inputs used to produce a commodity increase/decreases the
supply of the commodity decreases/increases respectively.
2. Technology and productivity: the technology
applied to the production process and the productivity has a
direct effect on supply of a commodity by reducing the cost of
production and increasing efficiency.
3. Price of alternative products: The alternative
products may be a substitute or complement. An increase in
the price of the substitute product causes a reduction in supply
of the commodity and vice versa, however, an increase in the
price of a complementary product causes an increase in supply
of the commodity. Thus, the substitute inversely affects supply
where as the complement directly affects supply.
4. Number of firms in the industry
The size of the industry affects the supply in the
same direction. Increase/decrease in the number of
producers causes the supply to increase/decrease.
Moreover, other factors such as producer’s expectation
of future prices and a grant/subsidy to the consumer
affects the supply positively while the tax on
producers affect supply negatively.
• Note that the conceptual explanations presented on
the demand theory with regard to difference
between demand and quantity demanded and the
representation of relationship between demand and
its determinant through schedule, curve and function
would also have analogous conceptual explanations in
the supply theory under the lessons of difference
between supply & quaintly supplied and supply
schedule, curve and function.
 Market Equilibrium
• Market equilibrium refers to equilibrium of
demand and supply in which the quantity
demanded of a commodity equals the quantity
supplied of a commodity. Consequently, such
equilibrium brings the equilibrium price and
quantity. The equilibrium price is also known as a
market clearing price, because at this price the
market is clear in a sense that there is no unsold
stock and no unsupplied demand, instead the
supply equals the demand.
 Elasticity
• Elasticity of Demand is a technical term used by
economists to describe the degree of
responsiveness of the demand for a commodity due
to a fall in its price. A fall in price leads to an
increase in quantity demanded and vice versa.
 The Determinants Of Price
Elasticity Of Demand
• The exact value of price elasticity for a commodity
is determined by a wide variety of factors.
• The two factors considered by economists are the
availability of substitutes and time. The better the
substitutes for a product, the higher the price
elasticity of demand.
• The longer the period of time, the more the price
elasticity of demand for that product. The price
elasticity of necessary goods will have lower
elasticity than luxuries
 The elasticity of demand depends
on the following factors:
1. Nature of the commodity: The demand for necessities
is inelastic because the demand does not change much
with a change in price. But the demand for luxuries is
elastic in nature.
2. Extent of use: A commodity having a variety of uses has
a comparatively elastic demand.
3. Range of substitutes: The commodity which has more
number of substitutes has relatively elastic demand. A
commodity with fewer substitutes has relatively inelastic
demand.
4. Income level: People with high incomes are less
affected by price changes than people with low incomes.
 Continued…
5. Proportion of income spent on the commodity:
When a small part of income is spent on the commodity, the
price change does not affect the demand therefore the demand
is inelastic in nature.
6. Urgency of demand / postponement of purchase: The
demand for certain commodities are highly inelastic because
you cannot postpone its purchase. For example medicines for
any sickness should be purchased and consumed immediately.
7. Durability of a commodity: If the commodity is durable
then it is used for a long period. Therefore, elasticity of
demand is high. Price changes highly influences the demand for
durables in the market.
8. Purchase frequency of a product/ recurrence of demand:
The demand for frequently purchased goods are highly elastic
than rarely purchased goods.
9. Time: In the short run demand will be less elastic but in the
long run the demand for commodities are more elastic.
 Significance Of Elasticity Of Demand:
• The concept of elasticity is useful for the managers for
the following decision making activities
1. In production i.e. in deciding the quantity of goods to be
produced.
2. Price fixation i.e. in fixing the prices not only on the
cost basis but also on the basis of prices of related goods.
3. In distribution i.e. to decide as to where, when, and how
much etc.
4. In international trade i.e. what to export, where to
export
5. In foreign exchange
6. For nationalizing an industry
7. In public finance