Lesson One

1.0 NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Introduction to Economics and its branches
Managerial economics is generally thought of as applied microeconomics. It is the branch of
economics that applies economic theory and methods to business and administrative decision making.
It uses the tools and techniques of economic analysis to solve managerial problems, thus prescribing
the rules for improving managerial decisions. Other than telling managers how things should be done
in the organization, it helps them recognize how economic forces affect their organization and
describe the economic consequences of managerial decisions.
Generally managerial economics is an application of microeconomic aspects that are important to
managers, and thus focuses on such areas as; demand, production, cost, pricing, market structures and
government regulation. A strong understanding of the principles governing behavior of firms and
individuals should result in better managerial decisions, higher profits and an increase in the value of
the firm.
The flow diagram: Role of managerial economics in managerial decision making

Management decision problems e.g. product price and output;

production technique; advertising-choice and intensity; employment
and training; investment and financing etc

Economic concepts (framework Decision sciences (tools and

for decision) e.g. theory of techniques of analysis) e.g. statistical
consumer behavior, theory of the estimation, optimization, forecasting,
firm, market structures and pricing and game theory

Managerial economics: use of economic concepts and decision

sciences methodology to solve management decision problems

Optimal solution to management decision problem

Almost any business decision can be analyzed with managerial economics techniques, but it
is most commonly applied to:
 1. Risk analysis - various models are used to quantify risk and asymmetric information
and to employ them in decision rules to manage risk.
2. Production analysis - microeconomic techniques are used to analyze production
efficiency, optimum factor allocation, costs, economies of scale and to estimate the
firm's cost function.
3. Pricing analysis - microeconomic techniques are used to analyze various pricing
decisions including transfer pricing, joint product pricing, pricing discrimination,
price elasticity estimations, and choosing the optimum pricing method.
4. Capital budgeting - Investment theory is used to examine a firm's capital purchasing
decisions.
Importance of the principles of managerial economics to a manager:
1. It provides the framework for evaluating whether resources are being allocated efficiently in
the firm, given the economic environment in which the firm operates e.g. labour
2. Helps managers to respond to various economic signals e.g. if the price of output increase or
technology improves then the prudent manager should plan to increase output
3. Helps managers to arrive at a set of operating rules that aids in the efficient utilization of
scarce human and capital resources. These rules help them attain their pre-determined
objectives
Note:
1. To establish the optimal decisions to management problems, managers must thoroughly
understand the economic environment in which they operate, managerial economics describes
how this economic environment effects, and is affected by managerial decisions. Example,
managerial economics reveals that imposing import quotas on automobiles reduces the
availability of import substitutes for domestically produced vehicles, raises prices of
automobiles, increases the possibility of monopolies in that sub-sector etc.
2. Managerial economics is as relevant to non-profit oriented businesses as is to profit-oriented
ones

THE BUILDING BLOCKS OF MANAGERIAL ECONOMICS

A: The Circular Flow of Economic Activity

Expenditure Expenditure
Goods/product market
 Goods and services

Households Firms

Factors of production

Income Factor markets Income

Figure: Circular flow of income, output, resources and factor payments

Households own or control economic resources (land, labour and capital) that are valuable to
firms, and they sell them to firms as inputs into the production process. The money received by the
households from the sale of these resources, is called factor payments. This income is then used to
satisfy their consumption demand for goods and services.
The interaction between households and firms occur in two distinct arenas:
a) Product Market: where goods and services are bought and sold
b) Factor Markets: where factors of production are traded
In the product market, households demand goods and services produced by firms, and the
interaction between demand and supply determines the price and quantity sold. In this market, money
flows from households to firms while goods and services flow in the opposite direction. In the factor
market the opposite is the case, since households are the suppliers of economic resources. Prices are
similarly determined by demand and supply conditions.
Note:
a) Prices and profits serve as signals for regulating the flows of money and resources through the
factor markets, and the flows of money and goods through the goods market.
b) In the market economy depicted by this circular flow, households and firms are highly
interdependent e.g. an individual’s labour will have no value in the market unless there is a
firm that is willing to pay for it. Also, firms cannot satisfy production unless some consumers
want to buy their products.

B: THEORY OF THE FIRM

To earn profits, the firm organizes the factors of production to produce goods and services that
will meet the demands for individual consumers and other firms. An understanding of the reason for
the existence of firms, their specific role in the economy and their objective provide a background for
the theory of the firm. The rationale for the existence of firms emanates from the following:
a) They are useful in the process of producing and distributing goods and services
 b) They exist as organizations because the total cost of producing a given level of output is
lower than if the firm did not exist e.g. transaction costs associated with various negotiations
and agreements between parties tend to benefit all (firms and households)
c) Some government interference in the market place applies to transactions among firms rather
than within firms e.g. sales taxes usually apply only to transactions between one firm and
another. By internalizing some transactions within the firm that would otherwise be subject to
government interference, production costs are reduced e.g. consider a firm that has to choose
between purchasing cabinets from another firm or hiring a cabinet maker.
The Theory: Objective of the Firm
Traditionally, economists have assumed that the objective of the firm is to maximize profits i.e.
managers consistently make decisions so as to make profit. But profit for which period? current? next
five years? Etc. often managers are observed making decisions that reduce current year profits in an
effort to increase profit in future years e.g. investing in research and development (R & D), new
capital marketing programs etc. In other words, in the more complete model of the firm the primary
goal of the firm is the expected value maximization. Thus, as both current and future profits are
important it is assumed that the goal is to maximize the present (discounted) value (PV) of future
profits. Formally,
Max PV(π) = π1 + π2 + ………… + πt π = profit in time period t
1+r (1+r)2 (1+r)t r = discount rate

The present value of all future profits is also interpreted as the value of the firm i.e. what a willing
buyer would pay for the business. Thus, to maximize the discounted value of all future profits is
equivalent to maximizing the value of the firm.

Constrained decision making

Profit maximization is constrained by the limited information available to a manager. These
constraints involve legal, moral, contractual, financial and technological constraints.
i) Legal constraints include the array of state and local laws that must be obeyed by all
citizens, both individuals and corporate e.g. environmental laws (pollution, waste
disposal, fuel efficiency requirements etc), healthy and safety standards and employment
laws (minimum wages, wrongful termination etc)
ii) Contractual requirements bind the firm because of some prior agreements e.g. long term
leases on buildings, contract with a labour union that represents the firm’s employees etc.
Labour contracts also limit the flexibility in employee scheduling and job assignments.
 iii) Capital or Financial requirements limit the amount of capital resources ávailable to a
particular project or activity or firm
iv) Technological0constrqints set physical limits on the amount of output ðer unit of time
tèat can be generated by particular machines or workers
v) In other instances, output must muet certain minimum quality requirements e.g.
nutòitional requirements for food products, minimum customer$service levels, reliability
requirements for electronic products etc
Criticism of the Theorù of the firm
The theory dges not explicitly recognize oôher gïals, including the possibility that managers might
take actions that would benefit other parties other than the stakeholders (managers themselves or
society), which reduce stakeholders wealth. Thus, the model seems to ignore the possibilities of
satisficing, managerial self-dealing, and voluntary social responsibility on the part of business.
Given that firms assert the existence of multiple goals, engage in ‘social responsibility’ programs,
and sometimes exhibit what appears to be satisficing behaviour, then the economic model of the firm
could be regarded as adequate as a basis for the study of managerial decision making.

C) ECONOMIC PROFIT
Conventionally, profit is defined as total revenue less total (explicit/accounting) costs. To the
economist, it is the excess of revenues over the costs of doing business i.e. the economist recognizes
other costs referred to as implicit costs (costs that are not reflected in cash outlays by a firm, but are
associated with foregone opportunities) e.g. opportunity cost of alternative investment, manager’s
time and talent (for own business) etc. Thus, economic profit is the business profit minus the implicit
costs of equity and other owner-provided inputs used by the firm.
Sometimes the operation of economically unprofitable businesses is continued because of a
failure to understand and properly include implicit costs. So, rational decision making requires that all
relevant costs, both explicit and implicit be recognized.

Some theories explaining the existence of Economic profits

1. Frictional theory of economic profits: According to it, markets often are in disequilibrium
because of unanticipated changes in product demand or cost conditions. Shocks exist in the
economy, producing disequilibrium conditions that lead to either positive or negative
economic profits for some firms e.g. a rise in the use of plastic or aluminum in automobiles
might drive down the profits of steel manufacturers
2. Monopoly theory of economic profit: It is an extension of frictional theory, and asserts that
some firms, because of such factors as economies of scale, high capital requirements, patents
 or import protection, can build monopoly positions that allow them to keep their profits above
normal for extended periods
3. Innovation theory of economic profits: It argues that above-normal profits arise as a result of
successful innovation. Example, Xerox Corporations, which historically earned a high rate of
return because it successfully developed, introduced, and marketed superior copying device,
continued to earn these excess profits until other firms entered the industry to compete with it
and drive these high profits down to a normal level.
4. Compensation theory of economic profits: It holds that above-normal rates of return may
simply be a reward to firms that are extraordinarily successful in meeting customer needs,
maintaining efficient operations etc. Hence, inefficient firms can be expected to earn
relatively unsatisfactory (below-normal) rates of return, and vice versa. The theory recognizes
economic profit as an important reward to the entrepreneurial function of owners (or
managers)
Note:
a) Each of the theories above describes economic profits as arising due to different reasons
b) Economic profits play an important role in a market-based economy. Excess profits serve as a
valuable signal that firm or industry output should be increased while below-normal profits
provide a signal for contraction or exit. Thus, economic profit serves as one of the most
important factors affecting the allocation of scarce economic resources. Similarly excess
profits can constitute an important reward for innovation and efficiency.