Managerial Economics

How is Managerial Economics Useful?

A. Evaluating choice alternatives

B. Making the best decision

*Evaluating Choice Alternatives

1. Recognition of economic forces that affect organizations

2. Economic consequences of managerial behavior

3. Links economic concepts and quantitative methods to develop vital tools for DECISION MAKING

#1 Recognition of economic forces that affect organizations

 Meet short-run objectives

 Pricing Strategies e.g. behavior of demand & supplies

 Production Strategies

#2 Economic consequences of managerial behavior

 Maximize Profits

 Production Rules

 Marketing Rules

#3 Links economic concepts and quantitative methods to develop vital tools for DECISION MAKING

 Simplifies complexity

 Use of tools and concepts to arrive at a set of operating rules

 efficient use of scarce human & capital resources

*Making the Best Decision

 Establish the appropriate decision rules

 Understand the economic environment

 Comprehensive application of economic theory & methodology

 Objective: Profit maximization

 Internal – business’ capacity

 External – political, competition
 Microeconomics – individual segments of the economy i.e. consumers, workers, owners of
resources, individual firms, industries & markets for goods & services

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  Business practices or tactics – routine business decisions to earn the greatest profit under
prevailing market conditions

 Industrial organization – focus on the behavior and structure of firms & industries

 Strategic decisions – business actions taken to alter market conditions and behavior of rivals to
increase or protect firm’s profits

Management Decision Problems

Product selection, output & pricing
Internet strategy
Organization desing
Product development & promotion strategy
Worker hiring & training
Investment & financing

Economic Concepts Quatitative Methods

Marginal analysis Numerical analysis
Theory of consumer demand Statistical estimation
Theory of the firm Forecasting procedures
Industrial organization & firm Game-theory concepts
Public choice theory Optimization techniques
Information systems

Managerial Economics
Use of economic concepts and quatitative
methods to solve management decision
problems

Optimal solutions to management decision

problems

The Theory of the Firm

It is a business model that is useful for producing and distributing goods and services.

 Series of contractual relationships

 Specifies the rights and responsibilities of various parties

 Primary goal is profit maximization

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 Society

Suppliers Investors

FIRM
Manageme Employees
nt MFIR
Customers

Profit Maximization involves

 Before

 Short-run profits

 Today

 Long-term expected value maximization encompassing

 Uncertainty (risk rate)

 Time value of money

CAPITALISM

Capitalism

 Voluntary transactions between individuals and firms create wealth.

Art of business

 Consists of identifying assets in low-valued uses & devising ways to profitably move them to
higher valued ones

Wealth – objective of a business

 It is created when assets move from lower to higher-valued assets

Value

 Measured as the amount of money that a buyer is willing and able to pay

How to create wealth?

 A company can be thought of as a series of transactions.

 A well-designed organization rewards employees who identify and consummate profitable

transactions or who stop unprofitable ones

What creates wealth?

 Voluntary transactions of moving lower valued assets to higher value

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How is managerial economics useful in wealth creation?

 Economic analysis identifies these lower valued assets & find alternatives to move to high value

Wealth-creating transactions

 Factory owners

 From Low value

 Purchase labor from worker

 Borrow capital from investors

 Sell manufactured products to consumers

 Move to High value

 Process then sell at a price that consumers are willing to pay

Wealth-creating transactions

 Insurance Investors

 From Low value

 AIDS patients sell their life insurance policies to investors at a discount

 Move to High value

 Insurance investors wait for AIDS patients to die and collect from insurance companies at full
value

Real Estate Agents

 A house is for sale:

 The buyer values the house at $130,000 – top dollar

 The seller values the house at $120,000 – bottom line

 The buyer and seller must agree to a price that “splits” surplus between buyer and seller. Here,
$128,000.

 The buyer and seller both benefit from this transaction:

 Buyer surplus = buyer’s value minus the price, $2,000

 Seller surplus = the price minus the seller’s value, $8,000

 Total surplus = buyer + seller surplus, $10,000 = difference in values

One Lesson of Business

 The art of business consists of identifying assets in lower valued uses, and profitably moving
them to higher valued uses.

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  In other words, make money by identifying unconsummated wealth-creating transactions and
devise ways to profitably consummate them.

Hindrance to wealth creation

 Taxes

 By deterring wealth-creating transactions – when the tax is larger than the surplus for a
transaction

Hindrance to wealth creation

 Price controls

 Example: rent control (price ceiling) in New York City - deters transactions between
owners and renters

Hindrance to wealth creation

 Subsidies

 Example: flood insurance – encourages people to build in areas that they otherwise wouldn’t

Value of the Firm

 Price at which the firm can be sold

 Present value of the firm’s expected future net cash flows (discounting process)

 Value of the expected profits, discounted back to the present at an appropriate interest or
discount rate

Value of the Firm

 Principles:

 The larger/smaller the risk associated with future profits, the higher/lower the risk-adjusted
discount rate used to compute the value of the firm and the lower/higher will be the value of
the firm.

 Discounting is required because profits obtained in the future are less valuable than profits
earned today. (P1 today worth more in the future if Invested)

 Value of the Firm

 Single Payment in the Future

FV = PV + [1 + i (i = prt)]

PV=

Where:

FV = Future Value

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Value of the Firm

 Maximization model represents the responsibilities of the different functional departments of a

firm

 Total Revenues (TR) – Marketing department for the promotion and Sales

 Total Cost (TC) – Production or operations department for the development costs

 Discount Factor – Finance department for the acquisition of capital or financing

Value of the Firm

 Principle

 Managers make decisions that will maximize value of the firm which is the sum of the
discounted expected profits in current and future periods.

 Managers maximize the value of the firm by making decisions that maximize expected profit for
every single period.

Constraints

 Limited availability of essential inputs e.g. skilled labor, raw materials, energy, specialized
machinery, warehouse space

 Limited amount of investment funds to sustain operational requirements

 Contractual requirements e.g. labor contracts limit schedule & job assignments; minimum level
of output to meet quality requirements

 Legal restrictions e.g. minimum wage, health & safety standards, environmental standards,
pricing & marketing practices

Limitations – Manager’s Dilemma

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Limitations – Alternative Models for Decision-Making By Managers Other Than Value Maximization

 Size and growth maximization as primary objective of management

 Competition in the capital markets forced managers to seek value maximization in their
financing decisions

 Stockholders are concerned with value maximization as it affects their rates of return on stock
investments.

 Managers are most concerned with their own personal utility or welfare maximization

 Managers with this kind of behavior run the risk of losing their job.

 Unfriendly takeovers are hostile to inefficient management

 The firm as a collection of individuals with widely divergent goals rather than as a single,
identifiable unit

 Recent studies show a strong correlation between firm profits and managerial compensation

Measuring and Maximizing Economic Profit

 Economic Cost of Using Resources

 Resources:

 labor services, capital equipment inputs, land, building, raw materials, energy, financial
resources and managerial talents

 Opportunity cost:

 What the owners must give up to use the resources.

 Two kinds of Inputs or Resources

1. Market-supplied

 Owned by others and hired, rented or leased by the firm

2. Owner-supplied

 Money – investment by owners

 Time and labor services provided by owners

 Land, building or any capital equipment owned and used by the firm

 Total Economic Cost

 Sum of the opportunity costs of market-supplied and owner-supplied resources to produce

goods and services

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  Two types:

1. Explicit cost

2. Implicit cost

 Explicit Costs

 Opportunity cost of using market-supplied resources from out-of-pocket money

payment made to the owners of resources e.g. microprocessor chips manufactured by
Intel Corp for iMac Computer of Apple

 Implicit Costs
 Opportunity cost of using owner-supplied resources which are the greatest earnings
forgone for using resources owned by the firm in the firm’s own production process.
 It does not necessarily mean it has zero value unless the market value is zero meaning
no other firm would be willing to pay for anything for the use of the resource.
 Implicit Costs
 Three most important types:
1. Opportunity cost of equity capital - cash provided by owners)
2. Opportunity cost of using land or capital owned by the firm
3. Opportunity cost of the owner’s time spent managing the firm or working for
the firm in some other capacity
1. Equity Capital
 Cash provided and placed in the business by the owners
 Includes normal rate of return on equity (risk adjusted) capital necessary to attract and retain
investment
 If cash was instead invested in a capital (money) market and earns for example
an interest, the interest is the opportunity cost which could have been the
earnings if the owners did not put the money in the business.

2. Use of Land or Capital Owned by Firm

 Two firms are manufacturing the same product.

 One firm rents a building while the other owns a building where the production is
undertaken.

 The rental fee represents the opportunity costs for both.

o Explicit – for the firm renting

o Implicit – for the firm who owns

2.1. Use of Land or Capital Owned by Firm

 Opportunity cost may not necessarily be the actual amount paid for the capital
input/resource.

 The opportunity cost reflects the current market value of the resource

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2.1. Use of Land or Capital Owned by Firm

 The implicit cost is the best return that could be earned.

o A building purchased at P20m but the market value has declined to P10m at
which it can be sold.

o If sold today & proceeds are invested at 10%, the implicit cost is not the P10m
but the P1m (10% x P10m)

o The implicit cost is not what the resource can be sold but rather it is the best
return sacrificed each year.

3. Value of Time Spent by Owners Managing the Firm

 The implicit cost is the salary that could be earned by the owners in an alternative
occupation.

o It is the same as the payment that would be necessary to hire an equivalent

manager or worker if the owner does not work for the firm.

 Principle
 The opportunity cost of using resources is the amount the firm gives up by using these
resources.
 Opportunity costs can be either explicit or implicit costs.
 Explicit costs are the costs of using market-supplied resources which are the monetary
payments to hire, rent or lease resources owned by others.
 Implicit costs are the costs of using owner-supplied resources which are the greatest
earnings foregone from using resources owned by the firm in the firm’s own production
process.
 Total economic cost is the sum of explicit and implicit costs.

Economic Profit versus Accounting Profit

 Economic Profit

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  Difference between total revenue and total economic cost

 Total Revenues

Less: Explicit Costs

Implicit Costs

Economic Profit

 Profit increases the wealth of the owners while loss paid out of the wealth of the
owners

 Used to value the firm

 Accounting or Business Profit

 Difference between total revenue and explicit cost

 Total Revenues

Less: Explicit Costs (Exemption: Implicit Cost deducted as Depreciation)

Profit

 Amount available to fund equity capital after payment for all other resources used by
the firm

 Follows GAAP in reporting profits

 Used for financial reporting by regulatory bodies

Variability of Economic Profits

 Disequilibrium Profit Theories

 Frictional Profit Theory

 Abnormal profits or losses observed following unanticipated changes in

demand or cost conditions.

o Technological advances e.g. use of plastic and aluminum in car

manufacturing drives down steel manufacturers

o Software applications boost faster access to information e.g.

cellphone models and versions

 Disequilibrium Profit Theories

 Monopoly Profit Theory

 Above-normal profits caused by barriers to entry that limit competition

thus creating a monopolistic position.

o Economies of scale

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 o High capital requirements

o Patents

o Import protection

o Luck (right industry at the right time)

 Monopoly profits are unwarranted and subject to heavy taxes or

regulated.

 Compensatory Profit Theories

 Innovation Profit Theory

 Above-normal profits that follow successful invention or modernization.

o Economies of scale

o High capital requirements

o Patents

o Import protection

o Luck (right industry at the right time)

 Monopoly profits are unwarranted and subject to heavy taxes or

regulated.

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