Managerial

Economics
Chapter 1

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.

Managerial Decision Problems

Economic theory
Microeconomics
Macroeconomics

Decision Sciences
Mathematical Economics
Econometrics

MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems
OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS
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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.

Value of the Firm

The present value of all expected future profits

Alternative Theories

Sales maximization

Adequate rate of profit

Management utility maximization

Principle-agent problem

Satisficing behavior
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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.

Theories of Profit
Risk-Bearing Theories of Profit
Frictional Theory of Profit
Monopoly Theory of Profit
Innovation Theory of Profit
Managerial Efficiency Theory of Profit

Risk-Bearing Theories
of Profit
According to F.B. Hawley, Profit is reward for risk
bearing which is the most important function of
an entrepreneur. Hawley believes that risks are
unpleasant and therefore no one likes to bear it,
until and unless some reward is insured. Profit is a
reward for bearing these risks.

Frictional Theory of Profit

FRICTIONAL THEORY OF PROFIT ALSO KNOWN AS

DYNAMIC EQUILIBRIUM THEORY.

Industries earning
above normal profits (economic profits) will
eventually find more competition. Added
competition will bring profits back to normal
(zero economic profits) over time. Competition
directs resources to industries with the greatest
profit.
Example: petroleum industry profits rise when
there are international wars in oil producing
countries.
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Innovation Theory of
Profit

The innovation theory of profit was developed

by Joseph A. Schumpeter.

Schumpeter was of the opinion that factors

such as emergence of interest and profits,

recurrence of trade cycles are only incidental to
a distinct process of economic development;
and certain principles which could explain the
process of economic development would also
explain these economic variables or factors.

Schumpeters theory of profit is thus embedded

in his theory of economic growth.

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Monopoly Theory of Profit

The term monopoly characterizes a market

situation in which there is a single seller of a

commodity that does not have close substitutes.

Monopoly arises due to such factors as:

(i) economies of scale;
(ii) sole ownership;
(iii) legal sanction and protection; and,
(iv) mergers and acquisition.
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Monopoly Theory of
Profit
A monopolist can earn pure or monopoly profit
and maintain it in the long run by using its
monopoly powers, including:

(i) powers to control price and supply;

(ii) powers to prevent entry of competitors by price
cutting; and,

(iii) monopoly power in certain input markets.

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Function of Profit
Profit is a signal that guides the allocation of
societys 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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Managerial Efficiency
Theory of Profit

Exceptional managerial skills can produce superior

profits.

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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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