Chapter 1: Managers, Profits, and Markets: Ninth Edition

Managerial Economics
Managerial Economics Thomas

ninth edition Maurice
Chapter 1: Managers, Profits, and Markets
McGraw-Hill/Irwin
McGraw-Hill/Irwin Copyright © 2011 by theby
McGraw-Hill Companies,Companies,
Inc. All rights reserved.
Managerial Economics, 9e Copyright © 2008 the McGraw-Hill Inc. All rights reserved.
Meaning of Managerial Economics
• Managerial economics is a branch of economics that deals with the

application of microeconomic analysis to decision-making techniques of
businesses and management units.
• Managerial economics is thereby a study of application of economics to

increase managerial skills.
• Managerial economics is the attempt to achieve optimal results from

business decisions, while taking into account the firm's objectives,
constraints imposed by scarcity and so on.
Definitions of Managerial Economics
• McGutgan and Moyer- “Managerial economics is the application of

economic theory and methodology to decision-making problems faced by
both public and private institutions”.
• McNair and Meriam- “Managerial economics consists of the use of

economic modes of thought to analyze business situations”.
Features of Managerial Economics

• 1. Microeconomics: It studies the problems and principles of an individual
business firm or an individual industry. It aids the management in
forecasting and evaluating the trends of the market.
• 2. Normative economics: It is concerned with varied corrective measures

that a management undertakes under various circumstances. It deals with
goal determination, goal development and achievement of these goals.
• 3. Uses theory of firm: Managerial economics employs economic

concepts and principles to the extent as required by the firms, which are
known as the theory of Firm or 'Economics of the Firm'. Thus, its scope is
narrower than that of pure economic theory.
Features of Managerial Economics

• 4. Aims at helping the management: Managerial economics aims at
supporting the management in taking corrective decisions and charting
plans and policies for future.
• 5. Takes the help of macroeconomics: Managerial economics

incorporates certain aspects of macroeconomic theory. Knowledge of
macroeconomic issues such as business cycles, taxation policies, industrial
policy of the government, price and distribution policies, wage policies are
integral to the successful functioning of a business.
1-5
Microeconomics and Macroeconomics

• Microeconomics is the study of the choices that individuals and businesses
make, the way these choices interact in markets, and the influence of
governments. Some examples of microeconomic questions are: Why are
people downloading more movies? How would a tax on e-commerce affect
eBay?
• Macroeconomics is the study of the performance of the national economy

and the global economy. Some examples of macroeconomic questions are:
Why is the unemployment rate in Bangladesh so high? Can the Federal
Reserve make U.S. economy expand by cutting interest rates?
1-6
Two big questions

• Two big questions summarize the scope of economics:
• ■ How do choices end up determining what, how, and for whom goods and
services are produced?
• ■ Can the choices that people make in the pursuit of their own self-interest
also promote the broader social interest?
1-7
How do choices end up determining what, how, and for whom

goods and services are produced?
• What? What we produce varies across

countries and changes over time. In the
United States today, agriculture accounts
for 1 percent of total production,
manufactured goods for 22 percent, and
services (retail and wholesale trade,
health care, and education are the biggest
ones) for 77 percent. In contrast, in
China today, agriculture accounts for 11
percent of total production,
manufactured goods for 49 percent, and
services for 40 percent.
1-8

• How? Goods and services are produced by using productive resources

that economists call factors of production. Factors of production are
grouped into four categories:
■ Land
■ Labor
■ Capital
■ Entrepreneurship
• Land The “gifts of nature” that we use to produce goods and services
are called land. In economics, land is what in everyday language we call
natural resources.
1-9

• Labor : The work time and work effort that people devote to producing
goods and services is called labor. Labor includes the physical and mental
efforts of all the people who work on farms and construction sites and in
factories, shops, and offices. The quality of labor depends on human
capital, which is the knowledge and skill that people obtain from
education, on-the-job training, and work experience.
• Capital : The tools, instruments, machines, buildings, and other

constructions that businesses use to produce goods and services are called
capital.
• Entrepreneurship : The human resource that organizes labor, land, and

capital is called entrepreneurship.
1-10

• For Whom? Who consumes the goods and services that are produced
depends on the incomes that people earn. People with large incomes can
buy a wide range of goods and services. People with small incomes have
fewer options and can afford a smaller range of goods and services.
1-11
Can the Pursuit of Self-Interest Promote the
Social Interest?
• Self-Interest: A choice is in your self-interest if you think that choice is

the best one available for you. You make most of your choices in your self-
interest. You use your time and other resources in the ways that make the
most sense to you, and you don’t think too much about how your choices
affect other people.
• Social Interest: A choice is in the social interest if it leads to an outcome

that is the best for society as a whole. The social interest has two
dimensions: efficiency and equity (or fairness). What is best for society is
an efficient and fair use of resources. Economists say that efficiency is
achieved when the available resources are used to produce goods and
services at the lowest possible cost and in the quantities that give the
greatest possible value or benefit. Equity or fairness doesn’t have a crisp
definition.
1-12
Goal of the firm

• The goal is to maximize wealth through maximizing profit
• Profit maximization refers to how much dollar profit the company makes. It is a
short term approach and a myopic person or business is mostly concerned about
short term benefits.
• Wealth maximization is long term process. It refers the value of the company
generally expressed in the value of the stock.
• Value maximization says that managers should make all decisions so as to

increase the total long run market value of the firm. The wealth of corporate
owners is measured by the share price of the stock, which in turn is based on
the timing of returns (cash flows), their magnitude and their risk. Maximizing
share price will maximize owner wealth.
The crucial importance of the concept of margin

• The benefit that arises from an increase in an activity is called marginal
benefit. For example, your marginal benefit from one more night of study
before a test is the boost it gives to your grade. Your marginal benefit doesn’t
include the grade you’re already achieving without that extra night of work.
• The opportunity cost of an increase in an activity is called marginal cost. For

you, the marginal cost of studying one more night is the cost of not spending
that night on your favorite leisure activity.
• To make your decisions, you compare marginal benefit and marginal cost. If
the marginal benefit from an extra night of study exceeds its marginal cost,
you study the extra night. If the marginal cost exceeds the marginal benefit,
you don’t study the extra night.
1-14
Profit Max vs. Wealth Max

• A short term horizon can fulfill objective of earning profit but may not help
in creating wealth. It is because wealth creation needs a longer term;
therefore financial management emphasizes on wealth maximization rather
than profit maximization.
• For a business, it is not necessary that profit should be the only objective; it
may concentrate on various other aspects like increasing sales, capturing
more market share, return on capital etc, which will take care of
profitability. So, we can say that profit maximization is a subset of wealth
and being a subset, it will facilitate wealth creation.
Profit Max vs. Wealth Max

In brief-
• Profit maximization is short term approach and it refers to how much

money the company makes. But Wealth maximization is a long term
approach and it refers the value of the company.
• Profit maximization is a subset of wealth.
• Profit max ignores timing, cash flows, and risk, but in wealth maximizing
those are the key decisions variables.
• Maximization of wealth approach believes that money has time value.
1-16
Constrains of Profit Max

• It is a short term approach
• It ignores the timing of returns, cash flows, and risk
• Profit max method could not discuss on market share, high sales, and
greater stability and so on.
• It could not consider the social responsibility that is one of the most
important objectives of many firms.
1-17
Maximizing the Value of a Firm

• Maximize firm’s value by maximizing profit in each time period
• Value of a firm =
p1 p2 pT T
pT
+ + ... + =�
(1 + r ) (1 + r ) 2
(1 + r )T
t =1 (1 + r )
t
Economic Profits
• Economic profits are not accounting profits
• Economic profits are equal to revenues minus economic costs
• All economic costs are measured in terms of opportunity costs
– Choices represent foregone opportunities
Economic Cost of Resources

• Market-supplied resources
– Owned by others & hired, rented, or leased
• Owner-supplied resources
– Owned & used by the firm
Total Economic Cost

• Total Economic Cost
– Sum of opportunity costs of both market-supplied resources & owner-
supplied resources
• Explicit Costs
– Monetary payments to owners of market-supplied resources
• Implicit Costs
– Nonmonetary opportunity costs of using owner-supplied resources
Economic Cost of Using Resources
E x p lic it C o s ts
of
M a r k e t -S u p p lie d R e s o u r c e s
T h e m o n e ta ry p a y m e n ts to
re s o u rc e o w n e rs
+
Im p lic it C o s ts
of
O w n e r -S u p p lie d R e s o u r c e s
T h e r e tu r n s fo r g o n e b y n o t ta k in g
th e o w n e r s ’ re s o u r c e s to m a rk e t
T o ta l E c o n o m ic C o s t
= T h e to ta l o p p o r tu n ity c o s ts o f
b o th k in d s o f re s o u r c e s
Economic Profit vs Accounting Profit

Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
• Accounting profit does not subtract implicit costs from total revenue
• Firm owners must cover all costs of all resources used by the firm
– Objective is to maximize economic profit
Brady’s Explicit Costs

Opportunity Cost of Brady’s Capital

Implicit Cost of Brady’s Owner Supplied
Resources
Total Opportunity Cost of All Resources

Brady’s Total Accounting Profit

Brady’s Economic Profit
Based on his profit in 2007, did Terry Brady increase his wealth by
quitting his job at Mattoon High and opening Brady Advantage?
Present Value and the Discount Rate
Economic Profit
Discount rate 0% 16% 10%
Year
1 $700,000 $ 603,448 $ 636,364
2 $800,000 $ 594,530 $ 661,157
3 $500,000 $ 320,329 $ 375,657
Total $2,000,000 $1,518,307 $1,673,178
Present value is negatively related to the discount rate.

Managerial Economics Thomas
ninth edition Maurice
Chapter 2
Demand and supply
McGraw-Hill/Irwin 1-33
Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Theory of Demand
1-34
Demand
• Demand: The amount of a particular economic good or service that a
consumer or group of consumers will want to purchase at a given price
over a given period of time.
1-35
Essentials of Demand
1. An Effective Need: There are three basics of an effective need:
• a. The individual should have a need to acquire a specific product.
• b. He should have sufficient funds to pay for that product.
2. A Specific Price: A specific price is required for proclamation of demand.

For example, to state that the demand of cars is 10,000 is worthless, unless
expressed that the demand of cars is 10,000 at a price of Tk. 10,00,000
each.
3. A Specific Time: Demand must be assigned for a specific time. For
example, it is an incomplete proclamation to state that the demand of air
conditioners is 4,000 at the price of Tk. 32,800 each. The statement should
be altered to say that the demand of air conditioners during summer is
4,000 at the price of Rs. 32,800 each.
1-36
Demand schedule
• A market demand schedule is a

table that lists the quantity of a Quantity
good all consumers in a market Possibiliti Price per demanded
will buy at every different price. es Hamburger per day
the relationship between price and
A 2.00 2
quantity (units) bought is called
demand schedule
B 1.50 4
C 1.00 6
D 0.65 7
E 0.40 8
1-37
The Demand Curve

• The graphical representation of the demand schedule is the
“demand curve”.
• In the demand curve , the quantity demanded is put on to the

horizontal axis and the price (P) on the vertical axis.
• In the curve the price and the quantity are inversely related.
That is, Q goes up when P goes down.
Demand curve
Demand curve
Possibili Price per Quantity demanded

ties burger per day
A 2.00 2
B 1.50 4
C 1.00 6
D 0.65 7
E 0.40 8
Law of Demand
• “The demand for a commodity increases with a fall in its price and
decreases with a rise in its price, other things remaining the same”.
• The law of demand thus merely states that the price and demand of a
commodity are inversely related, provided all other things remain
unchanged or as economists put it ceteris paribus.
1-40
Assumptions of the Law of Demand

1. Income level should remain constant: The law of demand operates only
when the income level of the buyer remains constant
2. Tastes of the buyer should not alter: Any alteration that takes place in the
taste of the consumers will in all probability thwart the working of the law
of demand.
3. Prices of substitute goods should remain constant: Changes in the prices
of other goods often impinge on the demand for a particular commodity.
1-41
Assumptions of the Law of Demand

4. Advertising expenditure should remain the same: If the advertising
expenditure of a firm increases, the consumers may be tempted to buy
more of its product. Therefore, the advertising expenditure on the good
under consideration is taken to be constant.
5. Size of population will remain fixed: If population increases, the demand

for a product will increase and vice-versa.
6. Price rise in future should not be expected: If the buyers of a commodity

expect that its price will rise in future they raise its demand in response to
an initial price rise. This behavior of buyers violates the law of demand.
Therefore, for the operation of the law of demand it is necessary that there
must not be any expectations of price rise in the future.
1-42
Why does the demand curve slope downwards

• Substitution Effect: When the price of a commodity falls it becomes
relatively cheaper if price of all other related goods, particularly of
substitutes, remain constant. In other words, substitute goods become
relatively costlier. Since consumers substitute cheaper goods for costlier
ones, demand for the relatively cheaper commodity increases. The increase
in demand on account of this factor is known as substitution effect.
• Income Effect: As a result of fall in the price of a commodity, the real
income of its consumer increase at least in terms of this commodity. In
other words, his/her purchasing power increases since he is required to pay
less for the same quantity. The increase in real income (or purchasing
power) encourages demand for the commodity with reduced price. The
increase in demand on account of increase in real income is known as
income effect.
1-43
Demand Function
• The functional relationship between the demand for a commodity and its
various determinants may be expressed mathematically in terms of a
demand function, thus:
• Qd = f ( P, M , PR , , Pe , N )
• where
– Price of good or service (P)
– Incomes of consumers (M)
– Prices of related goods & services (PR)
– Taste patterns of consumers (T)
– Expected future price of product (Pe)
– Number of consumers in market (N
1-44
Demand Function
• The above-stated demand function is a complicated one. Again, factors like
tastes are not quantifiable. Economists, therefore, adopt a very simple
statement of demand function, assuming all other variables, except price,
to be constant.
• Thus, an over-simplified and the most commonly stated demand function

is: Dx = f (Px), which connotes that the demand for commodity X is the
function of its price.
1-45
Movement along Demand curve Vs Shift of Demand

curve
• Two factors to be considered: price and other than price
• Demand curve is constructed considering other things remain equal except
price. The effect of change in price can be explained by the movement
along demand curve.
• If price changes, demand curve moves from one point to another along the
demand curve
1-46
Shift of Demand Curve
• When one of the other

determinants changes, a whole
new demand curve is
constructed, that is, the curve
shifts.
• A shift in demand curve is
referred to as change in demand
curve.
• If a change in one of the other
determinants causes demand to
rise-say, income rises, the whole
curve will shift to the right. At
each price, more will be
demanded than before. Quantity
Theory of Supply
1-48
Supply
• The amount of a particular economic good or service that a producer or
group of producers will want to produce and supply at a given price over a
given period of time.
1-49
The Supply schedule
• A market supply schedule is Supply Schedule
a table that lists the

Possibili Price per Quantity supplied
quantity of a good all ties Hamburger per day
suuplier in a market will sell A 2.00 14

at every different price. the
relationship between price B 1.50 10
and quantity (units) sold is C 1.00 6
called supply schedule D 0.65 4
E 0.40 2
Supply curve
Possibili Price per Quantity supplied

ties Hamburger per day
A 2.00 14
B 1.50 10
C 1.00 6
D 0.65 4
E 0.40 2
• The graphical expression of Supply schedule is supply curve.

• Price is measured in the vertical axis, quantity supplied is measured in the
horizontal axis
• The curve is positively sloping or upward sloping.
Law of supply
• The higher the price of a product, the higher the quantity of products
producers are willing to supply considering other things equal.
• The lower the price of a product, the lower the quantity of products
producers are willing to sell considering other things equal.
Assumptions of Law of Supply

1. Input prices (PI ) :Price of input remains constant because a rise in the
price (cost) of an input decreases supply and vice versa.
2. Prices of goods related in production (Pr):Price of related goods will

remain unchanged as a rise in the price of a substitute in production
decreases supply ,a rise in the price of a complement in production
increases supply
3. Technological advances (T):Technology will remain unchanged. An

advance in technology increases supply
53
Assumptions of Law of Supply

4. Expected future price of product (Pe):Future price of the product is
expected to be unchanged . If the price is expected to rise in the future, the
current supply decreases
5. Number of firms producing product (F): Numbers of suppliers will be

same an increase in the number of suppliers increases the supply.
1-54
supply function
The functional relationship between the supply of a commodity and its
various determinants may be expressed mathematically in terms of a
supply function, thus:
Qs = f ( P, PI , Pr , T , Pe , F )
Where,
•Price of good or service (P)
•Input prices (PI )
•Prices of goods related in production (Pr)
•Technological advances (T)
•Expected future price of product (Pe)
•Number of firms producing product (F)
1-55
Supply Function
• Supply function, or supply, shows relation between P & Qs when all other
variables are held constant
• Qs = f (P)
1-56
Movement along and shift in supply curve
• If the price of a commodity • The supply curve shifts if some

changes, the supply curve will relevant factor that affects the
move from one point to another supply, other than the price of the
along the supply curve. It is good, changes.
movement along the supply curve
1-57
Equilibrium of supply and demand

• The equilibrium price is determined by the intersection of the
demand and supply curves. It is the price at which the quantity
demanded equals the quantity supplied.
• The equilibrium quantity is the quantity bought and sold at the
equilibrium price.
• Market clearing price: price at which quantity demanded = quantity
supplied. This denotes that all supply and demand orders are filled,
the books are “cleared” of orders , and demanders and suppliers are
satisfied.
Equilibrium of supply and demand
• At the equilibrium price, there is no shortage or surplus
Quantity supplied per Quantity demended

Possibilities Price per Hamburger day per day
A 2.00 14 2
B 1.50 10 4
C 1.00 6 6
D 0.65 4 8
E 0.40 2 10
P
S
Surplus
Deficit D
Q
– Surplus- When quantity supplied has exceeds the quantity

demanded.
– Shortage-When the market quantity demanded has exceeds the
quantity supplied.
– Equilibrium point- The equilibrium price and quantity come
when the amount willingly supplied equals the amount willingly
demanded. In a competitive market, this equilibrium is found at
the intersection of supply and demand curves. There are no
shortages and surpluses at the equilibrium price.

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Managerial Economics

Managerial Economics Thomas

Chapter 1: Managers, Profits, and Markets

Meaning of Managerial Economics

• Managerial economics is a branch of economics that deals with the

• Managerial economics is thereby a study of application of economics to

• Managerial economics is the attempt to achieve optimal results from

Definitions of Managerial Economics

• McGutgan and Moyer- “Managerial economics is the application of

• McNair and Meriam- “Managerial economics consists of the use of

Features of Managerial Economics

• 2. Normative economics: It is concerned with varied corrective measures

• 3. Uses theory of firm: Managerial economics employs economic

Features of Managerial Economics

• 5. Takes the help of macroeconomics: Managerial economics

Microeconomics and Macroeconomics

• Macroeconomics is the study of the performance of the national economy

Two big questions

How do choices end up determining what, how, and for whom

• What? What we produce varies across

How do choices end up determining what, how, and for whom

• How? Goods and services are produced by using productive resources

How do choices end up determining what, how, and for whom

• Capital : The tools, instruments, machines, buildings, and other

• Entrepreneurship : The human resource that organizes labor, land, and

How do choices end up determining what, how, and for whom

• Self-Interest: A choice is in your self-interest if you think that choice is

• Social Interest: A choice is in the social interest if it leads to an outcome

Goal of the firm

• Value maximization says that managers should make all decisions so as to

The crucial importance of the concept of margin

• The opportunity cost of an increase in an activity is called marginal cost. For

Profit Max vs. Wealth Max

Profit Max vs. Wealth Max

• Profit maximization is short term approach and it refers to how much

• Profit maximization is a subset of wealth.

• Maximization of wealth approach believes that money has time value.

Constrains of Profit Max

Maximizing the Value of a Firm

Economic Cost of Resources

Total Economic Cost

Economic Cost of Using Resources

Economic Profit vs Accounting Profit

Accounting profit = Total revenue – Explicit costs

Brady’s Explicit Costs

Opportunity Cost of Brady’s Capital

Total Opportunity Cost of All Resources

Brady’s Total Accounting Profit

Brady’s Economic Profit

Present value is negatively related to the discount rate.

Demand and supply

2. A Specific Price: A specific price is required for proclamation of demand.

• A market demand schedule is a

The Demand Curve

• In the demand curve , the quantity demanded is put on to the

Possibili Price per Quantity demanded

Assumptions of the Law of Demand

Assumptions of the Law of Demand

5. Size of population will remain fixed: If population increases, the demand

6. Price rise in future should not be expected: If the buyers of a commodity

Why does the demand curve slope downwards

• Thus, an over-simplified and the most commonly stated demand function

Movement along Demand curve Vs Shift of Demand