Managerial Economics

1. 1
MANAGERIAL ECONOMICS FOR ORGANISATIONS
BY
I.D.O. CHILOKWU
Introduction
Generally, economics is concerned with the production,
distribution, exchange and consumption of goods and services. It is
concerned with the proper use and allocation of resources for the
achievement and maintenance of growth and stability. Managers
focus on the way in which individual, groups, business enterprises
and governments seek to achieve any economic objective they
select. Economics can be divided into two major fields. The first,
microeconomics explains how the interplay of supply and demand
in competitive markets create individual prices, wage rates, profit
margins and rental charges. Microeconomics assumes that people
behave rationally i.e. sensible and able to make decisions based on
intelligent thinking rather than on emotion (rational behaviour).
Consumers try to spend their income in ways that give them as
much pleasure as possible (consumers maximize utility); and
entrepreneurs seek as much profit as they can extract from their
operations.
The second field, macroeconomics deals with explanations of
national income, employment, national output, total investment,
total consumption, total savings, taxation, inflation, foreign
exchange, aggregate demand, general price level, wage level,

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international trade, growth of income, etc. As a field of study, it
explains the aggregate behaviours. Macroeconomics has the
objectives of analyzing the causes of unemployment, the causes of
inflation and the causes of sluggish growth of income and
employment among other objectives. It is an approach of economic
study and analysis which affects the life and interest of people
everywhere. It is useful in understanding the working of an
economy and in formulating economic principles, programmes and
policies that guide the economy along certain desired lines and
minimize economic fluctuations. Macroeconomics is composed of
different areas, based on different schools of thought. These schools
of thoughts are the Classical Economics, Neoclassical Economics,
Keynesian Economics and Neo-Keynesian Economics. The Classical
and Keynesian economics are differentiated in this work so as to
present a clear understanding of the other two schools of thought
i.e. Neoclassical Economics and Neo-Keynesian Economics.
Managerial economics comprises both microeconomic theories and
macroeconomic terms affecting the economic environment.
Gross Domestic Product (GDP)
In any study of the aggregate economy (macroeconomics), one of the
key elements is the aggregate amount of goods and services
produced over a certain period of time. The measure most often

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used is called the nominal gross domestic product (the GDP). This
is the market value of the total quantity of final goods and services
produced over the specified time period. The GDP is actually
measured in annual terms. In order to understand this measure, it
is necessary first to understand the concept of a final product. The
GDP does not measure the market value of everything that is
produced, because this would entail double counting. Each final
product includes intermediate goods whose value is included in the
value of the final product. Take for example, a simple loaf of bread,
the loaf is made from flour (and other ingredients), the flour is made
from seeds. The value of the bread (the final product) includes the
value of the flour, which includes the value of the seeds. The GDP
includes the market value of the bread – it does not then add the
values of the flour, wheat and seeds. The value of a final product is
also the value of the incomes of everyone involved in the production
of both the final product and the intermediate goods that went into
production.
Let’s say that the baker produces N1000 worth of bread using N700
worth of flour, used N500 worth of wheat, which the farmer grew
from N10 worth of seed. The different between the N1000 and the
N700 is the N300 of income generated by the baker. The difference
between the N700 and the N500 is the N200 of income generated by
the miller. The difference between the N500 and the N10 is the
N490 of income generated by the farmer. If we assume for simplicity
that the seed represents the income generated by the seed
producer. The sum of these incomes (N300 + N200 + N490 + N10) is

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equal to the market value of the bread (N1000). Each of the
producers will distribute this income to the factors of production
(wages, rent, interest and profit). As all the money is distributed or
kept by the producer as profit, the market value of the final product
is equal to the incomes of all the factors of production. This is
usually shown as a “flow of income” chart or simply circular flow of
income:
Fig. 1: Flow of Income
The inner arrows going in a clockwise direction show that the
households supply the factors of production to the firms, and the
firms produce goods and services for the households. The outer
arrows going in a counter-clockwise direction show the money
values of the household’s expenditures on the final goods and
services, which supplies exactly the required amount of the firms to
pay the factor incomes (wages, rent, interest and profit) to the
household suppliers of those factors (labour, land, capital and
enterprise).
FIRMS HOUSEHOLDS
Factors of Production
Factor incomes (wage, rent, interest, profit)
Expenditure on final goods and services
Final goods and services

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The government agency charged with calculating the GDP each year
measures it in two different ways: it add up the money values of the
final products and it add up all of incomes of the factors of
production. Theoretically, these two operations should give the
same result. They never do because of certain measuring errors.
The primary measurement method, is however, the measurement of
the money values of the final products. Basically, they measure
expenditure on final goods and services, and then made
adjustments for (a) the goods that are produced this period but not
sold, and (b) the goods that are sold this period but were produced
earlier.
The components of this measure of GDP (Y) are:
Consumption (C) – All household purchases of goods and services.
Investment (I) – All purchases by businesses of buildings,
machinery and tools, plus purchases of this measure that changes
the measure of expenditure into a measure of production. If
inventories increase during a particular period, then production is
more than sales during that period – the increase in inventory is
then added to the expenditure to show production. If inventories
decrease during a particular period, then sales are greater than
production – the reduction in inventory is then subtracted from
expenditure to show current production.

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Government expenditure (G) – All purchases of goods and services
by local, state and federal governments. This includes the purchase
of the services of all government employees, but it does not include
transfer payments. Transfer payments are not included because
they do not represent income from current production.
Net exports (NX) – This amount represents the money value of
domestically produced goods that are sold outside Nigeria (i.e.
exports) minus the purchase of goods and services produced in
other countries (i.e. imports). Our exports are part of our domestic
production, so obviously must be included. Our imports are
subtracted here because they are goods and services produced by
foreign countries, but they have already been included in our
consumption, investment and government expenditures. If imports
increase, but all other parts of the GDP remain the same, the GDP
will not change because the imports are first included in the
calculation of C+I+G, and then they are subtracted out.
Thus, Y = C + I + G + NX
Other Aggregate Measures
It is important to understand that the GDP only measures the
output that is produced within the country. If someone living in
Nigeria commutes into the United States to work, what that person
produces is part of the US GDP, not Nigeria’s GDP. Similarly, if a
Nigerian resident owns a company abroad, (e.g. Dangote) the
production of that company is part of the GDP of the foreign

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country where the company is located rather than being part of
Nigeria’s GDP. There is, however, another statistics that is used to
measure the output of the country’s permanent residents. This is
the gross national product (or the GNP). The Nigerian residents who
works in the US is adding to Nigeria GNP, and the Nigerian resident
who owns a company abroad is adding to the Nigerian GNP. The
GNP thus includes the incomes of Nigerian residents wherever they
earn it.
It is important to note that the net domestic product and the net
national product are two measures derived from the GDP and the
GNP respectively by subtracting what is called depreciation or the
consumption of fixed capital. This subtracted amount represents
the wear and tear on the country’s capital equipment of buildings,
machineries and tools.
Real Versus Nominal GDP
If the GDP changes, either the actual output of goods and services
has changed, or the prices at which they are selling has changed, or
both. Economists separate the changes in output from the changes
in prices. To do this, they use the concept of real output. The real
output of the economy (i.e. the real GDP) is measured by looking at
current outputs and pricing then at the prices that existed at some
time in the past.
Thus, nominal GDP for this year (2014) is this year’s output priced
at this year’s prices, and real GDP for this year is this year’s output

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priced at 2009 prices. 2009 is known as the base year (if 2009
prices are used as the base year). Because real GDP is not affected
by price changes (only 2009 prices are used), any changes in the
real GDP figure reflects only a change in the actual amounts of
goods and services produced.
From the nominal GDP and the real GDP however, we can derive a
statistics that is used for measuring the rate of inflation. This is
called the GDP Deflator. Prices obviously affect the nominal GDP
but not the real GDP, so dividing nominal GDP by real GDP gives an
indication of the prices. The Deflator is the nominal GDP multiplied
by a hundred and divided by the real GDP. As nominal and real
GDP are the same in the base year, the deflator is always 100 in the
base year. For any other year, the deflator states the price level for
that year as a percentage of the prices in the base year. The
percentage change in the GDP deflator from year to year is
published as the rate of inflation. The real GDP is used as an
indicator of recessions. The rate of growth of the economy is given
as the annual rate of change of real GDP. The economy is officially
considered to be in a recession if the real GDP has declined over at
least two successive quarters. A recession is usually accompanied
by other indicators of weaknesses in the economy; rising
unemployment, falling profits, etc.
Gross National Product (GNP)

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Gross National Product (GNP) can be defined as an economic
statistics which includes Gross Domestic Product, plus any income
earned by the residents from investments made overseas. Also, the
income earned within the domestic economy by oversees residents.
Gross National Product (GNP) is the total market value of all final
goods and services produced annually by land, labour, capital and
entrepreneurial talent by Nigerian residents whether these
resources are located in Nigeria or abroad.
Formular for Gross National Product
The general formular used for Gross National Product is:
GNP = GDP + Net factor income from abroad.
Where
GDP = Gross Domestic Product
Net factor income from abroad = income earned in foreign countries
by the residents of a country – income earned by non-residents in
that country.
Why is GNP required?
The Gross National Product is helpful in measuring the contribution
of a country’s residents to the flow of goods and services inside and
outside the national territory. Therefore, Gross National Product is
the basic concept of national income accounting.
Measurement of GNP

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The GNP is measured at:
 Current Market Prices (Nominal GNP)
This method of estimating the GNP involves measuring the GNP at
the prices of goods and services being measured at the prices
existing in the market in current year.
 Constant Prices (Real GNP)
Through this method, Gross National Product is estimated at a fixed
prices of a specific base year.
Calculating GNP
The main steps involved in calculation of GNP are as follows:
 Sum up the total consumer spending, government spending
and private investing by the citizens of a given country.
 Calculate the net exports by deducting the exports made by a
country’s citizens from the total amount of a country’s
imports.
 Add up the net exports for the citizens of a country to the
expenditure by its citizens worldwide thus reaching the GNP.
Calculating GDP Using the Expenditure Approach
1.1 Start with consumer spending. Consumer spending is the
measure of all spending a nation’s consumers make on goods
and services during the year. Examples of a consumer

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spending would include the purchase of consumable goods
like food and clothing, durable goods like tools and furniture
and services such as hair cut and doctor visits.
1.2 Add in investment. When economists calculate GDP,
investment does not mean the purchase of stocks and bonds,
but rather money spent by businesses to acquire goods and
services to help or maintain the business. Examples of
investments include materials or contracting services used
when a business builds a new factory, equipment purchases
and software to help a business run efficiently.
1.3 Insert the excess of exports over imports. Because GDP only
calculates products produced domestically, imports must be
subtracted out. Exports must be added in because once they
leave the country, they will not be added in through consumer
spending. To account for imports and exports, take the total
value of exports and subtract the total value of imports. Then,
add this result into the equation. If a nation’s imports have a
higher value than its exports, this number will be negative. If
the number is negative, subtract it instead of adding it.
1.4 Include Government spending. The money a government
spends on goods and services must be added to calculate
GDP. Examples of government spending include payroll for
public employees, spending on infrastructure and defence
spending. Social security and unemployment benefits are
considered transfer payments and are not included in

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government spending because the money is simply transferred
from one person to another.
Calculating GDP Using the Resource Cost–Income Approach
1.1 Start with employee compensation. This is the total of all
salaries, wages, benefits, pensions and social security
contributions.
1.2 Add in rent. Rent is simply the total income earned from
property ownership.
1.3 Include interest. All interest (money earned by supplying
capital) must be added.
1.4 Add proprietor’s income. Proprietor’s income is the money
earned by business owners, including incorporated business,
partnerships and sole proprietorships.
1.5 Add in corporate profits. This is the income earned by stock
holders.
1.6 Include indirect business taxes. This is all sales taxes,
business property tax and license fees.
1.7 Calculate all depreciation and add them. This is the decrease
in value of goods.
1.8 Add in net foreign factor income. To calculate this, take the
total payments received by domestic citizens from foreign
entities and subtract the total payments sent to foreign
entities for domestic production.

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Calculating GDP using the Output Method
What we are concerned here is the value of the final goods and
services or the value-added to these goods and services. Value
added is found by totaling the value of final goods and services or
the value-added achieved by various sectors of the economy. To
avoid double counting, the GDP by the output method must exclude
the value of goods and services at the intermediate stages. The
reason for this exclusion is that the value of goods and services that
go into production at intermediate stages is already included in the
price of the final product.
FISCAL POLICY
Taxes and Government Spending
Fiscal policy describes two governmental actions by the
government. The first is taxation. By levying taxes the government
receives revenue from the populace. Taxation is a transfer of assets
from the people to the government. The second action is
government spending. This may take the form of wages to
government employees, social security benefits, smooth roads,
building of airports, dams, houses, schools, network of roads, ports,
stadia and other infrastructural facilities. When the government
spends, it transfers assets from itself to the public. Since taxation
and government spending represent reversed asset flows, we can
think of them as opposite policies.
In measuring the economy, note that output or national income can
be described by the equation Y = C + I + G + NX, where Y is output

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or national income, C is consumption spending, I is investment
spending, G is government spending, and NX is net exports. This
equation can be expanded to represent taxes by the equation Y = C
(Y-T) + I + G + NX. In this case, C(Y-T) captures the idea that
consumption spending is based on both income and taxes, and C(Y-
T) represents disposable income. Disposable income is the amount
of money that can be spent on consumption after taxes are removed
from total income. This new form of the output or national income
equation, reflects both elements of fiscal policy and is most useful
for analysis of the effects of fiscal policy changes.
The government has control over both taxes and government
spending. When the government uses fiscal policy to increase the
amount of money available to the populace, this is called
Expansionary Fiscal Policy. Examples of this include lowering
taxes and raising government spending. When the government uses
fiscal policy to decrease the amount of money available to the
populace, this is called Contractionary Fiscal Policy. Examples of
this include increase taxes and lowering government spending.
Monetary Policy
Money Supply and Monetary Policy
The study of money, banking and interest rates capture the money
supply, as the total amount of currency held by the public. In
banking system, the public reserves excess money in the bank as
deposits, which the banks give out in form of loan to fund users
and investors. Thus, the money supply is better defined as the total
amount of currency plus deposits held by the public.

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Monetary policy is carried out by the federal authorities to change
the money supply. When the Federal authorities (CBN and the
Federal Ministry of Finance) increase the money supply, the policy
is called expansionary. When the Federal authorizes decrease the
money supply, the policy is called contractionary. These policies,
like the fiscal policy, can be used to control the economy. Under
expansionary monetary policy the economy expands and output
increases. Under contractionary monetary policy, the economy
shrinks and output decreases. Let’s investigate how the Central
Bank of Nigeria affects the money supply.
There are three (3) basic ways that the CBN can affect the money
supply. The first is through open market operations. The second is
by changing the reserve requirement. The third is through changing
the interest rate. Each of these actions in some way affects the total
amount of currency or deposits available to the public.
Open market operations are the sale and purchase of government
bonds issued and regulated by the CBN. When the CBN sells
government bonds, the public exchanges currency for bonds,
resulting in a shrinking of the money supply. When the CBN
purchases government bonds, the CBN exchanges currency for
bonds, thus resulting in an increase in the money supply. Open
market operations are the most common tool that the CBN uses to
affect the money supply.
The second way that the CBN can influence the money supply is
through changing the reserve requirements. Thus, if the reserve

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requirement is decreased, banks are required to hold more reserves
(cash) and can the make more loans. This in turn ignites the cycle
of loan to deposit, resulting in a greater increase in the money
supply.
The third way that the CBN can influence the money supply is
through changing the interest rate. As we know, banks make
deposits, withdrawals and loans from the CBN (as the banker’s
bank). If the CBN increases the bank rate, the rate at which banks
borrow from the CBN, banks will be less likely to make fewer loans
to the public because the interest rate will be high, and the public
will shun bank loans, resulting in shrinking of the money supply.
Furthermore, on the purpose of banks, the money multiplier shows
how much an initial deposit increases the money supply after loans
are made and redeposited. When a bank makes many loans, its
reserves are near the absolute required minimum. If a customer
makes a withdrawal, banks must either recall a loan or take out a
loan to pay the withdrawal while still maintaining the necessary
reserves. If the CBN increases the bank rate, banks will be less
likely to borrow money from the CBN and will thus be more weary
of making loans to ensure that they have the necessary reserve
requirements.
Expansionary Vs. Contractionary Monetary Policy
The CBN has two basic types of monetary policy. Expansionary
monetary policy increases the money supply, while contractionary
monetary policy decreases the money supply. Expansionary

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monetary policy includes purchasing government bonds, decreasing
the reserve requirement and decreasing the bank rate/interest rate.
Contractionary monetary policy includes selling government bonds,
increasing the reserve requirement and increasing interest
rate/bank rate. The point of monetary policy is to allow the CBN to
control the economy, and in particular output and inflation,
through the interest rate. Monetary policy and fiscal policy are like
the reigns held by the Federal authority as it steers the big, wild
horse/elephant known as the economy.
Inflation
Things cost most today than three years ago. In general, over the
past 54 years (1960-2014) in Nigeria, the overall level of prices has
risen from year to year. This phenomenon of rising prices is called
inflation. Inflation is defined as the continuous rise in the general
price level of goods and services in a specified period of time.
Inflation plays an important role in the macroeconomic economy by
changing the value of a Naira across time. Three important aspects
of inflation which this chapter may not contain are, first how to
calculate inflation, second, the effects of inflation calculations using
the CPI and GDP measures, third, the effects of inflation.
Unemployment
Unemployment is a macroeconomic phenomenon that directly
affects people. When a member of a household is unemployed the
family feels it in lost income and a reduced standard of living.
Because most people rely on their income to maintain their

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standard of living, the loss of a job will often directly threaten to
reduce that standard of living. In terms of society, unemployment is
harmful as well. Unemployed skilled manpower represents wasted
production capacity. This means that the economy is putting out
less goods and services than it could be producing. It also means
that there is less money being spent by consumers, which has the
potential to lead to more unemployment, beginning a cycle.
When there is unemployment, the economy is not producing at full
output since there are people who are not working. But, what
exactly is the relationship between unemployment and national
output or GDP? How much would we expect the GDP to increase if
unemployment fell 1%? These are useful and important questions
to ask when trying to understand the costs of unemployment. An
economist named Arthur Okun looked at the relationship between
unemployment and national output over a-20 year period. He
noticed a general pattern and stated an equation to explain it. His
equation, Okun’s law relates the percentage change in real GDP to
changes in the unemployment rate. In particular the equation
states:
% change in real GDP = 3% -2x (change in unemployment rate)
This equation basically says that real GDP grows at about 3% per
year when unemployment is normal. For every point above normal
that unemployment moves, GDP growth falls by 2%. Similarly, for
every point below normal that unemployment moves, GDP growth

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rises by 2%. This equation, while not exact, provides a good
estimate of the effects of unemployment upon output.
TRADE OFF BETWEEN INFLATION AND UNEMPLOYMENT
The Philips Curve
Building on Okun’s law, another economist, A.W. Philips discovered
a relationship between unemployment and inflation. The chain of
basic ideas behind this belief follows: as more people work the
national output increases, causing wages to increase, causing
consumers to have more money and to spend more, resulting in
consumers demanding more goods and services, finally causing the
prices of goods and services to increase. In other words, Philips
showed that unemployment and inflation shared an inverse
relationship: inflation rose as unemployment fell, and inflation fell
as unemployment rose. Since two major goals for economic policy
makers are to keep both inflation and unemployment low, Philip
discovery was an important conceptual breakthrough. Philip’s
discovery can be represented in a curve, called, aptly, a Philips
Curve.

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Unemployment rate(%)
Fig. 2: The Philips Curve
Notice that the inflation is represented on the vertical axis in units
of percent per year. The unemployment rate is represented on the
horizontal axis in units of percent. The curve shows the levels of
inflation and unemployment that tend to match together
approximately, based on historical data. In this curve, an
unemployment rate of 7% seems to correspond to an inflation rate
of 4%, while an unemployment rate of 2% seems to correspond to
an inflation rate of 6%. As unemployment falls, inflation increases.
Consumer Price Index (CPI)
The consumer price index (CPI) is a more direct measure than per
capita GDP of the standard of living in a country. It is based on the
overall cost of a fixed basket of goods and services bought by a
typical consumer, relative to price of the same basket in some base
year. By including a broad range of thousands of goods and services
Inflation
rate
(%
per
year)
6
4
2
0
2 4 6 8 10

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with the fixed basket, the CPI can obtain an accurate estimate of
the cost of living. The CPI measures the cost of living based on the
relative cost of a fixed basket of goods and services consumed by a
typical consumer in a country.
Time Price of Corn Price of Beans
1 N0.50 N1.00
2 N1.00 N2.00
3 N1.50 N3.00
Table 1: Goods and services consumed in a country
(a)Using the figures above, compute the CPI for the country in
year 1 using year 1 as the base year:
CPI = (N0.50 + N1.00)/(N0.50 + N1.00)
(b) Using the figures above, compute the CPI for the country in
year 2 using year 1 as the base year:
CPI = (N1.00 + N2.00)/(N0.50 + N1.00)
(c) What is the percent increase in the price level in the country
from year 1 to year 2?
Percent increase in CPI= CPI2 – CPI1
CPI1 = (N0.50 + N1.00)/(N0.50 + N1.00) x 100
CPI2 = (N1.00 + N2.00)/(N0.50 + N1.00) x 100
 Percent increase in CPI = 200 – 100 = 100%

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CLASSICAL AND KEYNESIAN MODELS
Macroeconomics is composed of different areas based on schools of
thoughts. These schools of thought are the Classic Economics,
Neoclassical Economics, Keynesian Economics and Neo Keynesian
Economics. Until the 1930s, most economic analysis did not
separate individual economic behaviour from the aggregate
behavior. The dichotomy macro-economy/micro-economy was first
coined by the Norwegian Economist, Ragnar Frisch in 1933. With
the Great Depression of the 1930s and the development of the
concept of national income and product statistics, the field began to
expand. Particularly influential were the ideas of John Maynard
Keynes, who formulated theories to try to explain the Great
Depression.
The Classical Model (1776 – 1935)
The classical model largely follows the conclusions reached in
microeconomics. The demand for labour and labour supply,
income, and transfer payments are the major microeconomic
references in the Classic Economic Model.
Keynesian Model (1936 – 1969)
The Keynesian Model is a vastly oversimplified view of the economy.
The point here is that the economy can be in an equilibrium. The
Keynesian IS/LM model shifts from the classical model focus on the

23. 23
wage rate to a focus on long-term and short-term interest rates.
Interest rate and income are the variables that adjust equilibrium.
The New Classical Model (1970)
Real Business Cycles shifts attention from nominal interest rates
back to the factors of production that dominated the original
classical model.
New Keynesian Economics (1982)
The recession of 1982 reopened the debate about the real effects of
nominal monetary policy, and the decade of the 1980s reopened the
debate about the simulative effects of government budget deficits.
The classic economic model’s collection include a recent reworking
of the Keynesian model.

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Table 2: An insight into the distinguishing features of Classical
and Keynesian Systems:
Classical Economics Keynesian Economics
1 This system is concerned
with free trade and free
movement of capital.
It is wrong to assume that there
exist perfect demand.
2 That unemployment will
not prevail and that full
employment will always be
attainable in economy.
Individual entrepreneurs decide on
how many workers to be employed.
Too high real wages and not
deficient demand are the true
causes of unemployment.
3 That supply creates its
own demand, therefore
demand cannot be
deficient.
Aggregate supply price of labour
and aggregate demand price of
labour determine employment.
4 From Classical Economics
was developed the
microeconomics.
From Keynes “General Theory of
Money, Income and Employment”
was developed modern
macroeconomics.
5 Classical Economists are
typified by Adam Smith,
Ricardo, Prof. J.B. Say.
Keynesian Economist is typified by
Prof. John Marnard Keynes.

25. 25
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Erber, G. and Hagemann, H. (2002). “Growth, Structural Change
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Zimmermann (ed.). New York: Springer.
Elizabeth, A.S. and Ackerman, F. (2013). “Climate Impacts on
Agriculture: A Challenge or Complacency?” Global
Development and Environment Institute Working Paper No. 13-
01.
Jhingan, M.L. (2003). Macroeconomic Theory. 11th ed. New Delhi:
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