Managerial Economics MBS Course

ECO 512
Managerial Economics
MBS FIRST SEMESTER
TRIBHUVAN UNIVERSITY
2018

Course Contents:
1. Introduction to Managerial Economics and Theories of Firm
2. Demand analysis and forecasting
3. Production and cost analysis
4. Pricing theory and practice
5. Risk Analysis
6. Market efficiency and role of the government
2KAMAL REGMI, SHANKER DEV CAMPUS KATHMANDU

References:
1. Adhikari, G.M., Paudel, R.K. and Regmi, K. (2017). Managerial Economics. Kathmandu:
KEC Publication and distributors
2. Dhakal, R. (2017). Managerial Economics. Kathmandu: Samjhana Publication
3. Mansfield, E. (1996). Managerial economics. New York: W.W. Norton and Co.
4. Petersen, H.C. and Lewis, W.C. (2008). Managerial Economics. New Delhi: Pearson
Education Ltd.
5. Pappas, J.L. and Hirschey, M. (1989). Fundamentals of Managerial Economics. New York:
The Dryden Press.
6. Salvatore, D. (2012). Managerial Economics. New York: McGraw Hill.
KAMAL REGMI, SHANKER DEV CAMPUS KATHMANDU 3

Unit 1:
Introduction to Managerial Economics and
Theories of firm

Concept of Managerial Economics.
oThe concept of managerial economics was initiated after 1950’s by Prof. Dean Joel and
Practicability of managerial economics in real practice was proved by Warren E. Buffet.
oManagerial economics in its simplest form may be defined as the application of economic
theory to the problems of management.
o Managerial economics is that part of economic theory which deals with the application
of economic tools and concepts to the solution of business problems or the problems of
resource allocation among the competing ends.
o Managerial economics is the discipline which deals with the application of economic
theory to business management.
o In conclusion, Managerial economics refers to the application of economic theory and
decision science tools to find the optimal solution to business decision problems.

Contd….
o Managerial economics prescribes rules for improving managerial decision.
o It tells managers how action should be undertaken to achieve
organizational goals efficiently.
o Managerial economics also helps managers recognize how economic
forces affect organizations and describes the economic consequences of
management behavior.

Managerial Decision Making Process :
Managerial Decision Making Problems:
-Product price and output
- demand or buy
-Production Technique
-Strategy Formulation
-Advertising, investment etc.
Managerial Economics :
Use of economic concepts and decision sciences to solve managerial decision making problems.
Traditional Economics
-Theory of firm
-Theory of demand and supply
-Theory of consumer behavior
-Theory of market
-Theory of pricing etc.
Decision Making Sciences:
-Mathematical economics
-Econometrics
-Statistical analysis
-Game theory
-Optimization etc.
Optimal Solution to the managerial Decision Making Problems.

Main Concern of Managerial Economics:
(O3)
O - Opening of firms/ Industries
O - Operation of firms/ Industries
O - Out (exit ) of firms/Industries from the market.
Managerial economics believes that successful managers make good decisions
and the most useful tool of managerial decision making is the methodology of
managerial economics.

CHARACTERISTICS OF MANAGERIAL ECONOMICS:
1. Microeconomic in Character
2. Pragmatic
3.Normative
4. Conceptual and Tactical
5. Theory of Firm
6. Goal-oriented
7. Coordination between Theory and Practice
8. Wise Choices
9. Multidisciplinary
10. Help of Macroeconomics

SCOPE OF MANAGERIAL ECONOMICS:
A. Operational Issues
◦ Demand Analysis and Forecasting
◦ Production and Cost Analysis
◦ Pricing Theory and Practices
◦ Profit Analysis and Profit Management
◦ Capital and Investment Decisions
◦ Inventory Management

Contd..
B. Environmental Issues
o What is the nature and trend of domestic business environment?
o What is the nature and trend of international business
environment?
o What is the nature and impact of social costs and government
policy measures

Contd..

RELATION OF MANAGERIAL ECONOMICS WITH
TRADITIONAL ECONOMICS:
Relationship with microeconomics
◦ Pricing, output determination, what to produce? how to produce? How
much to invest? etc.
 Relationship with macroeconomics
◦ Environmental issues
◦ Prediction of aggregate economic variables
◦ Policy issues
Note: Managerial economics differs with traditional issues in various aspects such as
practicability, character, scope, assumptions, hypothesis etc.

ROLE OF MANAGERIAL ECONOMIST:
Making decisions - organizing - processing information.
Specific Decisions
(i) Producing scheduling,
(ii) Demand forecasting,
(iii) Market research,
(iv) Economic analysis of the industry,
(v) Investment appraisal,
(vi) Security management analysis,
(vii) Advice on foreign exchange management,
(viii) Advice on trade,
(ix) Pricing and the related decisions, and
(x) Analysing and forecasting environmental factors.
General Tasks :
1. Organizing the resources and uses.
2. Processing the information.

USES OF MANAGERIAL ECONOMICS IN
BUSINESS DECISION- MAKING:
Determination of Price of output.
Demand forecasting.
Allocation of resources.
Determination of output level.
Determination of profit margin.
Investment decision making.
Maintenance of Inventories.
Environment analysis etc.

NATURE AND FUNCTIONS OF PROFIT:
Meaning of Profit:
◦ Profit means different for different people like businessman,
accountant, economists, workers etc.
◦ The role and excess of profit differs in different economies as well.
◦ Generally, Profit is the excess of income over expenditure.
◦ Profit includes various economic concepts like opportunity cost, Fixed
and Variable costs, and revenues.
Petersen and Lewis, “ No one will play the game if there is no chance of winning the prize in the
form of profit.”
Dean Joel, “A business firm is an organization designed to make profits, and profits are the
primary measure of its success.”

Business Vs Economic Profit:
Business Profit/Accounting Profit
= TR – Explicit Cost
- Explicit cost is the cost paid for external factors of production.
Economic Profit
= TR- (Explicit +Implicit Cost)
- Implicit Cost refers to the cost incurred for self owned factors of production along
with normal Profit.
Implicit cost = Imputed cost +Normal Profit

Functions of Profit:
o Measurement of performance.
o Incentive for expansion.
o Incentive for new inventions and innovations.
o Ensures future capital.
o Attracts new investor.
o Increases risk bearing capacity.
o Incentive for Research and Development.
o Main Heart of market economy.
o Indicator of success and achievement etc.

Case 1
Akshit a web designer, working as a manager of a web based company for Rs 120000
per year wants to start his own business by investing his own money of Rs. 400000 on
which he could earn 10% interest if deposited in bank. His estimated revenue during
the first year of operation is Rs 300000 and costs are salaries to employees Rs 90000,
supplies Rs 30000, rent Rs.20000 and utilities Rs 2000.
a) what is business profit?
b) what is economic profit?
c) If he seeks your advice on whether to start the business or not what will be your
advice and why?
d) what will be your advice is he could earn only 2% interest on his own money if
deposited in bank?

Case 2
Abhik working in a Bank earning Rs 15000 per month has deposited Rs. 480000 in
bank which yields 5% interest per annum. He wants to invest this money to
establish his own company and works as a manager in his own company. He has
estimated total revenue Rs. 82000 per month and estimated cost of production raw
materials 50000, advertisement 10000, annual depreciation 15%, of capital worth
200000, utilities 3000/month, miscellaneous expenses 8000. Find:
a) Business Profit
b) Economic Profit
c) If Abhik asks your suggestion whether to start business or continue Job. What is
your suggestion and why?

SURVEY OF THEORIES OF FIRM !

Profit Maximization Model:
o Classical Objective – Supported by classical and neoclassical economists.
o According to this objective- “The main objective of firm is to maximize profit.”
o Profit is the major incentive to produce and sell goods and services in the market.
o Each and every business firms aim to maximize the profit with the use of available
resources.
o Profit is the difference between Total Revenue (TR) and Total Cost(TC)
i.e. π = TR-TC
o It means profit will be maximized when the positive difference between TR and
TC will be maximum at a particular level of output.

Assumptions:
1. Only one commodity is produced by the firm.
2. The owner himself works as the manager of the firm.
3. Time period is static.
4. There is existence of imperfectly competitive market.
5. A firm acts rationally, i.e. it always attempts to maximize profit by
investing limited investment budget.

Two approaches of Profit maximization Model:
A. TR-TC Approach:
o According to this approach profit will be maximized when the gap between TR and
TC will be maximum.
o Graphically, when the vertical distance between TR curve and TC curve is maximum,
Profit will be maximum.
o In perfect competition market TR curve is positively sloped straight line starting
from origin and in Imperfect Compeition market/monopoly TR curve starts from
origin, increases at increasing rate at first, increses at decreasing rate, reaches to
maximum point and finally decreases.
o TC curve is Inverse ‘S’ Shaped starting from any point of Y-axis from where TFC
starts.

25
Graphically,
TR
TC
Output
TR,TC,π
O
Q1 Q2 Q3
R
C
π
π
H
Profit Maximization in Perfect Competition Market
Profitable range of output
A
B
25
KAMAL REGMI, SHANKER DEV CAMPUS KATHMANDU

26
Graphically,
TR
TC
Output
TR,TC,π
O
Q1 Q2 Q3
R
C
π
π
H
Profit Maximization in Imperfect Competition Market
Profitable range of output
A
B
26

B.MR-MC Approach:
o It is another alternative approach to explain profit maximization objective of
firms.
o Marginal Revenue(MR) refers to the additional revenue received by the firm by
selling one extra unit of output.
o Marginal Cost (MC) refers to the additional cost incurred in producing one
additional unit of output.
o There are two conditions to be satisfied for firms equilibrium under this
approach, which are:
1. Necessary/First order condition: MR=MC
2. Sufficient /Second Order condition: Slope of MC>Slope of MR or MC curve must
Intersect MR curve from below.

28
Graphically,
O Output
R/C/π
Q
E
P F MC
AR
MR
AC
C G
Profit
28

29
Mathematically,
MCMR
MCMR
dQ
TCd
dQ
TRd
dQ
TCTRd
ei
dQ
d
COF
TCTR







0
0
)()(
0
)(
..,0
,..


We Know that,
For Maximization of Profit,
0
)()(
,
0)(,
0,
...
2
2



dQ
MCd
dQ
MRd
or
MCMR
dQ
d
or
dQ
d
or
COS

Or, Slope of MR-Slope of MC<0
Or, Slope of MR < Slope of MC

Criticisms of Profit Maximization Model:
1. The model is based on unrealistic assumptions like single entrepreneur, production of
single commodity, etc.
2. Marginalism is very complex concept to determine profit maximizing objective.
3. The firm doesn't have only one objective. Modern firm are multi-goal firms.
4. The theory believes in "survival of the fittest" which is not applicable in production.
5. The structure of modern corporate business, i.e. separation of ownership and
management may divert managers' interest from maximizing profit to maximizing their
own welfare and so on.
6. Policies that tend to maximize profits cause increased risk and instability, which
managers fear. Therefore, risk averse managers avoid a policy of profit maximization.

Case 3
o Tamakoshi Electronics Ltd. has following demand and cost
functions, P = 2000 - 10Q and C = 1000 + 200Q
Calculate,
i) Price (P),
ii) Output (Q),
iii) Total revenue (TR), and
iv) profit (π) under the objective of profit maximization.

Case 4
o A firm has the demand function Q=30-P .
Total fixed cost of the firm is Rs 20 and variable cost
per unit of output is Rs 4.
Then find profit maximizing level of output price and
total profit of the firm.

VALUE MAXIMIZATION MODEL
o Long-run objective of the firm guided by another objective of profit
maximization.
o Designed to solve the weaknesses of short-run profit maximization
objective.
o Solomon and Pringle, "When the time period is short and uncertainty is not much, profit maximization &
value maximization are same."
oL. J. Gitman, "Since share price represents the owner's wealth in the firm, share price maximization is
consistent with owners wealth maximization."
oIn case of organization, value of firm refers to the shareholders wealth which
is measured by the share price of the stock.
oValue maximization model is also expressed as wealth maximization model.

Contd…
o Value can be defined as the present value of the firm's expected future net cash flows.
o Value can be defined as the present value of the firm's expected future net cash flows.
o Value of the firm = Present value of expected future profits (P.V.)
Where,
P.V.  present value of expected future profits
1, 2 . . . n  mean profit of each year
r  rate of discount or rate of interest

Contd…
o Since, profit is the difference between total revenue and total cost. Hence, the eqn. (i)
can be written as
Features of value maximization model:
(1) This model creates direct relationship between profit and managers remuneration
(2) This model is more useful in competitive markets
(3) It provides simple explanation and easy to make managerial decision
(4) It deals with both cost and benefit of the firm in long-run
(5) It also deals with social contribution and benefits.

Superiority of Value maximization model:
Value maximization model is superior than profit maximization model in following
respects:
o Profit maximization model deals with short-term profit maximizing business projects.
Value maximization model deals with long-run profit maximizing business projects and
this model incorporates all these activities including risk analysis.
oProfit maximization model is static model. It is because this model deals the objective
of a firm on the basis of single time period. But, value maximization model is dynamic
model. It is because this model explains the objective of a firm with future risk and
uncertainty on the basis of multi-period.
oProfit maximization model is focused on sole-trading business at which welfare
maximization of single owner is preferred. Value maximization model is focused on
corporate business at which welfare maximization of many shareholders is preferred.

BAUMOL'S THEORY OF
SALES REVENUE MAXIMIZATION
o W.J. Baumol criticized the profit maximization model developed sales-revenue
maximization model through the publications of an article "Business Behavior,
Value and Growth in 1956.”
o ultimate objective of the firm is to maximize sales rather than profit.
o Sales refers to the revenue of the firm therefore he named his hypothesis as
sales maximization hypothesis or revenue maximization hypothesis.
osales maximization means maximizing TR from sales.
oalso supported the view of profit maximization by saying that firms need
minimum profit to spend on expansion plans, make dividend to attract stock
buyers in future spend to increase long-term sales and to provide better return
to the shareholders.

Assumptions:
(1) The time horizon of a firm in a single period.
(2) During this period the firm attempts to maximize its total revenue subject
to a profit constraint not the physical volume of output.
(3) The firm must realize a minimum level of profit to keep shareholders
happy and avoid a fall of share prices.
(4) Cost curves are U-shaped and demand curves are downward sloping.
(5) Market is imperfectly competitive.

Business managers pursue the goal of sales
maximization rather than profit maximization
for the following reasons:
 Financial institutions consider sales as an index of performance of the firm and are willing to
finance the firm with growing sales.
 Salaries and slack earnings of the top managers are linked more closely to sales than to profit.
 Sales growing more than proportionately to market expansion indicate growing market share
and a greater competitive strength and bargaining power of a firm.
 Sustained growing sales at large scale gives prestige to the managers, while large profit go into
the pockets of shareholders.
 Business stability is the pre-condition for sustained growth of business. Managers thus prefer a
steady performance with 'satisfactory' profits to spectacular profit maximization projects.
 Firms can easily handle personnel problems when they have large sales. These firms can have
the capacity to make higher payments with some managerial emoluments to their employees.

Two cases under sales revenue
maximization:
1. Sales revenue maximization without profit constraint:
◦ When firm sets its goal of sales maximization without profit
constraint, it produces the level of output at which TR is
maximum with unitary price elasticity of demand, e = 1.
2. Sales revenue maximization with profit constraint:
o If the Board of Director directed the managers to meet profit
target, firm produces the level of output where TR is increasing
with positive MR and price elasticity of demand, e > 1.

Graphically,

Conclusions of Baumol’s Theory:
o Sales maximizer produces more output than profit maximizer
o Sales maximizer determines low price of the product in comparison
to profit maximizer.
o Sales maximizer obtains low profit in comparison to profit
maximizer.
oSales maximization hypothesis has a better predictive performance
than the traditional profit maximization objective hypothesis.

Criticisms of
Sales-Revenue Maximization Model
(1) It is consistent with profit maximization in long-run.
(2) The firms can sell more than profit maximizing level only due to the ignorance of
their demand curve.
(3) According to J. R. Witdsmith, Boumol's model has unacceptable conclusion.
(4) According to W.G. Shepherd, in case of oligopoly, the equilibrium lies at the
point of kink, under kinked demand curve. Therefore, in such a situation profit
maximization and sales maximization do not become competitive.
(5) It cannot be tested without knowing demand and cost functions of individual
firm.
(6) It doesn't show the process of equilibrium of the industry consisting of all firms
as sales maximizer is attained.

Case 6
Given the total demand function and total cost function
P = 20 – Q
TC = 50 + 4Q
Determine-the price (P), output (Q), total revenue (TR) and profit () under:
(a) Profit maximization model
(b) Sales revenue maximization model
(c) Sales revenue maximization model with profit constraint of Rs 13.

Case 7
o let, demand function, P = 20- 0.2Q, cost function, C= 140 + 4Q
a) Determine output, price and TR that maximize profit.
b) Determine output, price and Profit that maximizes sales.
c) Determine output, price and TR under profit constraint of Rs. 170.

Case 8
o A manufacturing company is operating in Kathmandu valley with the demand function given as
P = 10 ˗ 0.1Q, and the total cost function as C = 70 + 2Q.
If the company wanted to maximize profit, what is the price output combination and the total
profit and revenue? The management of the company realizes the need for capturing market.
Therefore, it started to promote its product with the strategy of sales revenue maximization instead of
profit maximization. What will be the price output combination and total profit under the condition of
sales revenue maximization?
The shareholders of the company did not like market share capture strategy (sales revenue
maximization) followed by the management. The shareholders showed strong dissatisfaction against
the management in its Annual General Meeting. They argued that management should not be given
opportunities for free play in the company. The shareholders' meeting consensually decided to put
restriction with minimum profit of Rs 10. Under this condition, what is the optimum Price (P), output
(Q) combination and total revenue? [TU 2016]

WILLIAMSON'S MODEL OF MANAGERIAL
DISCRETION:
o Oliver E. Williamson developed a full-fledged theory of firm related to managerial
discretion and he believed that the managers look at their self interest while making
decisions of firm.
o Managers have discretion in pursuing policies which maximize their own utility rather
than attempting the maximization of profits which maximizes the utility of the owner-
shareholders.
o Profit acts as a constraint to the manager's utility maximization behavior because the
financial market and the shareholders expect maximum profit.
o The objective of a firm is to maximize their own utility function with profit constraint.
o The job security of managers endangers, if managers fails to earn a minimum profit to
pay in the form of dividends to the owners.

Contd…
o Manager’s utility function can be written as,
U = f(S, M, ID)
Where,
U = manager's utility
S = staff expenditure
M = managerial emoluments
ID = discretionary investment

Contd…
Simplified Model:
The model can be expressed as:
Maximize (U) = f(S, M, ID)
Subject to πR > π0 + T
where,
◦ πR is the reported profit (reported to tax office) which is the difference between actual
profit (p) and managerial emolument i.e. πR = π - M, and,
◦ π0 is the minimum profit satisfy the shareholders
The actual profit is the current profit of firm which is the difference between total
revenue (R) and Total cost (C) including staff expenditure i.e. π = R - C – S

Contd…
When managerial emolument M =0, the model can be expressed as:
Maximize (U) = f(S, πD)
Subject to π> π0 + T
We know,
Discretionary profit πD= π - π0 - T,
Also,
Discretionary investment ID = π R - π 0 - T
or, ID = (π - M) - π 0 - T (... π R = π - M)
when M = 0
or, ID = (π - 0) - π 0 - T
or, ID = π - π 0 - T
or, ID = π D

Manager's utility curve
Collection of indifference curves U1, U2, U3 is the manager's utility curve and
shows the preference of manager. Higher indifference curve gives higher utility
to manager.

Relation between discretionary profit and
staff expenditure
Discretionary
Profit Curve
Point E is the equilibrium where
discretionary curve is tangent to the
manager's utility curve U2. Hence, Se is
the staff expenditure and De is the
discretionary profit. In profit
maximization goal of firm's staff
expenditure would be S and maximum
profit would be DM. This implies that
manager prefers more amount of staff
expenditure as compared to profit
maximizing situation i.e. Se > S.

Comparison of Profit maximization, revenue
maximization and managerial discretion models:
o Williamson’s model is based on the implicit assumption "other things remaining the same".
o This model is valid only in the market not having strong rivalry.
o If the market is with strong rivalry, profit maximization is most appropriate.
oWilliamson’s model is practically useful model because this model gives conclusions like
change in discretionary expenditures like staff expenditure, managerial emoluments and,
discretionary investment are the tendencies and the determinants of behavior of a rational
manager.
oThis model also shows the effect of taxes on objective of the firms or utility of the managers,
therefore, it is practically useful model.
o This model deals about reported profit, whereas sales revenue model and profit
maximization model deal about actual profits.

Unit One Ends!
Additional Cases and their Solution!

Managerial Economics MBS Course

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