2. Definition
Many definitions have been given about managerial economics.
Most of them consider it as the application of economic theory and methods to business
decision-making.
It can be seen as a means to an end by managers, in terms of finding the most efficient way of
allocating their scarce resources and reaching their objectives.
Managerial Economics is economics applied in decision-making.
It is a special branch of economics bridging the gap between the economic theory and
managerial practice.
Its stress is on the use of the tools of economic analysis in clarifying problems in organizing and
evaluating information and in comparing alternative courses of action
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4. Scope of Managerial Economics
■ Scope of Managerial Economics is wider than the scope of business
economics
■ managerial economics dealing the decision problems of both business and
non-business organizations,
■ business economics deals only the problems of business organizations.
■ The scope of managerial economics is a continual process, as it is a
developing science.
■ Demand analysis and forecasting, profit management, and capital
management are also considered under the scope of managerial
economics.
■ Managerial economics is wider in giving solution to the problems of
non profit organizations.
■ The scope covers two areas of decision making operational or internal
issues and environmental or external issues.
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5. Managerial Economics – Micro & Macroeconomics
■ Economic theory and economic analysis are used to solve the
problems of managerial economics.
■ Economics basically comprises of Micro economics and Macroeconomics.
■ Managerial economics covers both macroeconomics as well as
microeconomics, as both are equally important for decision making and
business analysis.
■ Macroeconomics deals with the study of entire economy. It considers
all the factors such as government policies, business cycles, national
income, etc.
■ Microeconomics includes the analysis of small individual units of
economy such as individual firms, individual industry, or a single individual
consumer.
■ The main branch of economic theory with which managerial economics is
related is microeconomics, which deals essentially with how markets work
and interactions between the various components of the economy.
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6. Positive or normative Economics
■ Positive economics is descriptive in character. It describes economic
activities as they are.
– For some economists economics is a positive science and they believed that
economist, should be neutral between ends and he cannot pronounce
on the validity of ultimate judgments of value.
– It is concerned with describing and analyzing the economy as it is.
■ Normative economics passes judgments of value.
– Managerial economics draws from descriptive economics and tries to
pass judgments of value in the context of the firm.
– Managerial economics is mainly normative in nature.
– Normative analysis -deals with how the economic problem should be
solved.
– It is value judgment about what the economy should like or what particular
policy action should be recommended.
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7. Basic Economic Concepts
■ Scarcity
It is the fundamental economic problem that any human society faces
Scarcity refers to the fact that all economic resources that a society
needs to produce goods and services are finite or limited in supply.
But their being limited should be expressed in relation to human wants.
Thus, the term scarcity reflects the imbalance between our wants and
the means to satisfy those wants. It is also important not to confuse with
scarcity and shortage.
Scarcity does not mean shortage.
Factors of Productions are scarce
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8. Basic Economic Concepts
■ Choice
If resources are scarce, then output will be limited.
If output is limited, then we cannot satisfy all of our wants.
Due to the problem of scarcity, individuals, firms and government are
forced to choose as to what output to produce, in what quantity, and what
output not to produce.
In short scarcity implies choice. Choice, in turn, implies cost.
That means whenever choice is made, an alternative opportunity is
sacrificed - This cost is known as opportunity cost.
Scarcity → limited resource → limited output → we might not satisfy all our
wants →choice involves costs → opportunity cost
In a world of scarcity, a decision to have more of one thing, at the same time, means
a decision to have less of another thing.
An opportunity cost is the amount or value of the next best alternative that must be
sacrificed (forgone) in order to obtain one more unit of a product.
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9. 04-Jan-22
…theory of the FIRM
A. Theory of the Firm
■ It is the microeconomic concept founded in neoclassical economics that states
that a firm exists and make decisions to maximize profits.
– The theory holds that the overall nature of companies is to maximize profits meaning
to create as much of a gap between revenue and costs.
– The firm's goal is to determine resource allocation, production, pricing anddemand
within the market and allocate resources to maximize net profits.
■ The theory has been debated and expanded to consider whether a company's
goal is to maximize profits in the short-term or long-term.
– If a company's goal is to maximize short-term profits it might find ways to boost
revenue and reduce costs.
– However, companies need to make capital investments to ensure profitable in the
long-term.
– cash investment in assets would hurt short-term profits but help with the long-
term viability
– If competition is strong, long-term profits could only be maximized if there's a
balance between short-term profits and investing in the future.
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10. Theory of the FIRM – basic business model
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B. Role and Function of a FIRM
In Economics, Producers – often referred to as firms or companies play a role in
using Inputs (different factors of production) and Producing GoodsandServices(Output).
Role/ Function of Firms:
1. Deciding what to produce and how to produce.
2. Production or acquiring inputs that the firm intends to sell
3. Market and sell its output or the products that it has obtained
4. Finance the firm's activities of acquiring and selling or the controlling the
financial
5. Investing in capital and new technology to provide new goods and services for
the consumer in given country
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…theory of the FIRM
Firms
are major economic institutions in market economies.
have the following common characteristics:
Owners, Managers, Objectives, pool of resources (labor, physical capital, financial
capital and learned skills and competences)
Administrative or organizational structures through which production is organized.
Performance assessment by owners, managers and other stakeholders.
Whatever its size, a firm is owned by someone or some group of individuals
or organizations.
shareholders and they are able to determine the objectives and activities
appoint managers who will make day-to-day decisions.
owners bear the risks associated with operating the firm and have the right to receive
the residual income
The divorce between ownership and control and its implication for the operation and
performance of the firm is at the centre of many of the managerial economics decision making
- Principal Agent problem
12. …theory of the FIRM
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Decision making units in economic activities
(Consumers, Producers and Government)
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C. What is Profit?
• Profit - is the surplus revenue aftera firm has paid all its costs.
• Profit - can be seen as the monetary reward to shareholders and owners of a
business.
• A firm may seek short-run profit maximization and under-invest in the long-
term.
– In a capitalist economy, profit plays an important role in creating
incentives for business and entrepreneurs.
– For any big firm, the reward of higher profit will encourage them to try
and cut costs and develop new products.
• If an industry is profitable, it will encourage new firms to enter.
• If a firm becomes unprofitable, it will either have to adapt and change
or close down.
…theory of the FIRM
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– This profit motive can help increase efficiency, provide greater
choice for consumers and allocate resources according to
consumer preferences.
The Role of profits
…theory of the FIRM
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15. 04-Jan-22
■ Michael Porter‟s “Five Competitive Forces”:
– factors that influence the sustainability of firm profits
Market entry conditions for new firms
Market power of input suppliers
Market power of product buyers
Market rivalry amongst current firms
Price and availability of related products including both „substitutes‟ and
„complements‟
…theory of the FIRM
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…theory of the FIRM
■ Types of Profits
1. Frictional profit theory - Abnormal profits observed following unanticipated changes in
demand or cost conditions
2. monopoly profit theory - Above-normal profits caused by barriers to entry that limit
competition
- Due to economies of scale, high capital requirements, patents, or import protection
3. innovation profit theory - Above-normal profits that follow successful invention or
modernization –
- for example, Microsoft Corporation has earned superior rates of return because
it successfully developed, introduced, and marketed the Graphical User Interface
4. Compensatory profit theory - above-normal rates of return that reward firms for
extraordinary success in meeting customer needs, maintaining efficient operations
- If firms that operate at the industry‟s average level of efficiency receive normal
rates of return, it is reasonable to expect firms operating at above-average levels
of efficiency to earn above-normal rates of return.
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D. Profit Maximization
■ An assumption in classical
economics is that firms seek
to maximize profits.
Profit = Total Revenue (TR)
– Total Costs (TC).
• Therefore, profit
maximization occurs at the
biggest gap between total
revenue and total costs.
• A firm can maximize profits if
it produces at an output ;
whereby:-
– Marginal Revenue (MR)
= Marginal Cost (MC)
…theory of the FIRM
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…theory of the FIRM
■ Profits Maximization Basics
• Profit maximization is not entirely without merit.
– No profit, company falls behind in its growth and losing market share
– Investors will invest in profitable companies
– Short term success determines the level of investment
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…theory of the FIRM
■ Sales Revenue Maximization
■ The model was developed by Baumol (1959) who argued that managers
have discretion in setting goals and that sales revenue maximization was a
more likely short-run objective than profit maximization firms.
■ The reasons are as follows:
– Sales revenue is a more useful short-term goal for the firm than profit.
– Sales are measurable and can be used as a specific target to motivate staffs,
– Specific sales targets are thought to be clearly understood by all within the firm.
– Rewards for senior managers are often tied to sales revenue rather than profit,
– It is assumed that an increase in revenue will more than offset any associated
increases in costs, so that additional sales will increase profit
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…theory of the FIRM
Risks of focusing on Profit maximization
■ Solely focusing on profit maximization comes with a level of risk in regards to
public perception and a loss of goodwill between the company, consumers,
investors, and the public.
– maximizing profits is not the only driving goal of a company particularly with
publicly held companies
– firms that have issued equity or sold stock have diluted ownership - CEOs
having multiple goals including profit maximization, sales maximization,
public relations, and market share.
– Competition and the lack of investment in its long-term success such as
updating and expanding product offerings can eventually drive a company
into bankruptcy.
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…theory of the FIRM
■ Limitations of Profit Maximization
It is not so easy to know exactly your marginal revenue and the marginal cost of
last goods sold.
For example, it is difficult for firms to know the price elasticity of demand for
their good – which determines the MR.
It also depends on how other firms react.
If they increase the price, and other firms follow, demand may be inelastic.
But, if they are the only firm to increase the price, demand will be elastic
Many firms may have to seek profit maximization through trial and error.
e.g. if they see increasing price leads to a smaller % fall in demand they will try
increase price as much as they can before demand becomes elastic
It is difficult to isolate the effect of changing the price on demand.
Demand may change due to many other factors apart from price.
Firms may also have other objectives and considerations.
For example, increasing price to maximize profits in the short run could
encourage more firms to enterthe market; therefore firms may decide to
make less than maximum profits and pursue a higher market share.
Firms may also have other social objectives such as running the firm like a
cooperative
– to maximize the welfare of stakeholders (consumers, workers, suppliers) and
not just profit of owners.
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…theory of the FIRM
E. Value Maximization Vs Profit maximization
1) Profit Maximization - is a short-term objective that assure the growth of the
capital , but it neglects risk and uncertainty the company can pass -through in
the future – traditional/classical theory of the firm
– the firm is thought to have profit maximization as its primary goal.
– The firm’s owner-manager is assumed to be working to maximize the firm’s
short-run profits.
2) Value Maximization - is a long- term objective that undertakes safe actions
in order to increase the market value of its common stock over time - more
complete model of a firm
– the value maximization model also offers insight into a firm’s voluntary
“socially responsible” behavior.
– the traditional theory of the firm emphasizes profits and value
maximization while ignoring the issue of social responsibility
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…theory of the FIRM
Social Responsibility of Business
■ What does all this mean with respect to the value maximization theory of the
firm?
– Is the model adequate for examining issues of social responsibility and for
developing rules that reflect the role of business in society?
■ firms are primarily economic entities and can be expected to analyze social
responsibility from within the context of the economic model of the firm.
■ close relation between the firm and society indicates the importance of
business participation in the development and achievement of social
objectives
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…theory of the FIRM
Types of Firms
■ Individual entrepreneurs – self-employed individuals
■ Private companies – often small/mid-sized companies who are owned by a
small number of individuals.
■ Public limited companies – generally large companies who are listed on the
stock market. The public can buy shares in the company and share in their
profits.
■ Co-operatives/social ventures. Firms which are not targeting profit
maximization but exist to further particular social and economicgoals.
■ Government-owned companies – In some industries, the largest firms are
State-owned companies.
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26. Chapter Review Questions (Discussion Forum)
1. Are firms primarily an economic entities? Discuss?
2. How would the objectives of
a) a large firm differ from a small owner-managed firm? (give examples/cases)
b) For profit business enterprise and social enterprise differ? (give examples/cases)
c) A public enterprise and private enterprise differ? (give examples/cases)
3. Is it reasonable to expect firms to take actions that are in the public interest but are
detrimental to stockholders? Is regulation always necessary and appropriate to
induce firms to act in the public interest? Substantiate with real world examples
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