Man eco-session 1

The Nature & scope of Man Eco
Dr. Prema Basargekar

PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Copyright © 2007 by Oxford University Press, Inc. (Adapted by OUP India, 2008) Slide 2
 Define managerial economics
 How Is Managerial Economics Useful?
 Economics and Managerial Decision Making
 Theory of the Firm
 Profit Measurement
 Theory of profit
 Why Do Profits Vary among Firms?
 Role of Business in Society

 “Economics studies human behaviour as a
relationship between ends and scarce means
which have alternative uses”- Lionel Robbins
 Economics is “the study of the behavior of
human beings in producing, distributing and
consuming material goods and services in a
world of scarce resources.” (McConnell, 1993)

 Management is the discipline of organizing and
allocating a firm’s scarce resources to achieve its
desired objectives. Involves the ability to organize
and administer various tasks in pursuit of certain
objectives.
 Managerial economics is the use of economic
analysis to make business decisions involving the
best use (allocation) of an organization’s scarce
resources.

 Business decision process is becoming more
& more complex due to
a. Change in ownership pattern
b. Change in scale of operation
c. Change in business environment
Making appropriate business decision
requires clear understanding of market
conditions of product, inputs & financial
markets which require application of
economic concepts, theories & tools.

 The application of economic theory and the tools
of decision science to examine how an
organization can achieve its aims or objectives
most efficiently.
◦ applications of economic theory
◦ quantitative methods
◦ statistical methods
◦ computational methods

 Microeconomics
◦ Study of the economic behavior of individual decision-
making units.
◦ Relevance to Managerial Economics
 Macroeconomics
◦ Study of the total or aggregate level of output, income,
employment, consumption, investment, and prices for the
economy viewed as a whole.

 Mathematical Economics
◦ Expresses and analyzes economic models using the
tools of mathematics.
 Econometrics
◦ Employs statistical methods to estimate and test
economic models using empirical data.

 Economic Models
◦ Abstract from details
◦ Focus on most important determinants of economic
behavior – cause and effect
 Evaluating Economic Models
◦ A model is accepted if it predicts accurately and if the
predictions follow logically from the assumptions.

 Combines and organizes resources for the
purpose of producing goods and/or services for
sale.
 Internalizes transactions, reducing transactions
costs.
 Economic theory assumes that the primary goal of
managers is to maximize the value of the firm.

 Value of the firm is the present value of the
firm’s expected future cash flows.
 If the cash flows or future expected profits are
discounted back to the present value, we get
the present value of the firm.
 Discounting is required because profits earned
in the future are less valuable than profits
earned presently.

The present value of all expected future
profits
1 2
1 2
1(1 ) (1 ) (1 ) (1 )
n
n t
n t
t
PV
r r r r
π ππ π
=
= + + + =
+ + + +
∑L
1 1(1 ) (1 )
n n
t t t
t t
t t
TR TC
Valueof Firm
r r
π
= =
−
= =
+ +
∑ ∑

 Present value of Rs. 100 at the discount rate of
5% would be
 First year – 100/(1+0.05) = 95.24
 Second year – 100/(1+0.05)2
= 90.70
 If discounting rate is 10 %
 Then 100/(1+0.10) = 90.90
 100/ (1+0.10)2
= 82.64

 The manager of automated Products is
contemplating the purchase of a new machine that
will cost Rs. 3,00,000 and has a useful life of five
years. The machine will yield (year-end) cost
reduction to Automated Products of Rs. 50,000 in
year 1, Rs. 60,000 in year 2, Rs. 75,000 in year 3
and Rs. 90,000 in year 4 and year 5.
 What is the present value of the cost savings of
the machine if the interest rate is 8 % ? Should the
manager purchase the machine?

 By spending Rs. 3,00,000 today on a new machine, the firm will
reduce costs by Rs. 3,65,000. However the present value is
 PV = 50,000/1.08 + 60,000/ 1.082
+ 75,000/1.083
+ 90,000/1.084
+
90,000/1.085
 = 2,84,679
 NPV = PV – Cost
 = 2,84,679 – 3,00,000
 = - 15,321
 Since NPV is negative, the manager should not purchase the
machine. She can earn more by investing the same amount at 8 %
in any financial asset.

 Scarcity of Inputs: Skilled labour, specific raw
material, funds
 Legal Constraints: Govt rules & regulations,
licenses, permissions, wage laws, health & safety
standards, pollution emission standards, etc.
 Constrained Optimization: within these constraints
firms have maximise wealth or its value.

 Sales maximization
◦ Adequate rate of profit –
◦ Dichotomy bet. Ownership & Mgt.
◦ After adequate rate of profit
◦ Reasons: salary, loans, dev indicators related to sales;
strengthening competitive spirit
 Management utility maximization
◦ Principle-agent problem
 Satisficing behavior –
complexity &uncertainty make decision complicated
Mangers have to satisfy variety of people like Labour,
shareholders, customers, financiers, authorities, etc

 Business Profit: Total revenue minus the explicit
or accounting costs of production.
 Economic Profit: Total revenue minus the explicit
and implicit costs of production.
 Opportunity Cost: Implicit value of a resource in its
best alternative use.

 Find out accounting & economic profit.
 A. A manager working at the salary of Rs.
30,000/pm leaves his job & starts his own firm. He
uses his own capital of Rs.4,00,000/ which he had
kept in fixed deposit at 10%p.a. He pays Rs.
10,000/ pm to 2 workers each. He pays Rs.
30,000/- as rent pm. His total revenue from sales
is Rs. 7,00,000/-.

 Explicit cost:
 Salary: (10,000 * 2) * 12 = 2,40,000
 Rent : 30,000 * 12 = 3,60,000
 Total explicit cost = 6,00,000
 Accounting profit = 7,00,000 – 6,00,000 = 1,00,000
 Implicit cost:
 Salary forgone: 30,000 * 12 = 3,60,000
 Interest forgone: 4,00,000 * 0.1 = 40,000
 Total implicit cost = 4,00,000
 Total cost (Implicit + Explicit)
 6,00,000 + 4,00,000
 Economic profit = 7,00,000 – 10,00,000 = - 3,00,000

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

 Risk-Bearing Theories of Profit: above normal
returns (economic profits) are required to get to
cover for risk. The greater the risk; the greater
shd be the returns
 Frictional Theory of Profit: Profits arise due to
friction or disturbances from long-run equilibrium
where firms tend to earn only normal profits.

 Monopoly Theory of Profit: Monopolist can control
the supply & can continue to make profits even in
the long run.: economies of scale, control over
crucial input, legal protection, mergers, takeovers,
etc.
 Innovation Theory of Profit: Profit is a reward for
successful innovation.: new commodity, new
method of prod, new market, new inputs, new way
of organization
 Managerial Efficiency Theory of Profit: Firms that
are more efficient than the average would earn
above normal returns and economic profit.

 Profit is a signal that guides the allocation of
society’s resources.
 High profits in an industry are a signal that buyers
want more of what the industry produces.
 Low (or negative) profits in an industry are a
signal that buyers want less of what the industry
produces.

 Concepts learnt:
 Managerial economics
 Theory of firm
 Time value of money
 Discounting principle
 Constrained optimization
 Business & accounting profit
 Economic profit
 Theories of profits

Man eco-session 1

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