This document provides an introduction to key concepts in managerial economics. It discusses how managerial economics applies microeconomic principles to real-world business decision making. The document outlines the decision making process and highlights important factors for managers to consider like objectives, constraints, alternatives, and implementation. It also examines concepts like profits, costs, revenues, and risk/return analysis to evaluate alternatives. Fundamental economic tools for analysis including marginal analysis, net present value calculations, and risk measurement are also introduced.

1. 1
KENYATTA UNIVERSITY
EAE 303: MANAGERIAL ECONOMICS
LECTURE NOTES
TOPIC 1: Introduction
Managerial economics deals with the application of microeconomic reasoning to real
world decision making problems faced by private, public and not for profit institutions.
Managerial Economics extracts from microeconomics theory, those concept and
techniques that enable the decision maker to select strategic directions, to allocate
efficiently the resources of the organization, and to respond effectively to tactical issues.
The type of decisions made by managers usually involves questions of resource
allocation within the organization in both the short and long run. Macroeconomic theory
enters into decision making when a manager attempts to forecast future demand based on
forces influencing the overall economy.
The decision making model.
The ability to make good decisions is the key to successful managerial performance.
Mangers in profit seeking firms are faced with a wide range of important decisions in the
areas of pricing, product choice, cost control, advertising, capital investment, dividend
policies etc.
Decision making has several common elements;
1. Establishing or identifying the objective of the organization.
2. Establishing the problem requiring solution
3. Identifying possible alternative solutions
4. Choosing the best alternatives

2. 2
5. Implementation of the decisions
The role of profits
Economic profits is the difference between total revenue and total cost where revenues
are 11xQP and cost are thought of as the highest valued alternative opportunity that is
foregone.
In a free enterprise system, economic profits play an important role in guiding the
decisions made by the thousands of competing independent economic units.
Establish or
identify
objectives
Define the
problem
Identify possible
alternative
solutions
Evaluate
alternatives and
select the best
Implement and
monitor the
decisions
Consider
organizational and
input constraints
Consider societal
constraints

3. 3
Theories of profit
1. Risk-bearing theory of profit
Economic profit above a normal rate of returns is necessary to compensate the owner
of the firm for the risk they assume when making their investment. A firm’s share
holders are not entitled to a fixed rate of return on their investments. They are residual
claimants to the firm’s resources thus they need to be compensated for this risk in the
form of a higher rate of return.
2. Dynamic equilibrium or function theory of profits
There exists a long run equilibrium normal rate of profit (adjusted for risk) that all
firms should tend to earn. At any point in time, however, an individual firm or firms
in a specific industry might have a rate of return above or below this long run normal
return level.
3. Monopoly theory of profit
In some industries, one firm is effectively able to dominate the market and potentially
earn above normal rates of return for a long period of time. This ability to dominate
the market may arise from economies of scale, control of essential natural resources,
and control of critical potent or government restrictions that prohibits competition.
4. Innovation theory of profits
It suggests that above normal profits are the rewards for successful innovations. Firms
that develop unique high quality products (Microsoft) or firms that successfully

4. 4
identify unique market opportunities such as DHL are rewarded with potential for
above normal profits.
5. Managerial efficiency theory of profit
This theory maintains that above normal profits can arise because of the exceptional
managerial skills of well managed firms. The ability to earn above normal profits by
exercising high quality managerial skills is a continuing incentive for greater
efficiency in our economic system.
Objectives of the firm
The common objective of firms is profit maximization i.e.
TCTR
TCTRMax


This model is limited because it does not incorporate the time dimension in the
decision process and it does not consider risk. The share holder wealth maximization
model of the firm overcomes these limitations.
The shareholder wealth maximization model of the firm
The most widely accepted objectives of the firm are to maximize the value of the firm
for its owners i.e. maximize shareholders wealth. Shareholders wealth is measured by
the market price of a firm’s common stock.

5. 5
The shareholders wealth maximization goal states that firm’s management should
maximize the present value of the expected future cash flows to the equity owner.
Let cash flows be profits hence the value of a firm’s stock is equal to the present
value of all expected future profits, discounted at the shareholders required rate of
returns.
 
 

 

1
0 1.......................................
1t
t
e
t
k
V

0V - Current (present) value of a share of stock
t - Profit expected in each of the future periods.
ek - The investors required rate of return.
 2.................................................ttt TCTR 
 
 4....................................................
3........................................................
tttt
ttt
FQVTC
xQPTR


tV - Variable cost per unit
tF - Fixed cost in period t.
Hence
 

 


1
0
1t
t
t
ttttt
k
FQVQP
V
The discount rate ek depends on
i) perceived risk of the firm

6. 6
ii) capital market conditions
Future streams of profits depends on
i) revenue generated
▪ demand theory and forecasting
▪ pricing
ii) costs
▪ production method
▪ nature of cost function

7. 7
Managerial actions to influence shareholders wealth
Economic environmental factors
1. level of economic activity
2. tax rate and regulations
3. competition
4. laws and government regulations
5. unionization of employees
6. international business conditions and currency exchange rates
Major policy decisions under management control
1. product and service offered for sale
2. product technology
3. marketing and distribution network
4. investment strategies
5. Employment policies and compensation packages for managers and
other employees.
6. ownership form – proprietorship, partnership or corporation
7. capital structure – use of debt and equity to finance the firm
8. working capital management policies
9. dividend policies
10. alliances, mergers, spinoffs
Amount, timing and risk
of expected profits
Shareholders wealth
(market price of stock)
Conditions in financial
markets
1. interest rate
levels
2. investor
optimism
3. anticipated
inflation

8. 8
Goals in the public sector and the not for profit enterprise
These organizations pursue a different set of objectives because of the nature of the good
or service they supply and the manner in which they are funded.
Characteristics of NFP enterprises
1. No one posses the right to receive profits or surpluses (read inefficiency)
2. Exempt from taxes on corporate income
3. Donations to NFP are tax deductible.
Public sector agencies tend to provide services with a significance public good character.
▪ Non excludable
▪ Non rival ness
Not for profit objective
1. Maximization of the quantity and quality of output subject to a break even budget
constraint.
2. Utility maximization of the administrators
3. Maximization of cash flows.
4. Maximization of the utility of contributors.
The efficiency objective
A major focus of the economists is on the efficiency dimension of organizational
objectives. Whatever set of objectives the organization may decide to pursue, these
objectives should be pursued in the most resource-efficient manner.

9. 9
The model that has been developed to provide a framework for the allocation of public
and NFP resources among competing uses primarily has been the cost benefit analysis
model. Benefits and cost associated by an appropriate discount rate, and projects are
evaluated on the basis of the magnitude of the discounted benefits in relation to cost.
Government and NFP organizations spending is normally constrained by a budget
ceiling, the criterion used in evaluation of expenditures may be one of the following.
1. Maximize benefits for given cost
2. Minimize cost while achieving a fixed level of benefit.
3. Maximize net benefits (B-C)
Fundamental economic concept
Managerial economics analysis is based largely on a few fundamental economic
concepts; marginal analysis, net present value, meaning and measurement of risk, trade-
offs that must be made between risk and returns, and the use of risk in decision analysis.
1. Marginal Analysis
A basis for making various economic decisions that analysis the additional benefits
derived from a particular decision and compares them with the additional cost
incurred.
For example
MCMR 
2
2
2
2
Q
TC
Q
TR






10. 10
L
TP
MP
L
TP
AP
QTP
L
L





Q total profit marginal profit average profit
0 -200 0 -
1 -150 50 -150
2 -25 125 -12.5
TP
AP
MP
0
AP
MP
Q
0 BOP
TP
Q
intpoInflexion

11. 11
2. Net Present Value (NPV)
The timing of cost and benefits necessitates the use of net present value. Present value
is the value today of a future amount of money or a series of future payment
evaluated at the appropriate discount rate. The appropriate discount factor is also
called the present value interest factor (PVIF)
i
PVIF


1
1
i represents compensation for post- poning the receipt of cash returns for one year.
Present value  0PV of an amount received one year in the future  1FV is equal to
that amount times the discount factor.
i
FV
PVIFFVPV



1
1
10
NPV of an investment made by a firm represents the contribution of that investment
to the value of the firm and accordingly to the wealth of shareholders.
      



n
i
n
i
ii
i
B
i
C
NPV
1 1 11
Risk and NPV rule
The increase in the perceived risk of the investment results in a dramatic decline in its
NPV. However, the primary problem facing managers is the difficulty of evaluating
the risk associated with investment and then translating that risk into a discount rate
that reflects an adequate level of risk compensation.

12. 12
3. Meaning and measurement of risk
Risk implies a chance for some unfavorable event to occur, for instance actual cash
flows being less than forecasted cash flow. In business, risk can be said to be a
decision making situation in which there is variability in possible outcomes and the
probabilities of the outcomes can be specified by the decision maker.
Probability is the percentage chance that a particular outcome will occur.
The expected value (EV) is the weighted average of the possible outcomes where the
weights are the probabilities of the respective outcomes.


n
i
jj prr
1
Example 1
Outcome Probability
No default, bonds redeemed at maturity 0.30
Default on interest for one or more period 0.65
No interest default but bonds not redeemed
At maturity 0.05

13. 13
Investment I Investment II
NCF jr prob jp jj pr  NCF jr prob jp jj pr 
200 0.2 40 100 0.2 20
300 0.6 180 300 0.6 180
400 0.2 80 500 0.2 100
Ir 300 IIr 300
Standard deviation: an absolute measure of risk
Standard deviation is a statistical measure of the dispersion of a variable about its
mean.
 

n
i
jjj prr
1

Standard deviation can be used to measure the variability of a decision alternative. It
gives an indication of the risk involved in the alternative. The larger the standard
deviation, the more variable the possible outcomes and the riskier the decision
alternative.
SD = 0, indicates no variability hence no risk.

14. 14
Investment I
j jr IF Frj   2
Frj  jp   jj prr 
1 100 300 -100 10000 0.2 2000
2 300 300 0 0 0.6 0
3 400 300 100 10000 0.2 2000
4000
25.634000 
Investment II
j jr IIF Frj   2
Frj  jp   jj prr 
1 100 300 -200 40000 0.2 8000
2 300 300 0 0 0.6 0
3 500 300 200 40000 0.2 8000
16000
49.12616000 

15. 15
Coefficient of variation: a relative measure of risk
The standard deviation is an appropriate measure of risk when the decision
alternatives being compared are approximately equal in size (similar expected values
of the outcomes) and the outcomes are estimated to have symmetrical probability
distribution.
The coefficient of variation considers relative variation and this is well suited for use
when a comparison is being made between two unequally sized decisions alternatives.
r
CV


Risk and required returns
The relationship between risk and returns on an investment in either a physical asset
or financial assets (security) can be defined as
Required returns = risk free return + risk premium
Iinvestment
IIinvestment
r
300
occurence
oftyprobabilii

16. 16
Risk returns trade-offs in stock and bonds
Investors require higher rate of return on securities subject to difficult risk. Bonds
rating agencies for instance (Standards and Poor’s, Duff and Phelps, Fitch etc)
provide evaluation of the default risk of many corporate bonds in the form of bond
rating.
E.g. Moody’s rate bonds on a 9 point scale from Aaa, Aa thrugh C, where Aaa rated
bonds have the lowest expected default risk.
Security Yield
U.S. Treasury bond (30 years) 5.85%
Aaa-rated corporate bonds 7.65%
Aa-rated corporate bond 7.81%
A- Rated corporate bond 8.11%
Baa – rated corporate bond 8.35%
RISK AND DECISION ANALYSIS
A decision problem has several basic elements
1. The decision maker
2. At least two alternatives
3. The problem exist within an uncertain environment

17. 17
The classification of decision making problems among the certainty, risk, uncertainty and
unknowingness categories is determined by the knowledge of the possible outcomes (or
pay offs) that will occur when one of the two (or more) alternatives actions is chosen in a
decision problem. Define a situation to be decision making under.
1. Certainty if each action is known to lead invariably to a specific outcome
2. Risk if each action leads to one of a set of possible specific outcomes, each
outcome occurring with a known probability.
3. Uncertainty if each action has as its consequences a set of possible specific
outcomes, but where the probabilities of these outcomes are completely unknown
or not meaningful or
4. Unknowingness if each action has unknown consequences, the outcomes of which
cannot be determined.
Let’s focus on four approaches for incorporating risk into decision making process
1. expected marginal utility
2. decision trees
3. risk adjusted discount rate
4. simulation results
1. Expected Marginal Utility
Expected utility is the product of the utility of each outcome times its respective
probability of occurrence, summed over all possible outcomes.

18. 18
The maximization of expected utility criterion will yield decisions that are in accord with
the individual’s true preference, provided the individual is able to asses a consistent set of
utilities over the possible outcomes in the problem. Expected utility is calculated by
summing over all the possible outcomes that may result from a decision, the product of
the utility of each outcome iU , times its respective probability of occurrence ip
  

n
i
ii pUUE
1
One of the major drawbacks of this approach is that whose utility function do we use in a
large organization? Manager? Shareholder.
2. Decision tree
Decision problem involving a sequence of alternative actions and states of nature can also
be analyzed using decision trees. In a decision tree, decision nodes (numbered boxes) are
used to represent points at which the decision maker must choose among several
alternatives actions, and state of nature nodes (numbered circles) are used to represent
possible state of nature outcomes.

19. 19
1
2
3
nodedecision
Invest
investnotDo
branchesDecision
nodesnature
ofstate
 2.0success
 8.0Failure
 8.0Failure
 2.0success
320002.0160000 
40000
0
0
EMV
320008.040000 
02.00 
08.00 
02 EMV
01 EMV

20. 20
3. Risk adjusted discount rate approach
When making long term capital budgeting (investment) decisions, the risk adjusted
discount rate approach is a commonly used method for dealing with the risk associated
with future cash-flow estimates.
 



n
t
t
t
NINV
k
NCF
NPV
1 1
Where
NCF – Net cash flow at time t.
NINV – Net investment
K – Firm’s cost of capital
Risk adjusted discount rate approach requires that the discounting be done using the risk-
adjusted rate *
k rather than the firm’s cost of capital (k). the magnitude of *
k depends on
the risk of project – the higher the risk the higher the risk adjusted discount rate. The risk
premium is kk *
4. Simulation approach
Simulation is a planning tool that models some events, when simulation is used in capital
budgeting it requires that estimated be made of the probability distribution of each cash
flow statement (revenues, expenses etc). These probability distributions are then put into

21. 21
the simulation model to compute the projects net present value probability distribution. In
any period, tNCF may be computed as
      DtDscqpqNCFt  1
Where
q - number of units sold
p- selling price per unit
c- unit production cost
s- unit selling cost
D- annual depreciation
t- marginal tax rate
Managing risk
a. Acquisition of additional information
b. Diversification
c. Hedging – price fluctuations – use of derivative securities such as future contracts to
offset.
d. Others – insurance, leasing

22. 22
TOPIC 2: DEMAND AND FORECASTING
1. Demand analysis
2. Estimation of demand
There are several methods/techniques of estimating demand, three of which are
marketing research methods.
1. Consumer survey
2. Consumer clinics
3. Market experiments
1. Consumer survey
Involves questioning a sample of consumers to determine such factors as their
willingness to buy their sensitivity to price changes or relative price levels, and their
awareness to advertise companies.
2. Consumer clinics and focus groups
Experimental groups of consumers are given a small amount of money with which to buy
certain items. The experiment can observe the impact on actual purchases as price, price
of competing goods and other variables are manipulated. Then the group of consumers
are closely observed discussing the choice they made and why? The drawbacks include
costs, Hawthorne effects.
3. Market experiment in test stores
Examines the way consumers behave in real market situation.

23. 23
STATISTICAL ESTIMATION OF THE DEMAND FUNCTION
Econometrics is a collection of statistical techniques available for testing economic
theories by empirically measuring relationships among economic variables.
  0' fpfQd
 AEyppfQ yxd ,,,
  yppQ yxdx 3210
The principal econometric techniques used in measuring demand relationships are
regression and correlation analysis. The estimation of a demand function using
econometric techniques involves the following steps.
1. Identification of the variables
Dependent and explanatory variables
  ationautocorrelpopAEyppfQ yxdx ,,,,
2. Collection of data
Secondary or primary data can be used
3. Specification of the model
This involves specification of the form of the equation or model that indicates the
relationship between the independent variables and the dependent variables. The specific
functional form of the regression relation to be estimated normally is chosen to depict the
true demand relationship as closely as possible. Many alternatives and variations maybe
tried. Because there is often no a priori reason for expecting one form of model the true

24. 24
relationship better than another, many variations are usually estimated dependent and
independent variables. To get a clue on the relationship, graph it.
Linear model
  MPAY 321
Multiplicative exponential model
321 
 MPAY 
  MPAY logloglogloglog 321
Simple regression
   


n
i
n
i
ii bxaye
ebxaY
1
2
1
1
2
  
 


 22
ii
iiii
xxn
yxyxn
b
xbya 
Making predictions
 p
p
xVarybay
bxay


ˆ
ˆ

25. 25
A measure of the accuracy of estimation with the regression equation can be obtained by
calculating the standard deviation of the error of prediction.
 
22
ˆ
22







n
bxay
n
e
s
yye
iii
e
If es is low, observation are tightly clustered about the regression line, and prediction
error will be low.
Using es to construct prediction intervals
 %952ˆ esy 
Correlation coefficient
In linear correlation, we determine the strength or degree to which two variables tend to
vary together
  
  




22
)( yyxx
yyxx
r
ii
ii
Which is simply
      
  



2222
iiii
iiii
yynxxn
yxyxn
r

26. 26
r ranges from +1 for two variables with perfect positive correlation to -1 for two variables
with perfect negative correlation.
Problem of applying linear regression
1. Autocorrelation – Cross similarities between variables in time. (time series)
2. Heteroskedasticity – non constant variance of the error term (to be dependent on
particular set of values.)
3. Specification and measurement errors
4. Multicollinearity – this is where two or more predictor variables in a multiple
regression model are highly correlated
Business and economic forecasting
Criteria used in the selection of a forecasting technique
1. The cost associated with developing the forecasting model compared with
potential gains resulting from its use.
2. The complexity of the relationship that are being forecast
3. The time period of the forecast (long term or short term)
4. The accuracy required of the model
5. The lead time necessary for making decisions dependent on the variables
estimated in the forecast model.
Evaluating the accuracy of forecasting model
One should be concerned with the magnitude of the errors of differences between the
observed (actual) Y and the forecasted values  Yˆ of the variables being examined.

27. 27
Various measures are used;
▪ 2
R - coefficient of determination.
This is how well the regression line approximates the real data points
▪ The average forecast error or root mean square error is used to evaluate the
accuracy of a forecasting
  
2
ˆ
1
tt yy
n
RMSE
n- Number of observations
The smaller the value of RMSE, the greater the accuracy of the forecasting model.
To compare the accuracy of alternative forecasting models, one must account for
differences in the average size of the variables used in the various models. Theil’s
statistic makes the necessary scaling adjustments as follows.
 

y
n
i
y
n
RMSE
U
ˆ
1
10 U , the closer to 1 the better the accuracy the forecasting model.
Forecasting techniques
1. Deterministic time - series analysis
2. Smoothing technique
3. Barometric techniques

28. 28
4. Survey and opinion – polling techniques
5. Econometric models
6. Stochastic time series analysis
7. Forecasting with input output table
1. Deterministic time – series analysis
Time series forecasting models are based solely on historical observations of the
values of the variables being forecast. These models do not attempt to explain
underlying casual relationships that produce the observed outcome.
Components of a time series
Variations that are evident in the time series can be decomposed into four
components
a) Secular trend - these are long run changes in an economic data series
over time
sales
1990 1999
years
t
trendularsec
trendCyclical

29. 29
b) Cyclical variation – major expansions and contractions in an
economic series that are usually greater than year duration.
c) Seasonal effects – these causes variations during a year that tend to be
more or less consistent from year to year.
d) Random fluctuations- an economic series may be influenced by
random factors that are by and large not predictable.
some elementary models
 
patterntheondepedent
yyyy
yy
tttt
tt







11
1
ˆ
ˆ
2. Smoothing techniques
This is another form of time series forecasting model which assumes that an
underlying pattern can be found in the historical values of a variable that is being
forecast. It is assumed that these historical observations represent not only the
underlying pattern but also random variation.
sales
 monthst
nsfluctuatio
random
effectsSeasonal

30. 30
a. Moving average
In an effort to minimize the effects of randomness of large errors, a series
of recent observations can be averaged to arrive at a forecast.
N
yyy
y Nttt
t
11
1
...
ˆ 



Where
1
ˆ ty = forecast value of y for one period in future
11,,  Nttt tyy = observed values of Yin period t, t-1,…, t-N+1 respectively
N = number of observations in the moving average
The greater the number of observations N used in the MA, the greater the
smoothing effect because each new observation receives less weight 





N
1
as
N increases.
N
yyy
y
MAmonth
N
yyy
y
234
5
123
4
ˆ
3ˆ







31. 31
Exchange Rates and International Trade
Dealing with different currencies or operating in various economies posses some threat to
the firm. Foreign exchange transactions risk exposure is a change in cash flows resulting
from contractual commitments to pay in or receive foreign currency. Exchange rate
volatility can translate into heavy losses if there are adverse exchange rate changes
between the date of the transaction and the date of the actual receipt or payment
Foreign Exchange Risk Management
a) Internal Hedging
Foreign currency hedging is a balance sheet approach to minimizing foreign
exchange risks. It involves taking two offsetting, opposite positions, in two
different parallel markets. The positions are such, that their end results offset each
other, i.e. excess profit on one side is compensated by an extra loss in the other,
leaving the trader with whatever was originally expected. The firm’s incomes and
expenditures do not get affected by any wayward exchange rate fluctuations. This
mainly involves matching the receipts and payments in a currency, so that any
losses in receipts are compensated by the gains in payments and vice versa.
b) Covered Hedge
i) Forward Contracts
Forward contracts are contracts that lock a fixed exchange rate, for the
receipts and payments in future. This rate is usually the market determined
forward exchange rate. Forward contracts offer stability to the receipts and
payments.
ii) Currency Swaps
Currency swaps are exchange transactions that take place over the counter.
One currency is exchanged immediately for another. In a currency swap
transaction, the payments of a fixed interest contract in one currency are
swapped with the payments of an equal amount in another currency.

32. 32
iii) Foreign Currency Options
Currency options are derivatives based on currency valuations. Foreign
currency options give their holder the right but not the obligation to
purchase (call option) or sell (put option) a specific foreign currency. This
safeguards the holders’ interest. If the market rate of the currency is more
favorable than the rate he would receive by exercising his option, he will
not exercise it, and vice versa.
iv) Spot Contracts
In spot contracts, contract payments and receipts are settled on the day or
on T+1 or T+2 settlement terms. This small duration does not allow for
massive exchange rate or interest movements and thus safeguards the
person from foreign currency risks.

33. 33
TOPIC 3: PRODUCTION ECONOMICS
Production function with two variable inputs
MRTS
x
x
isoquantofslope 



1
2
Optimal combination of inputs
 LKfQ
st
rKwLMinC
,

2X
1X0
y

34. 34
Measuring the efficiency of a production process
Technical efficiency – it is a measure of how close production achieves maximum
potential output given the input mix 





OA
OB
Allocative efficiency – it is a measure of how close production achieves the least-cost
input mix, given the desired level of output 





OB
OR
Technical and Allocative efficiency
R is both TE and AE
X2
O X1
S’
A
S
C
R
B’
B
C’
▪
▪
▪
▪

35. 35
Economic efficiency
It is the total efficiency. It is given by a ratio that is a combination of technical (OB/OA)
and allocative (OR/OB) efficiencies
OA
OR
OB
OR
OA
OB
AETEEE


NB
At R the firm will optimize on both the output and cost.
Profit maximization
Example 1 (General case)
y = f(x1, x2)
C = w1 x1, + w2 x2
2211.
2
xwxwypMax
x

 
 
 
0
.
0
.
.
2
2
21
2
1
1
21
1
221121













w
x
xxfp
x
w
x
xxfp
x
xwxwxxfpMax



p
w
MPwMPp
p
w
MPwMPp
xx
Xx
2
2
1
1
22
11
0.
0.



36. 36
Example 2
ba
xxy 21
2221
1121
2
1
21
2
12
1
1
1
221121
2211
.
.
0.
0.
.
.
xwxbxp
xwxaxp
wxbxp
x
wxaxp
x
xwxwxxp
xwxwypMax
ba
ba
ba
ba
ba
















functiondemandinputnalunconditio
w
pby
x
w
pay
x









2
2
1
1
2211. xwxwyp 
1
122
x
p
w
p
xw
y 



Y
X
*
Y
*
X
 XfY 
Isoprofit





0

37. 37
COST
The sacrifice incurred whenever an exchange or transformation of resources takes place.
Accounting cost involves the cost of exchanging a product or service (prices). Economic
costs involves the cost of the foregone alternative.
Cost function – mathematical model, schedule or graph that shows the cost of producing
various quantities of output.
Short – Run Cost Function
VCFCTC 
VC – cost of variable inputs to the production process.
FC – cost of inputs to the production process that are constant over the short run.
tcos
Q0
FC
VC
TC

38. 38
Q
TC
ATC
Q
VC
AVC
Q
FC
AFC



Marginal cost is the change in total costs that results from a unit increase in output.
Q
VC
Q
TC
MC






In the case of a continuous TC function
 
 
Q
VC
Q
TC
MC






Example
2
2
32
10.0360
100
10.0360
100
10.0360100
QQ
Q
ATC
QQAVC
Q
AFC
QQQTC





39. 39
Relationships among the various costs and production curves
Output
unit
pertcos
tcos
1Q 2Q
XAP
3Q
XMP
MC
ATC
AVC
AFC
Q
1X
TC
VC
FC
Q
Inferenceofspoint
Increasing
returns to the
variable inputs
Decreasing
returns to the
variable inputs

40. 40
Long run cost function
Over the long run planning horizon, the firm can choose the combination of inputs that
minimizes the cost of producing a desired level of output.
Optimal capacity utilization.
The relationship between the SR and LR average cost function is important in business
decision make up. Assume that the firm has been producing 1Q units of output using a
plant size 1, having a short run average cost curve 1SAC . The average cost of producing
1Q units is therefore 1C and 1Q is the optimal output for the plant size [output rate that
result in lowest average total cost for a given plant size] represented by 1SAC
Suppose the firm wishes to expand output to 2Q ? The average cost in the short run would
be '
2C . However in the long run, it would be possible for the firm to build a plant size of
2, having a short run average cost of producing 2Q units of output would be only '
2C .
AC
'
2C
1C
2C
3C
1Q 2Q 3Q 4Q0

41. 41
Thus because the firm has more options available to it in the long run, average total cost
of any given output generally can be reduced. 2SAC represents the optimal plant size for
the output rate 2Q .
Only when optimal output increases to 3Q where the firm will build the universally least
cost optimal plant size represented by 3SAC will further opportunities for cost reduction
cease. This is a long run concept of capacity utilization for the technology in place at this
plant.
ECONOMIES AND DISECONOMIES OF SCALE
Declining long run average cost over the lower part of the range of possible output are
usually attributed to economies of scale.
Sources of economies of scale.
1. Production specific – large volumes of a single product due to greater
specialization.
2. Plant-specific economies of scale – economies of scale related to the total output
(of multiple products) of one plant.
3. Firm specific economies – economies of scale related to the total output of a
firm’s operations.
Diseconomies of scale involve rising long run average costs as the level of output is
increased.

42. 42
Application
▪ estimation of cost function
▪ break even analysis

43. 43
TOPIC 4: PRICE, OUTPUT AND STRATEGY
The relevant market concept
A relevant market is a group of economic agents (individuals and firms) that interact with
each other in a buyer seller relationship. This interaction results in transactions between
the demand side of the market (buyer) and the supply side of the market (seller).
Markets are the focal point for economic activity. Because of the important role played
by markets in pricing and allocating of resources in a competitive economy, a manager
whose principle responsibility is strategic planning and public policy analysis should
focus considerable attention on the market structures that have developed for various
goods and services.
Porter’s five forces strategic framework
Michael porter has developed a conceptual framework for identifying the sources of
competitive advantages through their choice of management strategy. Porter
conceptualizes management strategy in terms of the likelihood of profitability for a
particular industry or line of business.

44. 44
PORTERS FIVE FORCES STRATEGIC MODE
Substitutes Potential
Entrants
Buyer power
Supplier power
▪ Value –price
for other
products that
meet
functionality
▪ Branded Vs
generic
▪ High capital
cost
▪ Economies of
scale
▪ Lack of
access to
distribution
channels
▪ Objective
product
differentiation
▪ Buyer
concentration
▪ Industry
over/under
capacity
▪ Homogeneity
of buyer
▪ Unique
suppliers
▪ Number of
potential
▪ Supply
shortage/surp
lus
▪ Vertical
requirements
contracting
▪ Industry
concentration
▪ Price
competition
tactics
▪ Exit barner
▪ Cost fixity
▪ Industry
growth rate
Sustainable
industry
profitability
Threat of
substitute
products
Threat of new
entrants
Bargaining power
of buyers
Bargaining power
of suppliers
Level of
competition in the
industry

45. 45
Market Structures
1. Atomistic or pure competition
Characteristics
i) Very large number of buyers and sellers with no impact on the market
price.
ii) Homogeneous products
iii) Complete knowledge
iv) Free entry and exit from the market.
2. Monopolistic competition
This is a market structure that is very much like pure competition. The major
distinction is the existence of a differentiated product.
Characteristic
i) Few dominants firms and a large number of competitive fringe firms
ii) Firms sell differentiated products
iii) Independent decision making by some individuals firms
iv) Ease of entry and exit from the market as a whole but very substantial
burrier to effective entry among the leading brands.

46. 46
Monopoly
The monopoly model is characterized as follows;
i) Only one firm producing some specific product line
ii) Low cross elasticity of demand
iii) No interdependence with other competitors
iv) Substantial barriers to entry
v) Large capital requirements
vi) Legal exclusion
vii) Trade secrets
Monopolies create inefficiencies in the market. This is because they dictate the quantity
to put into the market and the market price for their products.
price
Output
MC
MR
PAR 
me
ceB
C
AmP
cP
mY cY

47. 47
Output and Profit Determination in imperfect competition
Q
Q
TR
MR
QQQPTR
QQLRAC
QP
008.010
004.010.
000002.0006.08
004.010
2
2







02004.0000006.0
000006.0012.08008.010
000006.0012.08
000002.0006.08.
2
2
2
32








QQ
QQQ
MCMR
QQ
Q
TC
MC
QQQQLRACTC
 
2000
6
1000004.010
1000
*
*





TCTR
P
Q

Oligopoly
This is a market structure describing a market having a few closely related firms. The
number of firms is so small that actions by an individual firm in the industry with respect
to price, output and product style have a perceptible impact on the sale of other firms in
the industry. Oligopoly markets are best analysed by use of game theory
Symmetric and Asymmetric information
Competitive markets under ideal information conditions in which you get what you pay
for, differ enormously from competitive market under asymmetric information,
sometimes called the lemon’s ,bracket (explain)

48. 48
Incomplete information differs from asymmetric information. The former is uncertain
knowledge of pay offs, choices etc while the latter is unequal dissimilar knowledge.
The disappearance of high quality products from the market place illustrates the concept
of adverse selection.
Because sellers can anticipate only low price offer from buyers, the sellers never produce
high-quality products. That is, the market for experience goods will be incomplete in that
not all products qualities will be available for sale.
Solutions to adverse selection
1. Reliance relationship – long-term, mutually beneficial agreement
2. Hostage or bonding mechanism – a procedure for establishing trust by assigning
valuable property contingent on your nonperformance of an agreement.
GAME-THEORETIC RIVALRY: BEST PRACTICE TACTICS
Effective tactics in business require methods for anticipating rival initiatives, rival
response and counter response. Most such predictions of rival behaviors can be obtained
by analyzing non corporative sequential and simultaneous games, bidding games
manufacturer distributor games etc.
All such non cooperative game prohibits side payment and binding contracts between
rivals and interdependent on self enforcing reliance relationship to ensure strategic
equilibrium.

49. 49
Simultaneous and sequential games [strategy games]
A sequential game is a game with an explicit order of pay.
A simultaneous game is a game in which players must choose their actions
simultaneously.
Nash equilibrium strategy
In game theory, Nash equilibrium (named after John Forbes Nash, who proposed it) is a
solution concept of a game involving two or more players, in which each player is
assumed to know the equilibrium strategies of the other players, and no player has
anything to gain by changing only his or her own strategy (i.e., by changing unilaterally).
If each player has chosen a strategy and no player can benefit by changing his or her
strategy while the other players keep theirs unchanged, then the current set of strategy
choices and the corresponding payoffs constitute a Nash equilibrium. In other words, to
be in a Nash equilibrium, each player must answer negatively to the question: "Knowing
the strategies of the other players, and treating the strategies of the other players as set in
stone, can I benefit by changing my strategy?"
Stated simply, Amy and Bill are in Nash equilibrium if Amy is making the best decision
she can, taking into account Bill's decision, and Bill is making the best decision he can,
taking into account Amy's decision. Likewise, many players are in Nash equilibrium if
each one is making the best decision that they can, taking into account the decisions of
the others. However, Nash equilibrium does not necessarily mean the best cumulative
payoff for all the players involved; in many cases all the players might improve their

50. 50
payoffs if they could somehow agree on strategies different from the Nash equilibrium
(e.g. competing businessmen forming a cartel in order to increase their profits).
Prisoner’s dilemma
The Prisoner's Dilemma constitutes a problem in game theory. It was originally framed
by Merrill Flood and Melvin Dresher working at RAND in 1950. Albert W. Tucker
formalized the game with prison sentence payoffs and gave it the "Prisoner's Dilemma"
name (Poundstone, 1992).
In its "classical" form, the prisoner's dilemma (PD) is presented as follows:
Two suspects are arrested by the police. The police have insufficient evidence for
a conviction, and, having separated both prisoners, visit each of them to offer the
same deal. If one testifies ("defects") for the prosecution against the other and the
other remains silent, the betrayer goes free and the silent accomplice receives the
full 10-year sentence. If both remain silent, both prisoners are sentenced to only
six months in jail for a minor charge. If each betrays the other, each receives a
five-year sentence. Each prisoner must choose to betray the other or to remain
silent. Each one is assured that the other would not know about the betrayal
before the end of the investigation. How should the prisoners act?
If we assume that each player prefers shorter sentences to longer ones, and that each gets
no utility out of lowering the other player's sentence, and that there are no reputation
effects from a player's decision, then the prisoner's dilemma forms a non-zero-sum game
in which two players may each "cooperate" with or "defect" from (i.e., betray) the other

51. 51
player. In this game, as in all game theory, the only concern of each individual player
("prisoner") is maximizing his/her own payoff, without any concern for the other player's
payoff. The unique equilibrium for this game is a Pareto-suboptimal solution—that is,
rational choice leads the two players to both play defect even though each player's
individual reward would be greater if they both played cooperatively.
In the classic form of this game, cooperating is strictly dominated by defecting, so that
the only possible equilibrium for the game is for all players to defect. No matter what the
other player does, one player will always gain a greater payoff by playing defect. Since in
any situation playing defect is more beneficial than cooperating, all rational players will
play defect, all things being equal.
In the iterated prisoner's dilemma the game is played repeatedly. Thus each player has
an opportunity to "punish" the other player for previous non-cooperative play. If the
number of steps is known by both players in advance, economic theory says that the two
players should defect again and again, no matter how many times the game is played.
Only when the players play an indefinite or random number of times can cooperation be
an economic equilibrium. In this case, the incentive to defect can be overcome by the
threat of punishment. When the game is infinitely repeated, cooperation may be a
subgame perfect Nash equilibrium although both players defecting always remain an
equilibrium and there are many other equilibrium outcomes.
In casual usage, the label "prisoner's dilemma" may be applied to situations not strictly
matching the formal criteria of the classic or iterative games; for instance, those in which

52. 52
two entities could gain important benefits from cooperating or suffer from the failure to
do so, but find it merely difficult or expensive, not necessarily impossible, to coordinate
their activities to achieve cooperation.
Organizational form, governance and mechanism design
This topic explores the coordination and control problems faced by every business
organization and the institutional mechanism designed to solve these problems in a least
cost manner.
The most important organizational decision is the determination of the boundary of the
firm i.e. the breath of the span of hierarchical control. In dealing external suppliers,
outsource partners, divisions, authorized distributors, franchises and licenses, every firm
must decide where the internal organization stops and where market transactions take
over.
Contracts between business organizations provide an exante framework defining this
relationship, but all contracts are purposefully incomplete. Consequently every firm must
address the potential for post contractual opportunistic behavior by business partner and
then design governance mechanism to reduce these contractual hazards.
Choice of organizational form
The role of business contracting in cooperative game
Once a manufacturer commits to update a product, distributors may find that their best-
reply response is to continue providing extensive selling efforts and post sale services. If

53. 53
so, the required coordination of manufacturer and distributor actions can be achieved by a
self enforcing reliance relationship. At times, however, the pay offs are such that
coordination requires something more than the voluntary self-enforcing mechanisms that
secures equilibrium in non-cooperative game. E.g. a distribution who economizes on
selling cost may actually do better than with full efforts knowing that the distributor has a
dominant strategy to defect and discontinue some selling efforts, the manufacturer will
decide not to cooperatively advertise.
Organizational form and institutional arrangement play an extensive role in eliciting
efficient behavior institutional choices also involves the form of organization companies
adopt. E.g. Goodyear tires develop franchise of actions dominates all other sequential
patterns and meet the conditions of best-reply response for each player at each proper
sub-game node in the decision tree.
Governance mechanism and the problem of moral hazard
Governance structure provides the ex post implementation required to maximize value.
Governance structure is a mechanism that processes an alternative to incentives or direct
monitoring for eliciting contractually expected behavior.
Unobservable efforts in fulfilling contract promises is a more difficult but standard
business contracting problems i.e. moral hazards in all contractual agreements. After
securing terms to their liking, contract partners must be wary of the potential for post
contractual opportunistic behavior i.e. sticking on the agreement in inconspicuous and

54. 54
hard to detect but potentially minors ways. This contractual issue is sometimes referees to
as the problem of hidden action (or inaction)
Moral hazards in the prospect that a partly insulated from risk may behave differently
from the way it would behave if it were fully exposed to the risk. Moral hazard arises
because an individual or institution does not bear the fully consequence of its actions and
therefore has a tendency to act less carefully than it otherwise would, leaving another
party to bear some responsibility for te consequences of those actions e.g. car insurance.
Moral hazards are related to asymmetric information a situation in which one party in a
transaction has more information than another.
Determination of the optimal level of selling and promotional outlay
Selling and promotional expenses often collectively referred to as advertising are one of
the most important tools of non price competition employed by profit maximizes firms in
monopoly, oligopoly and monopolistic competition market.
The determination of the optimal advertising outlay is a straight forward application of
the marginal decision-making rules followed by profit maximizing firms.
Q
TR
MR


 Where PMRPP  ,
outputofunitadditionalangadvertinotbut
ngdistributiandpproducingofttotalinchange
Q
TC
MC
)sin(
cos







55. 55
The marginal profit or contribution margin additional unit of output is
  MCPMPCinmoncontributi arg
The marginal cost of advertising  MCA associated with the sale of an additional unit of
output is defined as the change in advertising expenditures  AK where K is the unit
cost of an advertising message A or
Q
AK
MCA



The Necessary condition
The optimal level of advertising outlays is the level of advertising where the marginal
profit contribution  MPC is equal to the marginal cost of advertising.
MCAMPC 
If MCAMPC  , advertising outlay should not be made and the level of advertising
should be reduced until MCAMPC  and vice versa.
PRICING TECHNIQUES
This topic builds on the price and output determination models
Conceptual framework for proactive value-based pricing

56. 56
Proactive pricing is tactically astute and internally consistent with operations strategy.
E.g. a high cost airline cannot slash prices dramatically even if 10 or 20 percent increases
in market share and there by achievable. It must anticipate not only a matching price
reaction by its lower cost rivals but perhaps further price cuts below its own cost.
Knowing all this in advance renders gain share discounting much less attractive despite
the temptation of additional incremental sales in a high margin business.
Pricing decision must be systematic and analytical based on hard facts not adhoc
hunches.
The appropriate conceptual framework for setting prices is an analysis of the determinant
of customer value. What triggers a customer’s purchase is value in excess of asking price
or a ratio of value to price greater than a competitor
competitorfor
price
value
price
Value

Firms must identify the value in each customer segment.
Differential pricing
Value based differential pricing implied identifying the different value drivers for various
segments of the target market. E.g congestion based pricing at peak demand periods on
road ways bridges and subways systems.
Price discrimination

57. 57
Price discrimination is defined as the act of selling the same product (a good or service)
produced under single control (that is, by one firm), at different prices to different buyer
during the same period of time condition.
1. it must be possible to segment the market and prevent unauthorized sale of the
seller product.
2. Differences in the price elasticity of demand from one segment to another must
exist.

58. 58
TOPIC 5: LONG-TERM INVESTMENT ANALYSIS
Investment analysis or capital budgeting is the process of planning for the purchase of
assets whose returns (cash flow) are expected to continue beyond one year.
Nature of capital expenditure
Decisions to replace assets have the effect of changing the technology employed by a
firm. This leads to the interaction of the relevant production and cost function.
Decisions to expand a firm’s assets base leads to an increase in the scale or size of the
productive facilities. Expansion decision are based on forecast of future demand and cost
after expansion. If quantity demanded is suitably high or cost sufficiently low, the
resulting profits may justify the expansion decision.
A capital expenditure is a cash outlay that is expected to generate a flow of future cash
benefits lasting longer than one year. Capital budgeting is the process of planning for and
evaluating capital expenditures.
In addition to assets replacement and expansion decision, other types of decisions that
can be analysed using capital budgeting techniques include research and development
expenditures investments in employee’s education and training lease Vs buy decisions,
and mergers and acquisitions.
The capital budgeting process
The process of selecting capital investment projects consists of the following important
steps
1. Generate alternative capital investment project proposal

59. 59
2. Estimate cash flows for the project proposal
3. Evaluate and choose from the alternatives available those investments projects to
implement.
4. Review the investment project after they have been implemented.
Generating capital investment project
Ideas for new capital investments can come from many sources both inside and outside
the firm. Most medium and large sized firms have staff groups whose responsibilities
include cost accounting, industrial engineering, marketing research, research and
development and corporate planning personnel.
Capital expenditure projects can be classified into various categories depending on the
nature of benefits expected.
A) Project designed to reduce cost
B) Project designed to improve a firm’s demand curve or to respond to
changes in that curve.
C) Project that create future growth options for the firm e.g. research and
development
D) Project designed to meet legal requirements and health and safety
standards.

60. 60
Estimating cash flows
Certain basic guidelines have been found helpful in approaching the analysis of
investment alternatives.
1. Cash flow should measured in an incremental basis (difference)
2. Cash flows should be measured on an after tax basis using the firms marginal tax
rate.
3. All the indirect effects of the project throughout the firm should be included in the
cash flow calculation.
NIAT Is equal to the difference in the income before tax  NIBT times  t1
Where t is the corporate (marginal) income tax rate.
 tNIBTNIAT  1
 NIBT is the difference in revenues  R minus the difference in operating costs
 C and depreciation  D
DCRNIBT 
Hence
  tDCRNIAT  1
Given net cash flow  NCF as

61. 61
   DtDCRNCF  1
For a typical investment project an initial investment is made in year 0, which
generates a series of yearly net cash flows over the life of the project (n). the net
investment NINV of a project is defined as the initial net outlay in year O. It includes
the acquisition cost of any new assets plus installation and shipping costs and tax
effects.
The incremental after tax net cash flow (NCF) of a particular investment project are equal
to cash inflows minus cash outflows. For any year during the life of the project these may
be defined as the difference in net income after tax  NIAT with and without the project
plus the difference in depreciation  D
DNIATNCF 
Evaluating and choosing the investment project to implement
A decision to accept or reject the project is required once a capital expenditure project
has been identified and cash flows estimated. Various criteria can be employed to
determine the desirability of investment projects. Two widely used discounted cash flow
methods

62. 62
1. Internal rate of returns
The discount rate that equates the present value of the net cash flow from the project
with the net investment
 


n
t
t
t
NINV
r
NCF
1 1
Thus
ir 
Where
r is IRR
i is the firms required rate of return
2. Net present value
Present value discounted at the firms required rate of return (cost of capital) of the
stream of net cash flows from the project minus the projects net investment
 



n
t
t
t
NINV
k
NCF
NPV
1 1
n – Expected life of the project
k – Firm’s required rate of returns (cost of capital)

63. 63
ESTIMATING THE FIRMS COST OF CAPITAL
The cost of capital is concerned with what a firm has to pay for capital i.e. debt,
preferred stocks, retained earnings and common stock, it uses the finance its
investments
Cost of debt capital
The pretax cost of debt capital to the firm is the rate of returns required by investors.
For a debt issue, this rate of return kd equates the present value of all expected future
receipts – interest I and principal repayment M- with the offering price 0V of the debt
security.
    



n
t
nt
kd
M
kd
I
V
1
0
11
The cost of debt kd
When debt is issued at par value, the pretax cost of debt, kd is equal to the coupon
interest rate. Interest repayment made to investors however are deductible from the
firms taxable income. Therefore the after tax cost of debt is computed by multiplying
the pretax cost by 1 minus the firms marginal rate t.
 tkdki  1

64. 64
Cost of internal equity capital
The cost of equity capital to the firm is the equilibrium rate of returns required by the
firm’s common stock investors.
Firms raise equity capital in two ways
1. internally – retained earnings
2. externally – through sale of new common stock
The concept of the cost of internal equity can be developed using several different
approaches.
a) Dividend valuation model
b) Capital asset pricing model
Dividend valuation model
Recall shareholders wealth
For a shareholder who intends to hold the stock indefinitely, the value of the firm is
 

 

1
0
1t
t
e
t
k
D
V
Where
tD is dividends paid by firm in period t.
If the shareholders choose to sell the stock after n years his her wealth 0V is

65. 65
    



n
t
n
e
u
t
e
t
k
V
k
D
V
1
0
11
Where
uV is market value of shareholder holding in period n.
If the dividends of the firm are expected to grow perpetually at a constant compound rate
of g per year, then the value of the firm can be expressed as
gk
D
V
e 
 1
0
Where
0V is the market value of the firm
1D is dividends expected to be paid in period 1
Therefore
g
V
D
ke 
0
1

66. 66
Capital assets pricing model (READ MORE)
This is a theory that formally describes the nature of the risk – required return trade-off. It
provides one method of estimating a firms cost of equity capital.
COST BENEFIT ANALYSIS
This is a resource allocation model that can be used by public and not for profit sector
organizations to evaluate programs or investments on the basis of the magnitude of the
discounted benefits and cost.
Steps in CBA (general principal)
a) What is the objective function to be maximized
b) What are the constraints placed on the analysis
c) What cost and benefits are to be included and how are they valued?
d) What investment evaluation criterion should be used?
e) What is the appropriate discount rate
acceptratio
C
B
1
CBA – cannot measure benefits in monetary terms.