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Managerial economics for mm ims semester 1


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IMS - MM 1st sem

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Managerial economics for mm ims semester 1

  1. 1. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 1 MANAGERIAL ECONOMICS FOR MM FT SEMESTER 1 – 2013-15 UNIT 1 - INTRODUCTION TO ECONOMICS AND MANAGERIAL ECONOMICS a. NATURE b. SCOPE c. CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS d. RELATIONSHIP OF MANAGERIAL ECONOMICS WITH ECONOMICS, OPERATION RESEARCH, DECISION MAKING, STATISTICS, ACCOUNTING ETC. NATURE - “Application of economic theory and tools of analysis of decision science to examine how an organization can achieve its objectives most efficiently”- Salvatore Spencer and Siegelman: “… Integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management” Evan Douglas: “Application of economic principles and methodologies to the decision-making process within the firm or organization…under conditions of uncertainty” Decision Making Process – 5 Stages of Decision making Process: 1. Define the problem 2. Determine the objective 3. Identify possible solutions 4. Select the best possible solution 5. Implement the decision Importance of Quantitative Tools • Analysis of variables is a key procedure in economic analysis. • Economic research and policy-making require up-to-date data and extensive analysis. • Use of Mathematical tools • Use of Statistical Techniques Time Series: For Demand forecasting Regression: Two or multiple variables used to study interrelationships, estimation and prediction Measures of central tendency and variation
  2. 2. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 2 Role of Economics – What is the role of Economics in Business? Costs, prices, output, compensation, strategic behavior, importantly, ethics The Big Picture- Whose job? The BIG Picture Product Market FirmsHouseholds Factor Market Income spent Goods demand Inputs supplied Income earned Inputs demand Factor costs Goods supplied Revenue earned Economic theory forms the basis for different management areas such as accounts, finance, marketing, systems and operations. A manager has to deal with problems pertaining to the individual firm as well as domestic and global environment. • Microeconomics: Deals with individual unit • Macroeconomics: Deals with aggregates Microeconomics: Theory of demand and supply- consumer behavior, demand theory, demand forecasting and factors affecting individual and market supply- Helps in choice of commodities for production Theory of Production: Production function and laws of returns to scale etc- gives an idea about I/O relations, input requirement size of firm, technology choice of output. Helps producer to plan production, cost and budget. Market Analysis: helps understand degrees of competition, pricing-output decisions, price discrimination, monopoly power, and advertising
  3. 3. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 3 Profit Analysis: Provides logical analysis of break-even point, emergence of profits, profit- maximizing output, dealing with risk and uncertainty Theory of capital: Along with quantitative techniques enables investors to calculate cost of capital, efficiency of capital, efficient allocation of capital, and choice of projects as per risk- return analysis Behavior of macroeconomic indicators: GDP, GNP, GDCF, GDS, HDI etc. Business Cycles – Inflation- Employment Fiscal Policy Monetary Policy Foreign Trade: Imports and exports, Exchange rate, trade policies and capital flows Macro economics: How variables and policies impact business? Role of Economics in Business: • Economics is a tool, means to an end • To help Efficient allocation and achieve business objectives • Optimizing behavior- Maximize goals, minimize costs under constraint Logic, tools and techniques of economics to analyze business problems, evaluate business options and opportunities with a view to arriving at an appropriate business decision. • 3 main contributions of economic theory to business economics, according to Baumol: o Analytical models: To recognize the structure of managerial problems, eliminate minor details, and concentrate on main issue o Ascertaining relevant variables and specifying the data - Even if the models are not directly applicable, they enhance capabilities of business analyst o Economic theories offer conceptual clarity to avoid conceptual pitfalls Provides consistency to business analysis Role of Managerial Economist: A. To decide • What to produce? • Where? • How? • How much? • Allocation of resources? • For whom to produce? • At what price to sell? B. Plan and control business operations- • Cost minimization • Profit maximization • Managing competition • Economic intelligence • Market research C. Uncertainty & Risk management
  4. 4. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 4 • Forecast change in environment and policies- domestic and international • To manage change in global scenario • Everything comes at a price- quality is not free Growing Challenges to the Managerial Economist: • Globalization - People-goods-services- communication- Finance- Ideas o Global corporations o Research & production facilities across countries o Global markets o Global Finance o Employment Diversity o Global work culture o Resource base: Crossing boundaries o Global management practices o Outsourcing o Increased competition o Increased Opportunity o Tastes converging internationally? o Customizing to local tastes o Not merely exporters, but need to be insiders in major markets • Computerization and Technology o Easier model-building and simulation o Quick and complicated data analysis o Rapid spread of information o Internet changing both buyers and sellers o Videoconferencing- saving cost and time o Paperless administration o Speed of dispatch, lower inventories, less waste • Dismantling of Traditional Hierarchies o Information today can be transmitted directly from top management to workers o Middle managers are today increasingly being used to shelter top management from day-to-day activities • Changing Basis for Value Creation o Peter Drucker: World is moving from “economy of goods” to an “economy of knowledge” o Creation of value increasingly based on knowledge and communications and not natural resources and physical labour • Bridging the gap between theory and Practice : o Real world is complex, “chaotic”, interdependent as against simplifying economic assumptions o Not tailor-made solutions but a framework of logical thinking
  5. 5. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 5 • The Global business Leader has to Imbibe and inculcate essential qualities such as o Global outlook o Managing diversities o Flexibility with efficiency o Long-term goals with steps and migration path o Speed and stamina for transformation • Essentially, 3 sets of skills: o Human- understand, work with and motivate with other people as individuals as well as groups o Technical- Ability to use tools, techniques and processes that are specific to the field o Conceptual-Ability to analyze complex situations and respond effectively to challenges SCOPE OF MANAGERIAL ECONOMICS - • Demand analysis and forecasting • Cost analysis • Production and supply analysis • Pricing decisions, policies and practices • Profit management, and Capital management CHARACTERISTICS AND SIGNIFICANCE OF MANAGERIAL ECONOMICS – • Managerial economics is micro-economic in character • Uses broadly theory of the firm concepts • Also seeks to apply profit theory which forms part of distribution theories • Is pragmatic as it avoids difficult abstract issues of economic theory. • But involves dealing with real life complications of business world • Belongs to normative economics rather than positive economics. It is prescriptive rather than descriptive. It involves judgment as to what is good/bad for business. Managerial economics deals with which decision needs to be made on the basis of its merits and demerits. Economic theory does not go into judging decisions. Managerial economics tells what the aims and objectives of a firm should be. Then it tells how best these can be achieved • Managerial economics is therefore described as ‘normative micro-economics of the firm’ • Macro-economics is also useful to managerial economics as it provides an intelligent understanding of the environment in which the business must operate.
  7. 7. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 7 UNIT 2 - FUNDAMENTAL CONCEPTS a. INCREMENTAL REASONING b. MARGINAL ANALYSIS c. EQUIMARGINAL UTILITY d. TIME PERSPECTIVE e. CONSUMER SURPLUS f. OPPORTUNITY COST g. TIME VALUE OF MONEY h. THEORIES OF FIRM – • MANAGERIAL THEORIES – BAUMOL AND WILLIAMSON • BEHAVIORAL THEORIES – SIMON, CYRET AND MARCH INCREMENTAL REASONING - A Guide to Economic Reasoning - Economic reasoning is making decisions by comparing costs and benefits. Incremental reasoning is used in accepting or rejecting a business proposition or option. Whenever a manager takes a decision he asks the question – “Is it worthwhile?” - The implicit criterion is that incremental benefit should exceed its incremental costs. Decision or action is worthwhile already if the decision maker or the firm can expect to be better off than before. Original reasoning forces the manager to examine the changes in total revenues and total costs resulting for changes in production, sales, price and related decisions. Wrong decisions may follow if the focus is on the concept of average than on marginal analysis. 2 basics components of I.R are – Incremental Cost Incremental Revenue MARGINAL ANALYSIS – o Marginal Costs and Marginal Benefits o The relevant costs and benefits are the expected incremental, or additional, costs incurred and the expected incremental benefits of a decision. o Economist use the term marginal when referring to additional or incremental. o Marginal cost – the additional cost to you over and above the costs you have already incurred. This means not counting sunk costs – costs that have already been incurred and cannot be recovered. o Marginal benefit – the additional benefit above and beyond what you’ve already accrued. o According to the economics decision rule: If the relevant benefits of doing something exceed the relevant costs, do it.
  8. 8. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE If the relevant costs of doing something exceed the relevant benefits, don’t Rs. Invested (Rs’0000) Π A (Profit) (Rs’000) Π B (Profit) (Rs’000 1 9 2 17 3 24 4 30 5 35 6 39 7 42 8 44 9 45 10 45 Utility Approach to Consumer Behavior · Need for cardinal measure of utility · analysis is useful for explaining behavior · Total and Marginal utility · “law of diminishing Marginal Utility” · Equimarginal rule and utility maximization Nature of Total Utility - M.S , D.A.V.V, INDORE If the relevant costs of doing something exceed the relevant benefits, don’t do it. (Profit) (Rs’000) Δ A Δ B selection 4 - - A 8 8 4 A 12 7 4 A 16 6 4 A 20 5 4 A 24 4 4 A/B 28 3 4 B 32 2 4 B 36 1 4 B 40 0 4 B Utility Approach to Consumer Behavior - Need for cardinal measure of utility ysis is useful for explaining behavior Total and Marginal utility “law of diminishing Marginal Utility” Equimarginal rule and utility maximization Page 8 If the relevant costs of doing something exceed the relevant benefits,
  9. 9. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 9 · When more and more units of a good are consumed in a specific time period, the utility derived tends to increase at a decreasing rate · Eventually, some maximum utility is derived and additional units cause total utility to diminish. As an example, think of eating “free” hot cakes. · It is possible for total utility to initially increase at an increasing rate. Marginal Utility – · Marginal utility [MU] is the change in total utility associated with a 1 unit change in consumption. · As total utility increases at a decreasing rate, MU declines. · As total utility declines, MU is negative · When TU is a maximum, MU is 0 [This is sometimes called the “Satiation point” or the point of “absolute diminishing utility.” Marginal Utility [MU] is the change in total utility [∆TU] caused by a one unit change in quantity [∆Q] ; MU = ∆∆∆∆TU ∆Q Utility Q 1 2 4 8 5 6 7 3 TU 30 55 75 90 100 105 105 100 MU The first unit consumed increases TU by 30. . Remember that the MU is associated with the midpoint between the units as each additional unit is added. 30 .25 ∆Q The 2cd unit increases TU by 25. 25 . 20 . 15 10 . 5 0 -5 1 2 3 4 5 6 7 Q/ut 10 20 30 MU . .. MU Fall ‘ 97 Principles of Microeconomics Slide -- 9 1 2 3 4 5 6 7 Q/ut 20 40 60 100 80 120 TU TU 1 2 3 4 5 6 7 Q/ut 10 20 30 MU The MU is the slope of TU or the rate of change in TU associated with a one unit change in quantity. [Using calculus, MU is the change in TU as change in quantity approaches 0.] The first unit consumed, ∆Q increases TU by 30, ∆TU. ∆Q . . . . . . . . ∆TU For the first unit: ∆TU ∆Q MU = = 1 30 The slope of TU is = 30, ∆Q ∆TU . The second unit changes TU [ ∆TU] by 25, The slope of TU between the 1 and second unit is 25. . between the 2cd and 3rd units ∆TU = 20 or the slope of TU is 20. . . . . . . MU MU is the slope of the TU. Where MU = 0, TU is a maximum. max TU
  10. 10. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 10 Consumer Preferences – · Both MU and TU are determined by the “preferences” or utility function of the individual and the quantity consumed. · Utility cannot be measured directly but individual choices reveal information about the individual’s preferences · Surrogate variables [age, gender, ethnic background, religion, etc.] may be correlated with preferences. · There is a tendency for TU to increase at a decreasing rate [MU declines] as more of a good is consumed in a given time period: i.e. “diminishing marginal utility” Diminishing Marginal Utility – · Initially, it may be possible for TU to increase at an increasing rate. In which case MU will increase [MU is the slope of TU which is increasing]. · Eventually, as more and more of a good are consumed in a given time period, TU continues to increase but at a decreasing rate; MU decreases. · This is called the point of “diminishing marginal utility.” Law of Diminishing MU – Notes about the Law of Diminishing MU o Time period must be specified for law. o Law tells us that eventually the marginal utility curve will be downward sloping. o Law tells us that eventually the total utility curve will become “flatter.” o Slope of the total utility curve is equal to marginal utility Shape of MU – Eventually downward sloping Law of diminishing marginal utility • Positive always Rational behavior • Consumer only purchases a good if they get some positive utility from it. Consumer Choices – · If there were no costs associated with choices, the individual will consume a good until MU = 0 [this maximizes TU or the total benefits, TB] · Typically, individuals are constrained by a budget [or income] and the prices they pay for the goods they consume. · Net benefits are maximized where MB = MC; as long as the MU or MB of the next unit of good purchased exceeds the Price or MC, it will increase net benefits
  11. 11. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 11 Society and Individual – · The individual will purchase more of a good so long as their perceived or anticipated MB exceeds the price they must pay for the good: Buy so long as MB > P, optimum where, P = MB · From a social perspective that good should only be produced and sold if the price is greater than or equal to the MC: Sell so long as P > MC, optimum where P = MC · Social optimum when MB = P = MC LAW OF EQUI-MARGINAL UTILITY – o The Law of Equi-marginal utility is the further elaboration of the Law of diminishing marginal utility. o It is also known as the Law of Substitution and the Law of maximization of satisfaction. o “The households maximizing the utility will so allocate the expenditure between commodities that the utility of the last penny spent on each item is equal.” o Formula for Consumer’s equilibrium… MU(A)/P(A) = MU(B)/P(B) = ….= MU(N)/P(N) o Assumptions: Utilities are independent Marginal utility of money remains constant. Utility is cardinal. Consumer is rational. o Limitations.. Utility is immeasurable. Indivisible goods Prices and tastes are changing. Time Factor.
  12. 12. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 12 CONSUMER SURPLUS - Fall ‘ 97 Principles of Microeconomics Slide -- 31 1 2 3 4 5 6 7 QX/ut PX 1 2 3 4 5 6 7 Notice that someone is willing and able to pay $6.80 for the first unit. 6.80 If the market price [established by S and D] were $3, the buyer would purchase at $3 even though they were willing to pay $6.80 for the first unit. They receive utility that they did not have to pay for [6.80-3.00]. This is called consumer surplus. At market equilibrium, .Consumer surplus will be the area above the market price and below the demand function. consumer surplus CONSUMER SURPLUS OPPORTUNITY COST- o The Opportunity cost of the chosen activity is the value of the next-best alternative to the activity you have chosen. o Opportunity cost is the basis of cost/benefit economic reasoning. o In economic reasoning, opportunity cost must be less than the benefit of what you have chosen. TIME VALUE OF MONEY - Present value (PV) of an amount (FV) to be received at the end of “n” periods when the per- period interest rate is “i”: ( ) PV FV i n= +1
  13. 13. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 13 THEORIES OF FIRM – o Sales Maximization Model – William Baumol According to the sales-maximization model introduced by William Baumol and others, managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy stockholders. Baumol argued that a larger firm may feel more secure, may be able to get better deals in the purchase of inputs and lower rates in borrowing money, and may have a better image with consumers, employees, and suppliers. Indeed, some early empirical studies found a strong correlation between executives’ salaries and sales, but not between salaries and profits. More recent studies, however, found the opposite. o Williamson’s Model of Managerial Discretion – The managerial theory of firm developed by Oliver E. Williamson states that managers apply discretion in making and implementing policies to maximize their own utility rather than trying for the maximization of profit which ultimately maximizes the utility of owner shareholders. This is known as the management utility maximization. It postulates that with the advent of the modern corporation and the resulting separation of management from ownership, managers are more interested in maximizing their utility, measured in terms their compensation (salaries, fringe benefits, stock options, etc.), the size of their staff, the extent of control over the corporation, lavish offices, etc., than in maximizing corporate profits. This is referred to as the principal-agent problem. That is, the agent (manager) may be more interested in maximizing his or her benefits than maximizing the principal’s (the owner’s) interest. o Theory of Satisfying - Simon The advocates of satisficing theory say that firm’s goal should be satisficing rather than optimizing. Satisfying means acceptance of less than the best. They argue that the behavior of real-world managers is not always consistent with the profit-maximization goal. Because of the great complexity of running the large modern corporation – a task often complicated by uncertainty and a lack of adequate data – managers are not able to maximize profits but can only strive for some satisfactory goal in terms of sales, profits, growth, market share, and so on. Simon called this satisficing behavior. That is, the large corporation is a satisficing, rather than a maximizing organization. o Cyert and March’s Behavioral Theory Cyert and March opined that a large-scale corporate type of firm exists these days. Hence, entrepreneur cannot alone be a decision maker. The decision- making involves a complex group or organization. It consists of various individuals whose interest may conflict with each other.
  14. 14. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 14 The group is called ‘organizational coalition’ and includes managers, stockholders, workers, consumers and so on. All of these individuals participate in setting the goals of an organization. Unlike conventional theory of single goal, behavioral theory states that an organization has multiple goals. The real world firm generally possesses the following five goals: • Production Goal: According to this goal, production should not fluctuate too much nor fall below an acceptable level. Because this ensures stable employment, maintenance of adequate cost performance and growth, the workers and those in production department have this goal. • Inventory Goal: This goal originates mainly from the inventory department, or from the sales and production departments. The sales department needs enough stock of output for the customers, while the production department requires adequate stocks of raw materials and other items necessary for a uniform flow of the output. • Sales Goal: The sales goal is simply an aspiration with respect to the level of sales. Particularly, this goal arises from salesmen, since their success depends on their ability to maintain or expand the sales. • Market-share Goal: This goal is an alternative to the sales goal and arises from the sales department. This department decides on the advertising campaigns, the market research programmes, and so on. • Profit Goal: This goal is set by the top management in order to satisfy the demands of shareholders and the expectations of bankers; and also to generate funds with which they can achieve their own goals and projects, or satisfy the other goals of the firm. While making decisions, firms are guided by these five goals. The conflict among different goals may come up. For example, sales goal may require a lower price whereas the profit goal a higher price. Sales and production goal may require high inventories whereas profit goal may require low inventories. Such conflicts among coalition members are resolved within the firm as a result of persuasion and accommodation of each other’s viewpoint. The firm in the behavioral theories seeks to satisfice overall performance, rather than maximize profits, sales or other magnitudes. The firm is a satisficing organization rather than a maximizing entrepreneur. The top management, accountable for the coordination of the activities of the various members of the firm, want: • to attain a ‘satisfactory’ level of production, • to attain a ‘satisfactory’ share of the market, • to earn a ‘satisfactory’ level of profit • to divert a ‘satisfactory’ percentage of their total receipts to research and development or to advertising,
  15. 15. P.S CHANDIRAMANI @ I.M.S , D.A.V.V, INDORE Page 15 • to acquire a ‘satisfactory’ public image, and so on. But, it is not clear in the behavioral theories what is a satisfactory and what an unsatisfactory attainment is. Means for the Resolution of Conflicts: • The top management uses different methods to resolve the conflicts within the firm. The means for the resolution of conflicts are: o delegation of authority, o budget determination, o monetary payments like wages, salary and dividend, o side payment given to the scientist of research department in addition to regular salary, o slack payments – it is defined as payments to the various groups of the coalition above than the payments required for efficient working of the firm. o fulfilling demand according priority, o decentralization of decision-making.