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Session 1: 22.09.2021
The fundamentals of managerial economics
A review of concepts from macroeconomics and microeconomics, but not a perfect review because this
review is oriented towards the obtaining of specific final aims —> to maximize profits (π).
Macroeconomics and microeconomics are related and linked through economic policy.
Macroeconomics studies the economy from an aggregate point of view, is the study of the economy as a
whole, the overall economic system, because we have different factors, different actors, different markets.
Microeconomics looks at individual choice, that can be the consumer or the producer.
Managerial economics takes concepts from both these disciplines.
For the manager it’s important to understand how the market works, so at the macro level, but also what
are tastes and preferences of individuals, in order to take managerial decisions; managerial decisions
which are strategies to obtain the final aim of maximum profit. Behind this maximum profit there is for
instance efficiency and the reduction of costs.
The manager is the person in charge of all these decisions, here he’s, our actor. We will study the
managerial behavior based on the concept that we take from economics.
What is economics: is a social science with the aim of understanding how to drive production and
consumption of goods. Economics gives us insights on how to allocate the resources to obtain the
maximum profit, resources that are scarce, so we also need to minimize our effort to use these resources,
to be the most efficient as possible.
Economics (study the behavior of a manager from an economic point of view) of Effective (the right
strategy is driven by efficiency, trying to minimize the cost of production, to produce at the minimum cost
possible, so we can maximize our profit) Management.
Identifying goals and constraints: goal is for instance in terms of production, of sustainability, of
productivity (you are productive when our inputs are used in the most efficient way). At the aggregate
level, productivity is given by GDP divided by the number of workers, so how much each worker produces
or contributes to the production of GDP.
As for constraints, we have costs, government constraints in terms of quantity produced, of pollution, of
environmental sustainability, for certain kind of goods and services there might be price floors or price
ceilings, these are constraints of the government for specific goods and services, so maximum and/or
minimum prices, because for certain kind of goods it is necessary an exogenous intervention, so from the
outside by the government to avoid a relatively increase in prices and/or to avoid that prices reduce a lot.
Other governments constraints are taxes for some specific emissions. We have then competition, with
other industries in the market.
Recognize the nature and importance of profits: we will see that there is specific definition of profits, and
it is important for a manager to correctly account for profits. Based on the cost considered, we will have
specific and different definitions of profit and we will see what is the most important that must be
considered when deciding how much to produce.
Understand incentives: we might have for example incentives to produce environmentally friendly goods
or services, incentives for employees (so to fix some goals for employees and, at the end of the year, to
give them incentives if these objectives are obtained, it’s a form of motivation for employees).
Understand markets: in every market there is a demand and a supply side so, at the aggregate level,
understanding markets means understanding the interaction between demand and supply sides, so how
they work and what are the characteristics and the final point for a market is the equilibrium. In general, if
we want to describe how a market works, we need to keep in mind this:
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In each market we have then the equilibrium point, the intersection between demand and supply, meaning
demand and supply interact, finding, in the end, only one point in which demand equals supply; only in this
point, we have the equilibrium and at this point we find the equilibrium quantity and price, only in this
Recognize the time value of money: there is a time gap between the moment in which the cost is borne
and the moment in which revenue is received. So, we need to evaluate this specific time gap.
Use marginal analysis: marginal analysis is a way in which we see if we can increase or not our benefits by
increasing our production, increase or not our costs by changing our production, so what are the reactions
of costs and benefits to changes in output produced.
We will compare marginal benefit and marginal cost which are related to specific goods and services, and
we will see if we need to undertake a thumbs up or thumbs down decision, because for a manager, an
important decision is also whether to produce within the firm or to externalize phases and components of
the production.
Managerial economics is a valuable tool for analyzing many business situations and to compare benefits
and costs of taking specific decisions.
Then, it is important to correctly define and account for profits and costs.
In general, profits (π) are defined as total revenues (benefits) minus total costs.
The manager
We have an individual, a person who directs resources to achieve a stated goal.
Resources (labor and capital, and then also the role of technology) are a synonym of inputs.
For labor we have employees and the labor of the manager.
Capital is financial and monetary resources, but also equipment, machinery, and buildings.
Technology helps to improve, at the end, the efficiency in the use of inputs and also for workers and
affects the production process.
Important for a manager: responsibility for her/his own actions as well as for actions of individuals,
machines and/or inputs under the manager’s control. It is the attitude of the manager to control inputs as
well as the actions of individuals that can be employees and/or stakeholders.
The manager directs the efforts of others, organizing, controlling and a way of improving the direction of
these efforts is to motivate and give incentives.
The manager purchases inputs used in the production of the firm’s output, and they have to decide
whether to produce everything within the company or to externalize some production phases or to buy
some intermediate goods from outside.
The manager directs the product price or quality decisions; based on the type of production, it is
important to look at the level of standardization, the more the production is standardized, the more the
manager will aim at producing relatively high quantities, despite of the price, because there are more
producers, a high competition, you cannot focus on the price. On the other hand, if the production is
specialized, we have few firms that produce this good or service so we can adopt price strategies, with a
relatively high price, because we know that only few other competitors are able to do the same.
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The science of making decisions in the presence of scarce resources.
– Resources are anything used to produce a good or service or achieve a goal.
– Decisions are important because scarcity implies trade-offs.
Decisions regarding whether to produce or not, whether to produce within the firm or not (externalize or
not), decisions on the quantity, how much to produce (standardization), decisions on the introduction of a
new line of production and decisions regarding whether to differentiate or not.
Managerial economics
The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Manager of a Fortune 500 company ( that makes computer:
Fortune 500 is a list comprehending the firms with a relatively high level of revenues, so the most
profitable and competitive ones.
The top 10 firms with business success in terms of revenues in the current year; at the top 3 positions we
have Walmart, Amazon, and Apple. Then we have health companies.
So, here we can see the most successful companies in terms of managerial decisions; remember that the
aim of a manager is to maximize profits.
– Should the company purchase components – like disk drives and chips – from other manufacturers or
produce them within the firm? One of the first decisions regards deciding on whether to externalize
production or to produce within the firm or to buy some intermediate goods form outside, from other
– Should the firm specialize in making one type of computer or produce several different types? Then we
have differentiation issues and strategies: usually you start with one product or service, then you start to
differentiate. Having different lines of production enhance the opportunity to increase out market power,
reaching a relatively high number of consumers and interacting with number of producers. All these
decisions undertake costs, so they will more likely concern big firms, with a certain number of employees.
– How many computers should the firm produce, and at what price should you sell them? Another decision
concerns the quantity produced and the relative price (optimal quantity and price).
– How many employees? What about their productivity? Then, the number of employees, this is the issue
related to the input, which, in this case, is labor and productivity, so how much of the revenues are
produced by each employee, the contribution of each employee to the total revenue.
The nature and importance of profits
A typical firm’s objective it to maximize profits. π = TR - TC
• Accounting profit: total amount of money taken in from sales (total revenue) minus the dollar cost of
producing goods or services (total revenues - total costs borne).
• Economic profit: the difference between total revenue and total opportunity cost (total revenues - total
opportunity cost).
• Opportunity cost: the cost of the explicit and implicit resources that are forgone when a decision is
made. Total opportunity cost (explicit + implicit cost) > total cost (explicit cost).
• Explicit cost is what we pay, implicit cost is the cost of the alternative that I gave up.
Accounting profits overstate economic profits because the costs include only accounting costs.
Session 2: 23.09.2021
The role of profits
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Profit principle: profits are a signal to resource holders where resources are most highly valued by society.
By moving scarce resources toward the production of goods most valued by society, the total welfare of
society is improved.
Adam Smith’s classic line from An Inquiry into the Nature and Causes of the Wealth of Nations (1776).
Maximizing profits is the final goal of the manager.
GDP is the most important indicator of the wealth of nations, and in terms of individuals, we have income
and households’ income. The sum of income of individuals produces the wealth of nations. The average
level of income reduced due to the recent and current recession. In the past, Adam Smith started to define
the wealth and he looked at the profit for firms.
Each actor of the economy has its own wealth.
Profits: if the firm or the manager (so the principal agent of the firm) makes profit we have a signal of
wealth generally, but more strictly in terms of economics, the profits are a signal to resource holders
where resources are most highly valued by society. This means that the resources are efficiently used.
It’s important to allocate the resources where they must and can be more highly valued, so it’s important
the production site, this is what Adam Smith said.
Five forces and industry profitability (Porter, 1980)
This is an important scheme to analyze profitability, how an industry or each firm in the industry is able to
create profits; this implies the interaction of different actors, issues, and economic indicators.
We use the 5 forces in different contexts; here we see them in terms of profitability, in order to understand
how the manager can increase and make his or her firm more attractive in terms of profitability.
The final aim is to obtain profits, growth and also to sustain and maintain profits over a longer period of
Entry: the entry of other firms. Entry cost is the synonym of barriers to entry, for instance, relatively high
entry costs for sectors producing not standardized goods, also capital requirements, buildings, legal costs,
labor, land, regulation from authorities. The higher the entry cost, the less fragmented and more
concentrated the market will be.
Speed of adjustment: capacity of the employer and the firm to adapt to the market functioning.
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Sunk costs: they can’t be recovered, once borne, they are lost, for instance marketing costs like
advertising, machinery, equipment, rent for buildings.
Economies of scale: the capacity of the firm to increase the output produced by increasing the level of
inputs (workers, machines, investments) which affects the level of output produced.
Association/relation/correlation between change in the input used and the change in the output/volume
produced. We can have three different kinds of economies of scale: constant/proportional economies of
scale (1:1 relation, if I increase the input by 1 unit, I will have a unitary increase in the output produced), less
than proportional economies of scale (if I increase of 1 unit my input, there will be an increase in output
less/lower than 1), more than proportional economies of scale (increase of 1 unit of input, increase in
output of more than 1).
Network effects: if there is the chance of networking with other firms in a specific sector or with firms
abroad, I will have the opportunity of increasing my efficiency. So, if and how the firm has the opportunity
of networking and having relations with firms in the same sector in the same country or also abroad.
Reputation: if there is a well-known brand, there is associated an important reputation. Also, sustainability
is playing a more and more important role in the reputation of a company.
Switching costs: we need to be able, as a manager, to evaluate and calculate the cost of switching the
production to a new good or service, this pertains to the differentiation strategy. This affects decisions on
entering the market because the opportunity and possibility to differentiate may increase my market
power and profitability at the end.
Government restraints: we have different restraints, like taxes, restraints on quantity to be produced,
permits, requirements in terms of environment.
Power of Input Suppliers: here we talk about the market power of suppliers, a synonym of supplier is
provider. Market power affects the possibility of suppliers of making prices, so the level of prices, which
ultimately affects the final aim of the firm, so the profits.
Supplier concentration: few suppliers which detains all the market power; higher concentration, higher
power of obtaining relatively high prices, therefore relatively high profits. If I have a high market power, in
terms of competition, there is not a high competition, we have a low competition (think about the extreme
case of monopoly), which means that there are only few competitors and there are also few substitutes.
On the other side, if we have a high fragmentation (opposite of high concentration), in terms of a market,
we have a lot of competition and a lot of firms, low market power and prices relatively low, which means
relatively low profits. The opposite of monopoly, in this case, we have the presence of close substitutes,
goods or services, produced by other firms for example at lower prices, so the price will become lower and
lower and the profit as well.
Price/productivity of alternative inputs: the presence or not of alternative substitutes, this is important
especially if there is fragmentation, this erodes my profit.
Relationship-specific investments: this is more associated with concentration.
Supplier switching costs: this is also associated with concentration or fragmentation, they depend also on
the type of goods produced, if they are standardized or not (standardized associated with fragmentation,
not standardized associated with concentration).
Government’s restraints: for the supplier, the exogenous intervention of the government attains to
quantity, taxes, prices because for certain goods/services there is the risk that the price becomes too low
(price floor) or too high (price ceiling).
Power of Buyers: here we have the market power of consumers.
Similar to the case of suppliers, industry profits tend to be lower when customers or buyers have the power
to negotiate favorable terms for the products or services produced in the industry. In most consumer
markets, buyers are fragmented and thus buyer concentration is low. Buyer concentration and customer
power tend to be higher in industries that serve relatively few “high-volume” customers. Buyer power
tends to be lower in industries where the cost to customers of switching to other products is high as is
often the case when there is imperfect information that leads to costly consumer search or few close
substitutes for the product. Government regulations, like price floors or price ceilings, can also impact the
ability of buyers to obtain more favorable terms.
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Industry Rivalry/Competition: positively associated and related to sustainability, we have high
competition if the market is fragmented with relatively low prices and low profits. This means that the
mark-up (the possibility/opportunity to charge costs and obtain relatively high price rates) is close to 0 (it is
0 in a perfectly competitive market). On the other side, if we have a low competition, we will have more
concentration and high prices with relatively high profits, the mark-up will be close to 1 (1 with monopoly).
0 and 1 are of course the two extreme situations, what happens in reality is in-between these two
Degree of differentiation: it affects prices and also differentiation in terms of possibility of entering in a
new line of production.
Switching costs are higher the more the industry is concentrated.
Timing of decisions: decisions like entering in a new market, producing a new good or service. It is
important the timing because who comes first has its own advantages. Then, if other industries enter the
market, there would be a reduction of the profits of the first firm.
Information: it is important to have a perfect information and a timing information, because in order to
take optimal decisions, I need to be informed, I need to study the data available.
Government restraints: exogenous intervention that might limit the quantity, the price and for certain
sectors give a range and limit for the number of firms.
Substitutes and Complements
Substitutes: Goods or services that have the same utility of goods and services that I produce. The
presence of close substitutes is important. The more the market is fragmented the more likely is the
presence of close substitutes.
Complements: goods or services that can be used only together and in fixed proportions, if these 2
conditions are satisfied, this gives utility to the users of this good/service.
The presence of substitutes and complements affects the profitability because if we know that other firms
are producing goods that give the same utility, we have a relatively low opportunity of making profits
because we need to keep our prices under control. For complements, we need to follow markets of
complementary goods and need to adjust prices and quantities.
Network effects: it is associated with the concept of information and also in terms of prices. So, if we know
the existence of substitutes or complements, we need to readapt and rearrange our strategies.
Government restraints: the government exogenously fix quantity or price of something, reduce the
presence of substitutes and at the end reduces the competition
The level and sustainability of industry profits also depend on the price and value of interrelated products
and services. Porter’s original five forces framework emphasized that the presence of close substitutes
erodes industry profitability. Government policies, such as restrictions limiting the importation of goods,
can directly impact the availability of substitutes and thus industry profits.
More recent work by economists and business strategists emphasizes that complementarities also affect
industry profitability. It is therefore important to quantify these complementarities or “synergies” and
identify strategies to create and exploit complementarities and network effects.
It is therefore important to recognize that the many forces that impact the level and sustainability of
industry profits are interrelated.
For instance, the U.S. automobile industry suffered a sharp decline in industry profitability during the 1970s
as a result of sharp increases in the price of gasoline (a complement to automobiles).
This change in the price of a complementary product enabled Japanese automakers to enter the U.S.
market through a differentiation strategy of marketing their fuel-efficient cars, which sold like hotcakes
compared to the gas-guzzlers American automakers produced at that time. These events, in turn, had a
profound impact on industry rivalry in the automotive industry, not just in the U.S., but worldwide.
It is also important to stress that the five forces framework is primarily a tool for helping managers see the
“big picture”; it is a schematic you can use to organize various industry conditions that affect industry
profitability and assess the efficacy of alternative business strategies. However, it would be a mistake to
view it as a comprehensive list of all factors that affect industry profitability.
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The five forces framework is not a substitute for understanding the economic principles that underlie
sound business decisions.
Understand incentives
The manager needs to decide whether to give incentives or not and also the quantity ad frequency of such
• Changes in profits provide an incentive to how resource holders use their resources.
• Within a firm, incentives impact how resources are used and how hard workers work.
One role of a manager is to construct incentives (bonuses, commissions based on revenue and/or
profitability) to induce maximal effort from employees.
Incentives correlated to the quantity produced, specific objectives for employees (monetary incentives),
there will be also fidelizaotion between worker and manager, a relationship based on the fact that the
worker is more motivated, relationship that lasts in the medium and long run and the manager invests in
this worker, there is a bilateral relation, common in companies that produce non standardized goods.
Understand markets
Two sides to every market transaction: buyer and seller, and it is important the bargaining position of
consumers and producers.
Bargaining position: in each market, we can have different level and kind of competition and rivalry, and
this is associated with the bargaining power of producers and consumers. We can have 3 types of
competition or rivalry:
Consumer - producer: it’s a matter of relative bargaining power; if the bargaining power of consumer is
higher than the one of the producers, the producer sells at relatively lower prices.
If a producer decides to increase prices with respect to the average level, considered relatively low, there
won’t be any consumer available. On the other side, is when the bargaining power of consumer is lower
than the bargaining power of producer, in this case the prices will be high.
If the availability to buy or to pay of the consumer, is relatively low, they will be excluded from this market.
Consumer - consumer: if there is scarcity of goods, we have high prices. If the good is highly available, we
have low prices.
Producer - producer: prices go down due to competition, wins the price closest to the availability to pay
for consumers. At the end, the more efficient producers (relatively low costs) remain in the market.
The other important intervention in the market comes from government, which can affect the functioning
of the market in different and various ways, for example, limits on quantities produced, price floors or price
ceilings, taxes, issues related to the environment (sustainability).
The time value of money
Often a gap exists between the time when costs are borne, and benefits received.
Managers can use present value analysis to properly account for the timing of receipts and expenditures.
Assume I’m going to buy inputs today, so costs, but the revenue from such inputs will come back later in
time. For this reason, I need to be able to calculate the future value and then, at the future value, discount
the cost of time. So, there is a time gap and the easy tool that allows us to take into account the cost of
time (cost of waiting) is the present value analysis, simple technique that allows us to have an unbiased
evaluation of our assets and flow of money.
Present value analysis
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Present value of a single future value: the amount that would have to be invested today at the prevailing
interest rate to generate the given future value:
Present value reflects the difference between the future value and the
opportunity cost of waiting:
Present value is the amount that I can receive today from an investment that, after a certain period of
time, depending on the duration of the investment, will have a certain future value.
Two things are important here: the interest rate (the cost of time) and the fact that the interest rate is also
defined as the opportunity cost of waiting, because it gives value to the time and instead of doing an
investment and having such money, I can do something else.
Waiting is a cost, and it is important here the interest rate and the time.
- Future value: money that I will obtain in the future from an investment
- Cost: is the interest (i), so the opportunity cost of waiting
- Present value: is the future value divided/discounted by (1 + i) to the power of n, which is the time
period, the duration of the investment. It’s like an actualization.
Present value of a stream of future values:
This is the same but with the extended formula.
This is the compacted formula.
The time value of money in action
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Consider a project that returns the following
income stream:
Net present value
Present value of indefinitely lived assets
This is applied to a time period that goes to the
Perpetuity —> an investment for all lifelong.
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