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Managerial Economics
Economy. . .
. . . The word economy comes from a
Greek word Oikonomos which means
“one who manages a household.”
Economics is the study of how society
manages its scarce resources.
Microeconomics and Macroeconomics
• Microeconomics focuses on the individual parts
of the economy.
– How households and firms make decisions and
how they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
– Economy-wide phenomena, including inflation,
unemployment, and economic growth
The Diverse Fields of Economics
Examples of microeconomic and macroeconomic concerns
Microeconomics
Macroeconomics
Production
Prices
Income
Employment
Production/Output
in Individual
Industries and
Businesses
Price of Individual
Goods and Services
Distribution of
Income and Wealth
How much steel
How many offices
How many cars
Price of medical
care
Price of gasoline
Food prices
Apartment rents
Wages in the auto
industry
Minimum wages
Executive salaries
Poverty
Employment by
Individual
Businesses &
Industries
Jobs in the steel
industry
Number of
employees in a firm
National
Production/Output
Aggregate Price
Level
National Income
Total wages and
salaries
Employment and
Unemployment in
the Economy
Total Industrial
Output
Gross Domestic
Product
Growth of Output
Consumer prices
Producer Prices
Rate of Inflation
Total corporate
profits
Total number of
jobs
Unemployment
rate
POSITIVE
VERSUSare
NORMATIVE
• Positive statements
statements thatANALYSIS
attempt to describe
the world as it is. Positive economics studies economic
behavior without making judgments. It describes what exists
and how it works.
– Called descriptive analysis
• Normative statements are statements about how the world
should be. Normative economics, also called policy
economics, analyzes outcomes of economic behavior,
evaluates them as good or bad, and may prescribe courses of
action.
– Called prescriptive analysis
POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
?
– An increase in the minimum wage will cause a
decrease in employment among the least-skilled.
POSITIVE
?
– Higher federal budget deficits will cause interest
rates to increase.
POSITIVE
?
Fundamental Economic Problem
• There are three fundamental economic problems for every human
society. It is immaterial whether it is centrally planned, mixed or
advanced industrial society.
• They are what commodities are produced, how these goods are
made and for whom they are produced.
• What: Whether produce one good more and other less.
• How: how goods are produced; choice of technologies; division of
labor who will do what.
• For whom: for whom are goods produced? Distribution of products
among household; what pattern it takes; where the income goes.
Economic System
• Market, Command and Mixed System
– We have indicated three fundamental problems in the previous
section. One can solve those problems in different way. It is a
question of organization that what, how and for whom can be
dealt with. The three available systems try to address those
problems under their respective market system.
– A market economy is one in which individuals private firms
market the major decisions about production and consumption.
A system of prices, market, of profits and losses, of incentives
and rewards determines what, how and for whom. In extreme
case the economy is seen practicing laissez-faire which means
non-interference from the government side in economic
decision making.
Economic System
• In a command economy the extreme opposite happens
where the government takes all decision about the
economy.
• Mixed economy consists of the elements of command
and market. Most prevalent one.
• Society can not have everything. In must decide
through Input-Output relationship. It must choose the
technology. Inputs: land, labor, capital, and
entrepreneurship. Out is the commodity produced by
these inputs.
Lionel Robbins
Economics is the science which studies
human behavior as a relationship
between ends and scarce means which
have alternative uses.
What is Economics?
• Let us have some idea of some
economists and the main idea of
economics.
INTRODUCTION OF MANAGERIAL ECONOMICS
Concept of Managerial Economics (contd.)
Managerial economics is by nature goal oriented and prescriptive which
may be viewed as economics applied in decision making at the level of firm.
Like an individual most of the problems of the firm emerge in allocation of
scarce resources.
We can trace different ideas given by scholars in this subject.
“Managerial economics is the price theory in service of business executive.”
-D.J. Watson
“Managerial economics can be viewed as an application of that part of
microeconomics that focuses on such topics as risk, demand, production,
cost, pricing, and market structure.”
-Petersen and Lewis
“Managerial economics is concerned with the ways in which managers
should make decisions in order to maximize the effectiveness or performance
of the organizations they manage.”
- Edwin Mansfield
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What is Managerial Economics
 Douglas - “Managerial economics is .. the application of
economic principles and methodologies to the decisionmaking process within the firm or organization.”
 Pappas & Hirschey - “Managerial economics applies
economic theory and methods to business and
administrative decision-making.”
 Salvatore - “Managerial economics refers to the application
of economic theory and the tools of analysis of decision
science to examine how an organisation can achieve its
objectives most effectively.”
INTRODUCTION OF MANAGERIAL ECONOMICS
Concept of Managerial Economics (contd.)
Following diagram shows how does the managerial economics provide the
link between traditional economics and decision sciences
Management
Problems
Economic Theory
Decision Sciences
Managerial
Economics
Economic Methodology:
Descriptive Model
Prescriptive Model
Study of Functional Areas:
Accounting, Finance, and
Marketing
Optimal
Decision
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Managerial Decision Problems
Economic theory
Microeconomics
Macroeconomics
Decision Sciences
Mathematical Economics
Econometrics
MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems
OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS
What is Managerial Economics (contd.)
• Howard Davies and Pun-Lee Lam • “It is the application of economic analysis to
business problems; it has its origin in theoretical
microeconomics.”
From these ideas it can be concluded managerial economics is the discipline,
which deals with the application of economic theory to business
management. Thus it lies on the borderline between economics and
business management and serves as a bridge between these two disciplines.
INTRODUCTION OF MANAGERIAL ECONOMICS
Distinction between Managerial Economics and
Traditional Economics
There are some differences between managerial economics and traditional
economic theory because managerial economics seeks the help of other
disciplines such as statistics, mathematics, accounting, management to get
optimal solution to the managerial decision-making problems.
Differences between managerial economics and traditional economics which are
outlined below:
i. Managerial economics concerns with the application of economic
principles to the problems of the firm but the traditional economics deals
with the body of principles itself.
ii. Managerial economics is highly microeconomics in character. It studies the
problems of a firm but does not study the macroeconomic phenomenon.
But traditional economics consist of both micro and macro economics.
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INTRODUCTION OF MANAGERIAL ECONOMICS
Distinction between Managerial Economics and Traditional
Economics (contd.)
iii. Traditional economics is a study of both firm and an individual, whereas
managerial economics is a study of the problem of a firm only.
iv. Managerial economics focuses its attention in the study of profits
because it has great influence primarily on entrepreneurial decision and
value theory of the firm. In traditional economics, the microeconomics is
a branch under which all the theories of factor pricing such as rent,
wages, interest and profit are studied.
v. Traditional economics studies human behavior on the basis of certain
assumptions, but these assumptions may not be true in managerial
economics because managerial economics is concerned with practical
problems.
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What is Managerial Economics (contd.)
 It is an application of that part of microeconomics
that focuses on
 Risk
 Demand
 Production
 Cost
 Pricing, and
 Market Structure.
 It helps rational decision making through MODEL
BUILDING
INTRODUCTION OF MANAGERIAL ECONOMICS
Scope of Managerial Economics (contd.)
Microeconomics Applied to Operational Issues:
Operational issues of firms are of internal nature. Internal issues include all
those problems which arise within the business organization and fall within
the control of the management. Some of the basic internal issues are:
a) Choice of business and the nature of products, that is, what to produce,
b) Choice of size of the firm, that is, how much to produce,
c) Choice of technology, that is, choosing the factor-combination
(technique of production)
d) Choice of price, that is, how to price the commodity,
e) How to promote sales,
f) How to face competition,
g) How to decide on new investments,
h) How to manage profit and capital,
i) How to manage an inventory, that is, stock of both finished goods and
raw materials.
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INTRODUCTION OF MANAGERIAL ECONOMICS
Scope of Managerial Economics (contd.)
Microeconomics Applied to Operational Issues:
Microeconomics deals with such questions confronted by managers. The
following microeconomic theories deal with most of these questions.
a) Demand Analysis and Forecasting: - An understanding of the forces
behind demand is a powerful tool for managers. Such knowledge
provides the background needed to make pricing decisions, forecast
sales and formulate marketing strategies. A forecast of future sales is
essential before employing resources.
b) Theory of Production and Production Decisions: - Production theory
explains the relationship between inputs and output. It also explains
under what conditions costs increase or decrease; how total output
behaves when use of inputs is changed; and how can output be
maximized from a given quantity of resources. Thus, it helps the
managers in determining the size of the firm, and the amount of capital
and labour to be employed keeping in view the objectives of the firm.21
INTRODUCTION OF MANAGERIAL ECONOMICS
Scope of Managerial Economics (contd.)
Microeconomics Applied to Operational Issues:
c) Market Structure and Pricing Theory: - Price theory explains how prices
of outputs and inputs are determined under different market
conditions; when price discrimination is desirable, feasible and
profitable; and to what extent advertising can be helpful in expanding
sales in a competitive market. Hence, price theory can be helpful in
determining the price policy of the firm.
d) Analysis of Cost: - Estimates of cost are essential for planning purposes.
The factors determining costs are not always known or controllable
which gives rise to cost uncertainty. Factors of production are scarce
and they have alternative uses. Factors of production may be allocated
in a particular way to get maximum output. Thus the analysis of costs
and their links to output are also importance in managerial economics.
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INTRODUCTION OF MANAGERIAL ECONOMICS
Scope of Managerial Economics (contd.)
Microeconomics Applied to Operational Issues:
e) Profit and Capital Management (Investment Decisions): - Profit
provides the index of success of a business firm. Profit analysis is
difficult, because the uncertainty of expectations makes realization of
profit planning and measurement difficult and these areas are covered
in the study of managerial economics.
Capital management means planning and control of capital
expenditures. Hence, it is very important for a firm to manage required
capital through proper investment planning. The main topics covered
are: cost of capital, types of investment decisions, and evaluation and
selections of investment projects.
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INTRODUCTION OF MANAGERIAL ECONOMICS
Scope of Managerial Economics (contd.)
Microeconomics Applied to Operational Issues:
f)
Inventory Management: - Inventory refers to a stock of raw materials
or finished goods which a firm keeps. Management of inventory is very
important for a firm to keep intact of its current production and supply
capacity and to meet the challenges arising from change in market and
other conditions. In this regard, a major question that arises is: how
much of the inventory is the ideal stock? If it is high, capital is
unproductively tied up, and that might be useful for other productive
purposes if the stock of inventory is reduced. On the other hand, if the
level of inventory is low, production will be hampered. Hence,
managerial economics uses different methods which are helpful in
minimizing the inventory cost.
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Stories of Four Great Economists
Adam Smith (1723 – 1790) was a
Scottish Economist.
He is said FATHER OF ECONOMICS
He is also FATHER OF CAPITALISM
His Book: WEALTH OF NATIONS
We want to talk about POVERTY not
wealth.
His main theory is “There is an
invisible hand that determine
everything – Don’t disturb it”
What is the invisible hand?
•
Invisible hands – demand
and supply – determines
quantity and price
P
S
D
Q
Economics is very easy
• Teach a Parrot to say Demand and Supply –
then the parrot becomes an economist.
• Ask her any questions – she will say ‘demand
and supply’ – then she is a great economist.
David Ricardo
• David Ricardo 1772-1823
• His theory said, increase in
agricultural production
would ultimately decline.
Thomas Malthus
• Thomas Robert Malthus,
(1766-1834), English
economist and
demographer.
Malthus
• He was a Church Priest.
• Once he noted he had never seen a dead bird.
(except bats and crows).
• He searched the reasons.
• Bird die on a flowing stream and the body is
taken away by the water.
• Birds commit suicide when food is not available.
– A tragic case – God cannot do this.
• He investigated further and studied economics –
especially Ricardo
Population Theory
His theory: population
growth will always tend
to outrun the food
supply,
* There will be hunger,
famine, war, disasters,
* Population Control is
needed.
* This is called
Malthusianism
Karl Marx
Karl Heinrich Marx (1818 – 1883) was a
German
philosopher,
economist,
sociologist,
historian, journalist and
revolutionary socialist. His ideas played a
significant
role
in
establishing
communism. He published various books.
Das Kapital (1867–1894);
His thinking,
Factors of Production
Congealed Labor theory
Exploitation
Dialectic Materialism
John m Keynes
 1883 – 21 April 1946 – A British
Economist.
 Studied Mathematics
 Very young professor, most learned
young man,
 Wanted to marry an illiterate
women,
 Then what happened??
-- Wrote a book “General Theory”
Could not sell.
Lord Keynes (continued)
•
•
•
•
•
•
•
•
Went to stock market,
Dominated stock market,
Became rich,
Became Lord,
Married,
Divided economics into Macro and Micro,
An interview of his wife.
He successfully introduced mathematics in
economics
The Process of Model-building
• The economics ‘method’
• The steps: the hypothetical-deductive approach
– make assumptions about behaviour
– work out the consequences of those assumptions
– make predictions
– test the predictions against the evidence
– PREDICTIONS SUPPORTED? The model is accepted
as a good explanation (for the moment)
– PREDICTIONS REFUTED? Go back and re-work the
whole process
Definitions
&
assumptions
Theoretical
analysis
If predictions
not supported by
data, model is
amended or
discarded
Predictions
Predictions
tested
against data
If predictions
borne out by
data, the model
is valid, for
the moment
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Economic Laws
Idea
• Check the Idea
• Prove it. If proved then
Hypothesis
• Prove the Hypothesis
• If Proved then
Theory
Law
• Prove the theory
• If proved then
• Law is valid every where,
Economic Policy
Criteria for judging economic outcomes:
• Efficiency, or allocative efficiency. An efficient
economy is one that produces what people want at the
least possible cost.
• Equity, or fairness of economic outcomes.
• Growth, or an increase in the total output of an
economy.
• Stability, or the condition in which output is steady or
growing, with low inflation and full employment of
resources.
Figure 1 The Circular Flow
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Revenue
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of Taka
Copyright © 2004 South-Western
Revenue
(=GDP)
Good and
services sold
Spending
(=GDP)
MARKETS FOR
GOODS AND
SERVICES
Good and
services
bought
HOUSEHOLDS
FIRMS
Inputs for
Production
MARKETS FOR
FACTORS OF
PRODUCTION
Land, labor
and capital
Wages, rent,
interest and
profit (=GDP)
Income (=GDP)
Flow of goods & services
Flow of money: Taka
THE CIRCULAR FLOW DIAGRAM
Assumptions
Assumption: The economy composed of
households and firms only
Households: own factors of production,
consume goods and service
Firms: hire factors of production to
produce goods and services
The Circular Flow of Economic Activity
 The diagram above represents the transactions between
firms and households in a simple economy.
 In the upper loop, the arrow emanating from firms to
households represents the sale by firms of goods and
services to households. On the other hand, the arrow
from households to firms represents the payments.
 In the lower loop, the arrow originating from the
households to the firms shows that firms hire labor and
capital from households in order to produce goods and
services. The arrow emanating from the firms indicates
their payments for the use of the factors of production.
The Circular Flow of Economic Activity
 Prices of outputs and inputs are determined
in these markets and guide the decisions of
all market participants,
 The firm, an entity, organizes factors of
production to produce goods and services,
 The prices of product and factor of
production guide interaction between
individual and firms.
The Production Possibilities FrontierModel: The
Production Possibilities Frontier
The production possibilities frontier is a graph
that shows the combinations of output
that the economy can possibly produce
given the available factors of production
and the available production technology.
Figure 2 The Production Possibilities Frontier
Quantity of
Garments
Produced
3,000
D
C
2,200
2,000
A
Production
possibilities
frontier
B
1,000
0
300
600 700
1,000
Quantity of
Rice Produced
Figure 3 The Production Possibilities Frontier
Quantity of
Garments
Produced
3,000
D
C
2,200
2,000
A
Production
possibilities
frontier
B
1,000
0
300
600 700
1,000
Quantity of
Rice Produced
Theory of the Firm
• Expected Value Maximization
– Owner-managers maximize short-run profits.
– Primary goal is long-term expected value
maximization.
• Constraints and the Theory of the Firm
– Resource constraints.
– Social constraints
• Limitations of the Theory of the Firm
– Alternative theory adds perspective.
– Competition forces efficiency.
– Hostile takeovers threaten inefficient managers.
Value of the Firm
The present value of all expected future profits
Profit Measurement
• Business Versus Economic Profit
– Business (accounting) profit reflects explicit
costs and revenues.
– Economic profit.
• Profit above a risk-adjusted normal return.
• Considers cash and noncash items.
• Variability of Business Profits
– Business profits vary widely.
Why Do Profits Vary Among
Firms?
• Disequilibrium Profit Theories
–Rapid growth in revenues.
–Rapid decline in costs.
• Compensatory Profit Theories
–Better, faster, or cheaper than the
competition is profitable.
Role of Business in Society
• Why Firms Exist
– Business is useful in satisfying consumer
wants.
– Business contributes to social welfare
• Social Responsibility of Business
– Serve customers.
– Provide employment opportunities.
– Obey laws and regulations.
How to Read and Understand
Graphs
• Each point on the Cartesian
plane is a combination of
(X,Y) values.
• The relationship between X
and Y is causal. For a given
value of X, there is a
corresponding value of Y, or
X causes Y.
Reading Between the Lines
• A line is a continuous string
of points, or sets of (X,Y)
values on the Cartesian
plane.
• The relationship between X
and Y on this graph is
negative. An increase in the
value of X leads to a
decrease in the value of Y,
and vice versa.
Positive and Negative Relationships
An upward-sloping line
describes a positive relationship
between X and Y.
A downward-sloping line
describes a negative
relationship between X and Y.
Different Slope Values
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Different Slope Values
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b
 0.5
10
0
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0
10
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