CHAPTER I

INTRODUCTION TO MANAGERIAL ECONOMICS

1.1 DEFINITION OF MANAGERIAL ECONOMICS

WHAT IS ECONOMICS?
Economics is a social science which studies individuals and organizations engaged in the
production, distribution and consumptions of goods and services. It is a discipline which studies
how scarce economic resources are used to maximize production for a society. It can be divided
into two broad categories: micro economics and macro economics.

Macro economics is the study of the economic system as a whole. It includes techniques for
analyzing changes in total output, total employment, the unemployment rate, and exports and
imports. It also focuses on the effect of changes in investment, government spending, and tax
policy on exports, output, employment and prices.

Micro economics is the study and analysis of the behavior of individual segments of the
economy: individual consumers, workers and owners of resources, individual firms, industries,
and markets for goods and services. Micro economics is concerned with topics such as how
consumers choose the goods and services they purchase and how firms make hiring, pricing,
production, advertising, research and development and investment decisions.

SO WHAT IS MANAGERIAL ECONOMICS?

Managerial economics is the discipline that deals with the application of economic concepts,
theories and methodologies to the practical problems of business in order to formulate rational
managerial decisions for solving the problems.

Managerial economics has been generally defined as the study of economic theories, logic and
tools of economic analysis, used in the process of business decision making. It involves the
understanding and use of economic theories and techniques of economic analysis in analyzing
and solving business problems.

Managerial economics focuses on the application of micro economic theory to business

problems. Managerial economics provides a systematic, logical way of analyzing business
decisions – both today’s decisions and tomorrows. It addresses the larger economic forces that
shape both day-to-day operations and long-run planning decisions.

Managerial economics is applied micro economics. It is an application of the part of micro

economics that focuses on the topics that are importance to managers. These topics include

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demand, production, cost, pricing, market structure, and government regulation. The rational
application of these principles should result in better managerial decisions, higher profits and an
increase in the value of the firm.
Managerial economics is a tool for improving managerial decision making. It uses economic
concepts and quantitative methods to solve managerial problems.

Fig 1.1 Relationships between Managerial Economics and Related Disciplines

Management decision problems
 Product selection, output and pricing
 Internet strategy
 Organizational design
 Product development and promotion strategy
 Employee hiring and training
 Investment and hiring

Economic concepts Quantitative methods

 Marginal benefits  Numerical analysis
 Theory of consumer demand  Statistical estimation
 Theory of the firm  Forecasting procedures
 Industrial organization and firm  Game theory concepts
behavior  Optimization techniques
 Public choice theory  Information systems

Managerial economics

Optimal solutions to management decision problems

Managerial economics can be used by the goal-oriented manager in two ways:

1. The principles of managerial economics provide a framework for evaluating whether

resources are being allocated efficiently within a firm. For example, economics can help
the manager determine if profit could be increased by reallocating labor from a marketing
activity to the production line.

2. These principles help managers respond to various economic signals. For example, given
an increase in the price of output or the development of a new lower-cost production
technology, the appropriate managerial response would be to increase output.

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1.2 THE SCOPE OF MANAGERIAL ECONOMICS

Managerial economics largely depend on micro economic theories. Generally, the scope of
managerial economics extends to those economic concepts, theories, and tools of analysis used
in analyzing the business environment, and to find solutions to practical business problems. But
also it incorporates certain aspects of macroeconomic theory. These are essential to
comprehending the circumstances and environments that envelop the working conditions of an
individual firm or an industry. Knowledge of macroeconomic issues such as business cycles,
taxation policies, industrial policy of the government, price and distribution policies, wage
policies and antimonopoly policies and so on, is integral to the successful functioning of a
business. In broad terms, managerial economics is applied economics. The areas of business
issues to which Managerial economics can be directly applied are divided into two broad
categories:

 Operational or internal issues; and,

 Environment or external issues.

Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the
basic internal issues include:

 choice of business and the nature of product (what to produce);

 choice of size of the firm (how much to produce);
 choice of technology (choosing the factor combination);
 choice of price (product pricing);
 how to promote sales;
 how to face price competition;
 how to decide on new investments;
 how to manage profit and capital; and,
 How to manage inventory.

Environmental issues: These are issues related to the general business environment. These are
issues related to the overall economic, social, and political atmosphere of the country in which
the business is situated. The factors constituted under environmental aspect issues include the
following:

 The existing economic system

 General trends in production, income, employment, prices, savings and investment, and
so on.
 Structure of the financial institutions.
 Magnitude of and trends in foreign trade.

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  Trends in labor and capital markets.
 Government’s economic policies.
 Social organizations, such as trade unions, consumers’ cooperatives, and producer
unions.
 The political environment.
 The degree of openness of the economy.

Managerial economics is particularly concerned with those economic factors that form the
business climate.
1.3 NATURE OF THE FIRM
The concept of the firm plays a central role in the theory and practice of managerial economics.

A firm is an economic institution which organizes the factors of production like labor, capital
and financial resources to produce goods and services that will meet the demand of individual
consumers and other firms.
In order to earn profits, the firm organizes the factors of production to produce goods and
services that will meet the demands of individual consumers and other firms. In a free market
economy with in the firm the transactions and organization of productive factors generally are
accomplished by the central control of one or more managers. However the interaction of firms
and consumers is accomplished through the price system. There is no need for any central
direction by government. The price system guides the decentralized interaction among
consumers and firms, where as central planning and control tend to guide the interaction with in
the firm, basically focusing on operational issues. Operational issues are of internal nature and
they include all those problems like:
 choice of business and product
 choice of technology
 choice of factors combination

Managerial economic helps to analyses these internal issues and find solution to practical
problems of the firm.

WHY DO FIRMS EXIST IN A MARKET ECONOMY?

Firms exist as organizations because the total cost of producing any rate of output is lower than if
the firm did not exist. The costs are lower due to following reasons;

1. Economies of scale-In production process economic of scale occurs when the cost of
production decline with larger and larger volumes of output. As a result society will be
benefited enormously because production is organized in the firm.

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 2. Cost of the price system- There is a cost of using the price system to organize production.
The cost of obtaining information on prices and the cost of negotiating and concluding
separate contracts for each step of the production process would be burdensome.
3. Transaction costs-One general contract covers what usually will be a large number of
transactions between the owners and workers. The two parties do not have to negotiate a
new contract every time the worker is given a new assignment. The saving of the
transactions costs associated with such negotiations is advantageous to both parties, and
thus both labor and management voluntarily seek out such arrangements.

1.4 GOALS AND CONSTRAINTS

The nature of sound managerial decisions varies depending on the underlying goals of the
manager. An effective manager must follow the following steps in making decisions.
1. Identify goals and constraints
2. Recognize the nature and importance of profits
3. Understand incentives
4. Understand markets
5. Recognize the time value of money
6. Use marginal analysis

1. Identify goals and constraints

The first step in making sound decisions is to have well defined goals because achieving
different goals entails making different decisions. The decision maker faces constraints that
affect the ability to achieve a goal. Optimal decisions are taken by the manager to minimize the
constraints to maximize the goals.
2. Recognize the nature and importance of profits
The overall goal of most firms is to maximize profits or the firm’s value. A manager should be
aware of economic profits, accounting profits and its role.
3. Understand incentives
Profits signal the holders of resources when to enter and exit particular industries. Changes in
profits provide an incentive to resource holders to alter their use of resources. Incentives affect
how resources are used and how hard workers work. Managers should understand the role of
incentives within an organization and construct incentives to induce maximal effort from people.
4. Understand markets
The final outcome of the market process depends on the relative power of buyers and sellers in
the market place. The power or bargaining position of consumers and producers in the market
place is limited by three sources of rivalry;
A. Consumer- producer rivalry: occurs because of the competing interests. Consumers
attempt to negotiate low prices, while producers attempt negotiate high prices.

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 B. Consumer- Consumer rivalry: reduces the negotiating power of consumers in the market
place. When limited quantities of goods are available, consumers will compete with one
another for the right to purchase the available goods.
C. Producer-Producer rivalry: functions when multiple sellers of a product compete in the
market place; producers compete with one another for the right service the customers
available. Those firms that offer the best quality product at the lowest price can earn the
right to serve the customers.

5. Recognize the time value of money

The timing of many decisions involves a gap between the time when the costs of a project are
borne, and time when the benefits of the projects are received. It is important to recognize that $1
today is worth more than $1 received in the future. The manager must understand present value
analysis.

6. Use marginal analysis

Marginal analysis states that optimal managerial decisions involve comparing the marginal (or
incremental) benefits of a decision with the marginal (or incremental) costs.

1.5 THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

Product markets
Goods and services ($) Goods and services ($)

Firms
Households
`

Economic resources Economic resources

Income ($) Factor markets Factor payments ($)

Figure: 1.2 Circular flow of income, output resources and factor payments

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Individuals and firms are the fundamental participants in a market economy. Individuals own or
control resources that have value to firms because they are necessary inputs in the production
process. These resources are broadly classified as labor, capital and natural resources. Most
people have labor resources to sell, and may own capital and natural resources that are rented,
loaned or sold to firms to be used as inputs in the production process. The money received by an
individual from the sale of these resources is called a factor payment. This income to individuals
then is used to satisfy their consumption demands for goods and services.

The interaction between individuals and firms occurs in two distinct arenas. First, there is a
product market where good and services are bought and sold. Second, there is a market for
factors of production where labor, capital and natural resources are traded. These interactions are
depicted in figure-1.2 which describes the circular flow of income, output, resources and factor
payments in a market economy.

In the product market shown in the top part of the figure, individuals demand goods and services
in order to satisfy their consumption desires. They make these demands known by bidding in the
product market for these goods and services. Firms respond to these demands by supplying
goods and services to that market to earn profit. The firm’s production technology and input
costs determine the supply conditions, while consumer preference and income determine the
demand conditions. The interaction of supply and demand determines the price and quantity
sold. In the product market, purchasing power, usually in the form of money, flows from
consumers to firms. At the same time, goods and services flow in the opposite direction – from
firms to consumers.

The factor market is shown at the bottom of figure -1.2. Here, the flows are the reverse of those
in the product market. Individuals are the suppliers in the factor market. They supply labor
services, capital and natural resources to firms that demand them to produce goods and services.
Firms indicate the strength of their desire for these inputs by bidding for them in the market. The
flow of money is from firms to individuals, and factors of production flow from individuals to
firms. The price of these production factors are set in this market.

Prices and profits serve as the signals for regulating the flows of money and resources through
the factor markets and the flows of money and goods through the product market.

In the market economy depicted by this circular flow, individuals and firms are highly
interdependent; each participant needs the others. For example, an individual’s labor will have
no value in the market unless there is a firm that is willing to pay for it. Alternatively, firms
cannot justify production unless some consumers want to buy their products. As a result, all
participants have an incentive to provide what others want. All participate willingly because
they have something to gain by doing so. Firms earn profits, the consumption demands of
individuals are satisfied, and resource owners receive wage, rent and interest payments.

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1.6 THE CONCEPT OF PROFIT

The term profit means different things to different people. Businesspeople, accountants, tax
collectors, employees, and economists have their individual meaning of profit. Before exposing
you to the theories of profit, it will be helpful for you to distinguish between two often
misunderstood profits concepts: the Accounting profit and the Economic profit.

Economist’s concept of profit is the pure profit or ‘economic profit’. Economic profit is the
amount by which total revenue exceeds total economic cost.

The total economic cost is the sum of the opportunity costs of each and every resource used by a
firm. Implicit costs represent the value of resources used in the production process for which no
direct payment is made. This value is generally taken to be the money earnings of resources in
their next best alternative employment.

Economic profit = Total revenue – Total economic costs.

= Total revenue – Explicit costs – Implicit costs.

Accounting profit is the difference between total revenue and explicit costs
Accounting Profit = Total revenue – Explicit costs.
Thus, economic profit is smaller than accounting profit by the amount of the firm’s implicit
costs;

Economic Profit = Accounting profit - Implicit costs

Economists refer to the opportunity cost of using the owner’s own resources as normal profit.
Normal profit is another name for the implicit cost that a firm incurs when it employs owner-
supplied resources. It represents the payment that business owners must receive for using their
own resources in their own business. Normal profit is the implicit part of total economic cost;

Economic Profit = Total revenue – Explicit cost – Normal profit

= Accounting profit – Normal profit.
Example. Suppose a firm has revenues of $ 5 million and explicit costs of $ 3 million. The
owners of the firm have provided $ 1 million of capital to the firm. If the owners could have
earned a 10 percent return on the $ 1 million in their best alternative investment (of similar risk),
the normal profit is $ 100,000. Economic profit is $ 1.9 million (= $ 5 million - $ 3 million - $
100 thousand).

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Suppose this same firm receives total revenue of only $ 3.1 million, then the firm would be
earning only a normal profit, and economic profit is zero. Even though economic profit is zero,
the owners are still “breaking even “because the firm’s accounting profit of $ 0.1 million is just
enough to pay the owners a normal profit for the use of their resources.

1.6.1 THEORIES OF ECONOMIC PROFITS

1. Frictional theory of economic profits- It states that markets are sometimes in disequilibrium
because of unanticipated changes in demand or cost conditions. Unanticipated shocks produce
positive or negative economic profits for some firms. For example; ATM’s make it possible for
customers of financial institutions to easily obtain cash, enter deposits, and make loan payments.
A rise in the use of plastics and aluminum in automobiles drives down the profits of steel
manufacturers.

2. Monopoly theory of economic profits- This theory asserts that some firms are sheltered from
competition by high barriers to entry. Economies of scale, high capital requirements, patents, or
import protection enable some firms to build monopoly positions that allow above- normal
profits for extended periods.

3. Innovation theory of economic profits- It describes the above-normal profits that arise
following successful invention or modernization. Example, Microsoft Corporation earned
superior rates of return because of its Graphical User Interface. Mc Donald’s Corporation earned
above normal rates of return as an early innovator in the fast food business.

4. Compensatory theory of economic profits- It describes above normal rates of return that
reward firms for extra ordinary success in meeting customer needs, maintaining efficient
operations etc. If firms that operate at the industry’s average levels of efficiency receive normal
rates of return, it is reasonable to expect firms operating at above average levels of efficiency to
earn above normal rates of return. Inefficient firms can be expected to earn unsatisfactory, below
normal rates of return. The theory also recognizes economic profit as an important reward to the
entrepreneurial function of owners and managers.

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