AE11 – Managerial Economics

Module 1: Introduction to Managerial Economics

Lesson 2: Basic concepts of Managerial Economics

Learning objectives:
a. Define managerial economics
b. Explain the different characteristics of an effective manager
c. Distinguish accounting from economic profit
d. Determine the value of the firm

Outline
2.1 What is Managerial Economics?
2.2 The Economics of Effective Management
2.2.1 Identify goals and constraints
2.2.2 Recognize the nature and importance of profits
2.2.3 Understand incentives
2.2.4 Understand markets
2.2.5 Recognize the time value of money
2.2.6 Use marginal analysis
2.2.7 Make data-driven decisions
 2.1 What is Managerial Economics?

Defining “Managerial Economics”

Manager – is a person who directs resources to achieve a stated goal.

1. Direct the efforts of others, including those who delegate tasks within an organization such as a
firm, a family, or a club.
2. Purchase inputs to be used in the production of goods and services such as the output of a firm,
food for the needy, or shelter for the homeless; or 3. Are in-charge of making other decisions, such
as product price or quality.

 A manager generally has responsibility for his or her own actions as well as for the actions of
individuals, machines, and other inputs under the manager’s control.
 This control may involve responsibilities for the resources of a multinational corporation or for
those of a single household.
 In each instance, however, a manager must direct resources and the behavior of individuals for
the purpose of accomplishing some tasks.

Economics is the science of making decisions in the presence of scarce resources.

Resources are simply anything used to produce a good or service or, more generally, to achieve a
goal. Decisions are important because scarcity implies that by making one choice, you give up
another.

 Economic decisions thus involve the allocation of scarce resources, and a manager’s task is to
allocate resources so as to best meet the manager’s goals.

Managerial Economics, therefore, is the study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal.
It is a very broad discipline in that it describes methods useful for directing everything from
the resources of a household to maximize household welfare to the resources of a firm to maximize
profits.
The nature of sound managerial decisions varies depending on the underlying goals of the manager.
 2.2 THE ECONOMICS OF EFFECTIVE MANAGEMENT

Basic Principles that comprise Effective Management

an effective manager must:
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
7. Make data-driven decisions

2.2.1 IDENTIFY GOALS AND CONSTRAINTS

Identify Goals and Constraints

The first step in making sound decisions is to have a Well-defined goal Because achieving
different goals entails making different decisions.
If your goal is to maximize your grade in this subject rather than maximize your overall grade
point average, your study habits will differ accordingly. Similarly, if the goal of the government is to
distribute food to needy people in rural areas, its decisions and optimal distribution network will
differ from those it would use to distribute food to need inner-city residents.
Notice that, in both instances, the decision maker faces constraints that affect the ability to
achieve a goal.

Constraints are an artifact of scarcity. It makes it difficult for managers to achieve goals such as
maximizing profits or increasing market share.
The goal of maximizing profits requires the manager to decide the optimal price to charge for
a product, how much to produce, which technology to use, how much of each input to use, how to
react to decisions made by competitors, and so on.
 2.2.2 Recognize the Nature and Importance of Profits

Recognize the Nature and Importance of Profits

The overall goal of most firms is to maximize profits or the firm’s value.

Profit = Total Revenue – Total Cost

Types of Profit: a. Accounting Profit b. Economic Profit

a. Accounting Profits
- are the total amount of money taken in from sales (total revenue, or price times quantity sold)
minus the dollar cost of producing goods or services.
- what shows up on the firm’s income statement and are typically reported to the manager by
the firm’s accounting department.
When most people hear the word “profit”, they think of accounting profits.

b. Economic Profits
- are the difference between the total revenue and the total opportunity cost of producing the
firm’s goods or services.
The opportunity cost of using a resource includes both the explicit (or accounting) cost of
the resource and the implicit cost of giving up the best alternative use of the resource.
The opportunity cost of producing a good or service generally is higher than accounting costs
because it includes both the dollar value of costs (explicit or accounting costs) and any implicit costs.

Accounting Profit = Revenue – Explicit (Accounting) Cost

Economic Profit = Revenue – Economic Costs
Economic Costs = Explicit Cost + Implicit Cost

Economic costs are opportunity costs and include not only the explicit (accounting) costs but also
the implicit costs of the resources used in production.
Explicit costs – the dollar and actual value of the cost of an input/resource that is supplied in the
market
Implicit costs – opportunity costs of using owner-supplied inputs/resources
The Role of Profits
A common misconception is that the firm’s goal of maximizing profits is necessarily bad for
society. Individuals who want to maximize profits often are considered self- interested, a quality that
many people view as undesirable.
However, consider Adam Smith’s classic line from The Wealth of Nations:
“It is not out of the benevolence of the butcher, the brewer, or the baker, that we expect our dinner,
but from their regard to their own interest.”
Smith is saying that by pursuing its self-interest—the goal of maximizing profits—a firm
ultimately meets the needs of society.

Examples:
If you cannot make a living as a rock singer, it is probably because society does not
appreciate your singing; society would more highly value your talents in some other employment.
If you break five dishes each time you clean up after dinner, your talents are perhaps better
suited for filing paperwork or mowing the lawn.
Similarly, the profits of businesses signal where society’s scarce resources are best allocated.

Thus, profits signal the owners of resources where the 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.
 2.2.3 Understand Incentives

Understand Incentives
Within a firm, incentives affect how resources are used and how hard worker’s work.
To succeed as a manager, you must have a clear grasp of the role of incentives within an
organization such as a firm and how to construct incentives to induce maximal effort from those you
manage.
Many professionals and owners of small establishments have difficulties because they do not
fully comprehend the importance of the role incentives play in guiding the decisions of others.
Individuals often are motivated by self-interest. This is not to say that people never act out
of kindness or charity, but rather that human nature is such that people naturally tend to look after
their own self-interest.
An employee will not work accordingly if he/she receives no reward for working hard and
will incur no penalty if he/she fails to make sound decisions.
The employee receives the same amount of salary, regardless of the business/ company’s
profitability, so the employee may not strive hard, compared to what the owner ideally perceived.

The principal-Agent Problem

The principal-agent problem is a conflict in priorities between a person or group and the
representative authorized to act on their behalf. An agent may act in a way that is contrary to the best
interests of the principal.
This is an important consideration because conflicts of interest arise between workers,
managers and the firm owners. Example, workers, want to have more free time, owners want to have
more profit or even managers would like to have more leisure than work in the company.
 2.2.4 Understand Markets

Understand Markets
It is important to bear in mind that there are two sides to every transaction in a market: For
every buyer of a good there is a corresponding seller .
The final outcome of the market process, then, depends on the relative power of buyers and
sellers in the marketplace.
The power, or bargaining position, of consumers and producers in the market is limited by
the sources of rivalry that exist in economic transactions.

Three sources of rivalry that exist in economic transactions

a. Consumer–producer rivalry
b. Consumer–consumer rivalry, and
c. Producer–producer rivalry.

Each form of rivalry serves as a disciplining device to guide the market process, and each
affects different markets to a different extent. Thus, your ability as a manager to meet performance
objectives will depend on the extent to which your product is affected by these sources of rivalry.

a. Consumer–producer rivalry
- occurs because of the competing interests of consumers and producers.

Consumers attempt to negotiate or locate low prices, while producers attempt to negotiate
high prices. In a very loose sense, consumers attempt to “rip off” producers, and producers attempt to
“rip off” consumers.
Of course, there are limits to the ability of these parties to achieve their goals.

If a consumer offers a price that is too low, the producer will refuse to sell the product to the
consumer. Similarly, if the producer asks a price that exceeds the consumer’s valuation of a good,
the consumer will refuse to purchase the good.
 An illustrative example of this type of rivalry is the common haggling over price between a
potential car buyer and a salesperson.

b. Consumer–Consumer Rivalry
- reduces the negotiating power of consumers in the marketplace. It arises because of the
economic doctrine of scarcity. When limited quantities of goods are available, consumers will
compete with one another for the right to purchase the available goods.

Consumers who are willing to pay the highest prices for the scarce goods will outbid other
consumers for the right to consume the goods. Once again, this source of rivalry is present even in
markets in which a single firm is selling a product.
A good example of consumer– consumer rivalry is an auction.

c. Producer–Producer Rivalry
- unlike the other forms of rivalry, this disciplining device functions only when multiple sellers
of a product compete in the marketplace.

Given that customers are scarce, producers compete with one another for the right to service the
customers available. Those firms that offer the best-quality product at the lowest price earn the right
to serve the customers.
For example, when two gas stations located across the street from one another compete on
price, they are engaged in producer–producer rivalry.

Government and the Market

When agents on either side of the market find themselves disadvantaged in the market process, they
may attempt to induce government to intervene on their behalf.

Consumer groups may initiate action by a public utility commission to limit the power of utilities in
setting prices. Similarly, producers may lobby for government assistance to place them in a better
bargaining position relative to consumers and foreign producers.
In modern economies, government plays a role in disciplining the market process.
 2.2.5 Recognize the Time Value of Money

Time Value of Money

The timing of many decisions involves a gap between the time when the costs of a business is
incurred and the time when the benefits of the business are received.
In these instances, it is important to recognize that $1 today is worth more than $1 received in
the future.
The reason is simple: The opportunity cost of receiving the $1 in the future is the forgone
interest that could be earned were $1 received today. This opportunity cost reflects the time value of
money.

To properly account for the timing of receipts and expenditures, the manager must understand
present value analysis.

Present Value (PV) of an amount received in the future is the amount that would have to be invested
today at the prevailing interest rate to generate the given future value.

The present value (PV) of a future value (FV) received n years in the future is:

where i is the rate of interest, or the opportunity cost of funds.

For example, the present value of 100.00 in 10 years if the interest rate is at 7 percent is 50.83 since

This essentially means that if you invested P50.83 today at a 7% interest rate, in 10 years your
investment would be worth P100.
 Notice that the interest rate appears in the denominator.
 This means that the higher the interest rate, the lower the present value of a future amount.
The present value of a future payment reflects the difference between the future value (FV) and the
opportunity cost of waiting (OCW): PV = FV – OCW

The basic idea of the present value of a future amount can be extended to a series of Future
payments.
For example, if you are promised FV1 one year in the future, FV2 two years in the future,
and so on for n years, the present value of this sum of future payments is

Given the present value of the income stream that arises from a project, one can easily compute the
net present value of the project.

The Net Present Value (NPV) of a project is simply the present value (PV) of the income stream
generated by the project minus the current cost (C0) of the project:
NPV = PV − C0
If NPV is positive (+), the business/project is profitable because PV>Current Costs
If NPV is negative (-) the business/project is not profitable.

Suppose that by sinking C0 dollars into a project today, a firm will generate income of FV1
one year in the future, FV2 two years in the future, and so on for n years. If the interest rate is i, the
net present value of the project is
Example #1:
The manager of Automated Products is contemplating the purchase of a new machine that will cost
$300,000 and has a useful life of five years. The machine will yield (year- end) cost reductions to
Automated Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and $90,000 in years
4 and 5. What is the present value of the cost savings of the machine if the interest rate is 8 percent?
Should the manager purchase the machine?

Example #2:
Tom Riddle, a bookstore owner, expects to receive a profit of P10,000 in each of the next three years
and to be able to sell the firm at the end of the third year for P7,000. Tom believes that the
appropriate discount rate for his firm is 10 percent per year.
Calculate
(a) the value of Tom’s business (PV)
(b) the value of Tom’s business (PV) when discount rate is at 20 percent
(c) what is the effect on the value of the firm using a higher discount rate?
 2.2.6 Use Marginal Analysis

Use of Marginal Analysis

Marginal analysis is one of the most important managerial tools.

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

For example, the optimal amount of studying for this subject is determined by comparing (1) the
improvement in your grade that will result from an additional hour of studying and (2) the additional
costs of studying an additional hour.
So long as the benefits of studying an additional hour exceed the costs of studying an
additional hour, it is profitable to continue to study. However, once an additional hour of studying
adds more to costs than it does to benefits, you should stop studying.
The overall goal is to maximize the Net Benefits (NB), the difference between the benefits
and the costs.
NB = B - C

Marginal benefit (MB) - The change in total benefits arising from a change in the
managerial control variable.
Marginal (incremental) cost (MC) - The change in total costs arising from a change
in the managerial control variable.

Net Benefits = Marginal Benefits – Marginal Costs

Marginal Principle
To maximize net benefits, the manager should increase the managerial control variable up to the
point where marginal benefits equal marginal costs (MB=MC).

This level of the managerial control variable corresponds to the level at which marginal net benefits
are zero (MB=0); nothing more can be gained by further changes in that variable.

2.2.7 Make Data-driven Decisions

Make Data-Driven Decisions
 Good managers don’t simply guess how their decisions will affect their organizations; they
make data-driven decisions.
 These data greatly enhance the value of managerial economics because they permit managers
to quantify managerial decisions and to quantify the organizational impact.
 Increasingly, businesses and other organizations have personnel who use econometrics— the
statistical analysis of economic data—to obtain quantitative estimates of how various
managerial control variables impact benefits and costs.

The Regression Analysis

a statistical method used in finance, investing, and other disciplines that attempts to
determine the strength and character of the relationship between one dependent variable
(usually denoted by Y) and a series of other variables (known as independent variables).

Also called simple regression or ordinary least squares (OLS), linear regression is the most
common form of this technique. Linear regression establishes the linear relationship
between two variables based on a line of best fit.
The Regression Line
Econometricians uses a regression software package to find the values of a and b that
minimize the sum of the squared deviations between the actual points and the line.
In essence, the regression line is the line that minimizes the squared deviations between the line (the
expected relation) and the actual data points.
Other forms of regression:
- Log-linear regression (logY-X)

- Double log regression (logY-logX)

- Multiple regression (regressions of a dependent variable on multiple explanatory variables.)

- Logistic regression (dependent variable is binary) ... and others.