Polytechnic University of the Philippines
College of Social Sciences and Development
Department of Economics
MANAGERIAL ECONOMICS
Prepared by
Melcah Pascua Monsura
Russel R. Penamante
Celso G. Tan Jr.
Table of Contents
Overview…………………………………………………………………………………….……..…..…4
Chapter 1
THE NATURE, SCOPE, AND PRACTICE
OF MANAGERIAL ECONOMICS
1.1 Definition of Managerial Economics
and its Nature…………………...…………………………………..………………..……...5
1.2 Why Managerial Economics is Relevant for Managers………………..………………....6
1.3 Managerial Economics is Applicable to Different Types of Organizations…………......6
1.4 Social Responsibility of Business…………………………………………………..….…...7
1.5 Social Responsibility of Business and Social Contract………………………..………….7
Assessment 1…………………………………………………………………..……..…....….10
Chapter 2
ECONOMIC DECISION MAKING
2.1 Public Decisions: Economic View...……………………………………………..………..13
2.2 Decision within Firms: Profit-Maximization…..……………..…………………………....14
2.3 Optimal Decision using Marginal Analysis………………………..………………..…….15
Assessment 2…………………………………………………..………………..……..…...…17
Chapter 3
DEMAND ANALYSIS: Estimation and Forecasting
3.1 Demand Analysis………...………………………………………………………..……….18
A. Demand Schedule…………………………………………………………..…..….18
B. Demand Curve………………………………………………………..………….…19
C. Demand Function……………………………………………….…………….........20
3.2 Price Elasticity of Demand………………………………………..…………………….…21
3.2.1 Price Elasticity of Demand and Total Revenue Relationship………………..23
3.2.2 Cross Elasticity of Demand………………………………………..……………25
3.2.3 Income Elasticity of Demand…………………………………………..……….25
3.2.4 Price Elasticity and Prediction………………………………………..………...26
3.3 Demand Analysis and Optimal Pricing…...………………………………..…………..…27
3.3.1 Price Elasticity, Revenue, and Marginal Revenue………………….…..........28
3.3.2 Optimal Markup Pricing……………………………..…………………….........29
3.3.3 Price Discrimination……………………………………..……………………....31
3.4 Estimating Demand………..……………………………………………..........................33
3.4.1 Collecting Data……………………………………………………..……………34
3.5 Regression Analysis………………………………………………………….…………….36
3.5.1 Simple Regression……………………………………………………..……..…36
3.5.2 Multiple Regression………………………………………………..………..…..38
Assessment 3…………………………………………………………..……………………...43
Chapter 4
FORECASTING DEMAND
4.1 Qualitative Forecasting Technique………………..………………………..………........46
4.2 Quantitative Forecasting Technique…………………………………………..………….47
4.2.1 Time-Series Models………………………………………..……………………47
4.2.2 Smoothing Technique…………………………………..……………………....48
4.3 Quantitative Forecasting Technique using Econometric Models……………..……..…49
Assessment 4…………………………………..……………………………………………...53
Chapter 5
THE THEORY OF PRODUCTION AND COST
5.1 Production Function…………………………………………………………..……………55
5.2 Returns of Scale………………………………………………………………….………...56
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5.3 Production Periods…………………………………………………..……………..………56
5.3.1 Short-run Production Relationships………………………………..…….……56
5.4 Three Stages of Production……………………………….……………………………....59
5.5 Costs of Production……………………………………………………..………………….59
5.5.1 Economic Costs…………….…………………………………………………...60
5.5.2 Explicit and Implicit Costs…………………………………..……....................60
5.6 Short Run Production Costs…..………………………………..………………………....60
5.7 Marginal Decisions…….……………………………………………..…………………….63
5.8 Long-Run Production Costs…………………………………………..............................64
5.9 Production and Costs in the Long Run………………………………………..……….…66
Assessment 5………………………………………………………………..………………...70
Chapter 6
OPTIMAL OUTPUT DECISIONS AND PRICING STRATEGIES
6.1 Pure Competition…………………………………………………………………..……….72
a. Demand as Seen by a Purely Competitive Seller…………………………..........72
b. Profit Maximization in the Short Run…………………………………..……..……72
c. Loss Minimizing Case……………………………………………….…………..….75
d. Shutdown Case………………………………………………………………..........76
6.2 Pure Monopoly……………………………………………………..……………………....77
a. Monopoly Demand………………………………………………………..………...77
b. The Monopolist is a Price Maker…………………………………………..……….78
c. Profit Maximizing Position of Pure Monopolist…………………..……………..…79
d. Possibility of Losses by Monopolist………………………..……………………....79
6.3 Monopolistic Competition…………………………………..…….……………………..…80
a. A Firm’s Demand Curve……………………………………………..……………..81
b. Profit Maximization in the Short-Run………………………………….……..........81
6.4 Oligopoly………………………………………..…………………………………………...83
a. Oligopoly Behavior: Game Theory……………………………………..………….83
b. Three Oligopoly Models………………………………………………..…………...85
Assessment 6…………………………………………………………………..…………..….87
Chapter 7
ECONOMIC RISK AND UNCERTAINTY
7.1 Risk versus Uncertainty………………………………………………………..…………..88
7.2 Key Difference Between Risk and Uncertainty…………………………..……………....89
7.3 Application of the Concept of Risk and Uncertainty……………………..……………....89
7.4 Five Sources of Business Risk………………………………….…………………………90
7.5 Risk and Return………………………………………………..…………………………...90
Chapter 8
Capital Budgeting
8.1 Definition of Capital Budgeting…………………………………………….………………91
8.2 Characteristics of Capital Investment Decisions……………………………..……....…91
8.3 Capital Budgeting Process………………………………………………..……………….91
8.4 Types of Capital Investment Projects………………………………..…………………...93
8.5 Capital Budgeting Techniques………………………………………..…………………..95
8.5.1 Present Value and Net Present Value Method……………………..………..96
8.5.2 Payback Period Method………………………..…………………………........97
8.5.3 Discounted Payback Period Method……………………..…………………....98
8.5.4 Profitability Index………………………………………..……………………....98
8.5.5 Internal Rate of Return (IRR) Method…………………………………..……...98
8.6 Importance and Significance of Capital Budgeting……………………………….……..99
Assessment 7………………………………………………………………………..……….100
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Overview
Managerial Economics is the analysis of major management decisions using the tools
of economics. Managerial economics applies many familiar concepts from economics—demand
and cost, marginal analysis, monopoly and competition, the allocation of resources, and economic
trade-offs—to aid managers in making better decisions. This module provides the framework and
the economic tools needed to fulfill this goal. Furthermore, the discussions in this module illustrate
the central decision problems faced by the managers and to provide the economic analysis they
need to guide their decisions.
The first three chapters will discuss the introduction of Managerial Economics and how
managers of the firms decide based on estimating and forecasting demand using regression
analysis. Forecasting demand through trends, business cycles, seasonal variations, and random
fluctuations will also discuss. These are crucial for economic decision making of managers. The
optimal decision of the managers will be based on demand estimation and marginal analysis.
The next three chapters, Chapter 3 to Chapter 6, will discuss how the managers analyze
the production and cost of production of the firms. In addition, the optimal output and pricing
strategies to realize maximum profit will discuss using the four market structures. Each market
type has its own characteristics, demand, and pricing strategies which will be discussed in
Chapter 6.
The remaining chapters include the concepts of risks, uncertainties, and capital budgeting.
Since every firm faces risks and uncertainties in their operations and productions, it is crucial to
understand the firm’s reactions and decisions in these situations. Moreover, capital budgeting will
also consider in identifying good investment for the firm’s possible expansion and continuous
operation.
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CHAPTER 11
THE NATURE, SCOPE AND PRACTICE OF MANAGERIAL ECONOMICS
Learning Objectives: This chapter provides introduction of managerial economics and on how
the economic concepts, theories, and methodologies help managers to improve their
decision-making. This part also stresses the importance of managerial economics to the
firms. At the end of this chapter, the readers will be able to define managerial economics,
establish the relation of managerial economics to other branches of learning, and
demonstrate the use of managerial economics in the real-world managerial decision
making.
1.1 Definition of Managerial Economics and its Nature
One standard definition for economics is the study of the production, distribution, and
consumption of goods and services. Secondly, it the study of choice related to the allocation of
scarce resources. The first definition indicates that economics includes any business, nonprofit
organization, or administrative unit. The second definition establishes that economics is at the
core of what managers of these organizations do. We use economics to examine how managers
can design organizations that motivate individuals to make choices that will increase a firm’s
value. This module discusses the economic concepts and principles from the perspective of
“managerial economics,” which is a subfield of economics that places special emphasis on the
choice aspect in the second definition.
Managerial economics is a branch of economics that applies microeconomic concepts,
methods, and analysis to examine how an organization or business can achieve its aims and
objectives most efficiently through decision-making. Thus, the purpose of managerial economics
is to provide economic method and scientific reasoning to solve managerial decision problems.
These economic theories and methods involved with two different conceptual approaches to the
study of economics such as microeconomics and macroeconomics. Microeconomics studies
phenomena related to goods and services from the perspective of individual decision-making
entities—that is, households and businesses. Macroeconomics approaches the same
phenomena at an aggregate level, for example, the total consumption and production of a region.
Microeconomics and macroeconomics each have their merits. The microeconomic approach is
essential for understanding the behavior of atomic entities in an economy. However,
understanding the systematic interaction of the many households and businesses would be too
complex to derive from descriptions of the individual units. The macroeconomic approach
provides measures and theories to understand the overall systematic behavior of an economy.
Since the purpose of managerial economics is to apply economics for the improvement of
managerial decisions in an organization, most of the subject material in managerial economics
has a microeconomic focus. However, since managers must consider the state of their
environment in making decisions and the environment includes the overall economy, an
understanding of how to interpret and forecast macroeconomic measures is useful in making
managerial decisions.
Specifically, managerial economics deals with microeconomic reasoning on real-world
problems such as pricing and production decisions in selecting best strategy in difference
competitive environments. These business decisions can be analyzed through:
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Most of the discussions were derived from Principles of Managerial Economics available at Creative CommonsNonCommercial-ShareAlike 4.0 International License (http://creativecommons.org/licenses/by-nc-sa/4.0/).
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1. Risk Analysis – Various uncertainty models, decision rules and risk quantification
techniques are used to assess the riskiness of a decision.
2. Production Analysis – Microeconomic techniques are used to analyze production
efficiency, optimum resource allocation, costs, economies of scale, and to estimate the
firm’s costs of production.
3. Pricing Analysis – Microeconomic techniques are used to examine various pricing
decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and optimal pricing method.
4. Budgeting – Investment theory is used to examine a firm’s capital purchasing decisions.
1.2 Why Managerial Economics Is Relevant for Managers
In a civilized society, we rely on others in the society to produce and distribute nearly all
the goods and services we need. However, the sources of those goods and services are usually
not other individuals but organizations created for the explicit purpose of producing and
distributing goods and services. Nearly every organization in our society—whether it is a
business, nonprofit entity, or governmental unit—can be viewed as providing a set of goods,
services, or both. The responsibility for overseeing and making decisions for these organizations
is the role of executives and managers. Most readers will readily acknowledge that the subject
matter of economics applies to their organizations and to their roles as managers. However, some
readers may question whether their own understanding of economics is essential, just as they
may recognize that physical sciences like chemistry and physics are at work in their lives but have
determined they can function successfully without a deep understanding of those subjects.
Whether or not the readers are skeptical about the need to study and understand economics per
se, most will recognize the value of studying applied business disciplines like marketing,
production/operations management, finance, and business strategy. These subjects form the
core of the curriculum for most academic business and management programs, and most
managers can readily describe their role in their organization in terms of one or more of these
applied subjects. A careful examination of the literature for any of these subjects will reveal that
economics provides key terminology and a theoretical foundation. Although we can apply
techniques from marketing, production/operations management, and finance without
understanding the underlying economics, anyone who wants to understand the why and how
behind the technique needs to appreciate the economic rationale for the technique. We live in a
world with scarce resources, which is why economics is a practical science. We cannot have
everything we want. Further, others want the same scarce resources we want.
Organizations that provide goods and services will survive and thrive only if they meet the
needs for which they were created and do so effectively. Since the organization’s customers also
have limited resources, they will not allocate their scarce resources to acquire something of little
or no value. And even if the goods or services are of value, when another organization can meet
the same need with a more favorable exchange for the customer, the customer will shift to the
other supplier. Put another way, the organization must create value for their customers, which is
the difference between what they acquire and what they produce. Thus, those managers who
understand economics have a competitive advantage in creating value.
1.3 Managerial Economics Is Applicable to Different Types of Organizations
The organization providing goods and services will often be called a “business” or a “firm,”
terms that connote a for-profit organization. And in some portions in the following discussions, we
discuss principles that presume the underlying goal of the organization is to create profit.
However, managerial economics is relevant to nonprofit organizations and government agencies
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as well as conventional, for-profit businesses. Although the underlying objective may change
based on the type of organization, all these organizational types exist for the purpose of creating
goods or services for persons or other organizations. Managerial economics also addresses
another class of manager: the regulator. The economic exchanges that result from organizations
and persons trying to achieve their individual objectives may not result in the best overall pattern
of exchange unless there is some regulatory guidance. Economics provides a framework for
analyzing regulation, both the effect on decision making by the regulated entities and the policy
decisions of the regulator.
1.4 Social Responsibility of Business
In modern capitalist economies, business firms contribute significantly to economic
welfare. Within free markets, firms compete to supply the goods and services that consumers
demand. Pursuing the profit motive, they constantly strive to produce goods of higher quality at
lower costs. By investing in research and development and pursuing technological innovation,
they endeavor to create new and improved goods and services. In most cases, the economic
actions of firms (spurred by the profit motive) promote social welfare as well: business production
contributes to economic growth, provides widespread employment, and raises standards of living.
The objective of value maximization implies that management’s primary responsibility is to the
firm’s shareholders. But the firm has other stakeholders as well: its customers, its workers, even
the local community to which it might pay taxes. This observation raises an important question:
To what extent might management decisions be influenced by the likely effects of its actions on
these parties? For instance, suppose management believes that downsizing its workforce is
necessary to increase profitability. Should it uncompromisingly pursue maximum profits even if
this significantly increases unemployment?
Alternatively, suppose that because of weakened international competition, the firm has
the opportunity to profit by significantly raising prices. Should it do so? Finally, suppose that the
firm could dramatically cut its production costs with the side effect of generating a modest amount
of pollution. Should it ignore such adverse environmental side effects? All these examples
suggest potential trade-offs between value maximization and other possible objectives and social
values. Although the customary goal of management is value maximization, there are
circumstances in which business leaders choose to pursue other objectives at the expense of
some foregone profits. For instance, management might decide that retaining 100 jobs at a
regional factory is worth a modest reduction in profit. Value maximization is not the only model of
managerial behavior. Nonetheless, the available evidence suggests that it offers the best
description of a private firm’s ultimate objectives and actions.
1.5 Social Responsibility of Business and Social Contract2
It is evident from above, the social responsibility of business implies that a corporate
enterprise has to serve interests other than that of common shareholders who, of course, expect
that their rate of return, value or wealth should be maximized. But in today’s world the interest of
other stakeholders, community and environment must be protected and promoted. Social
responsibility of business enterprises to the various stakeholders and society in general is the
result of a Social Responsibility of Business Enterprises towards Stakeholders and Society in
General contract as shown in the figure below.
2
https://www.economicsdiscussion.net/business/social-responsibility/social-responsibility-of-business/10141
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Environment
Employees
Business Enterprise
Shareholders
Figure: Responsibilities of Business
Enterprises towards Stakeholders to
Society in General
Consumers
Society
Social contract is a set of rules that defines the agreed interrelationship between various
elements of a society. The social contract often involves a quid pro quo (i.e. something given in
exchange for another). In the social contract, one party to the contract gives something and
expects a certain thing or behavior pattern from the other. In the present context the social
contract is concerned with the relationship of a business enterprise with various stakeholders
such as shareholders, employees, consumers, government, and society in general. The business
enterprises happen to have resources because society consisting of various stakeholders has
given them this right and therefore it expects from them to use them to for serving the interests of
all of them. Though all stakeholders including the society in general are affected by the business
activities of a corporate enterprise, managers may not acknowledge responsibility to them. Social
responsibility of business implies that corporate managers must promote the interests of all
stakeholders not merely of shareholders who happen to be the so-called owners of the business
enterprises.
1. Responsibility to Shareholders:
In the context of good corporate governance, a corporate enterprise must recognize the
rights of shareholders and protect their interests. It should respect shareholders’ right to
information and respect their right to submit proposals to vote and to ask questions at the annual
general body meeting. The corporate enterprise should observe the best code of conduct in its
dealings with the shareholders. However, the corporate Board and management try to increase
profits or shareholders’ value but in pursuing this objective, they should protect the interests of
employees, consumers, and other stakeholders. Its special responsibility is that in its efforts to
increase profits or shareholders’ value it should not pollute the environment.
2. Responsibility to Employees:
The success of a business enterprise depends to a large extent on the morale of its
employees. Employees make valuable contribution to the activities of a business organization.
The corporate enterprise should have good and fair employment practices and industrial relations
to enhance its productivity. It must recognize the rights of workers or employees to freedom of
association and free collective bargaining. Besides, it should not discriminate between various
employees. The most important responsibility of a corporate enterprise towards employees is the
payment of fair wages to them and provide healthy and good working conditions. The business
enterprises should recognize the need for providing essential labor welfare activities to their
employees, especially they should take care of women workers. Besides, the enterprises should
make arrange-ments for proper training and education of the workers to enhance their skills.
3. Responsibility to Consumers:
Some economists think that consumer is a king who directs the business enterprises to
produce goods and services to satisfy his wants. However, in the modern times this may not be
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strictly true, but the companies must acknowledge their responsibilities to protect their interests
in undertaking their productive activities. Invoking the notion of social contract, the management
expert Peter Drucker observes, “The customer is the foundation of a business and keeps it in
existence. He alone gives employment. To meet the wants and needs of a consumer, the society
entrusts wealth-producing resources to the business enterprise”. In view of above, the business
enterprises should recognize the rights of consumers and under-stand their needs and wants and
produce goods or services accordingly.
4. Obligation towards the Environment:
The foremost responsibility of business enterprises is to ensure that they should not
damage the environment and for this purpose they should reduce as much as possible air and
water pollution by their productive activities. They should not dump their toxic waste products in
rivers and streams to avoid their pollution. Pollution of environment poses a great health hazard
for the people and is a cause of several respiratory and skin diseases. In economic theory
pollution of environment is regarded as social cost that must be minimized. There is now a growing
awareness towards reduction in environment pollution. According to the recent findings the
climate change is occurring due to greater emission of carbon dioxide and other pollutants.
Therefore, the corporate enterprises should adopt high standards of environmental protection and
ensure that they are implemented regardless of enforcement of any environment laws passed by
the government. Many countries including India have passed laws to protect the environment, but
they are not properly and strictly enforced. Business enterprises in their attempt to maximize
profits recklessly and negligently pollute the environment. Therefore, it is required that
government should take tough measures and enforce environment laws strictly if environment is
to be protected.
5. Responsibility to Society in General:
Business enterprises function by public consent with the basic objective of producing
goods and services to meet the needs of the society and provide employment to the people. The
traditional view is that in performing this function businesses maximize profits or shareholders’
value and doing so they do not behave in any socially irresponsible way. According to Adam Smith
whose invisible hand theorem is often quoted that while maximizing their profits, businessmen
are led by an invisible hand to promote the interests of the society. To quote him, “An individual
or business generally, indeed neither intends to promote the public interest, nor knows how much
he is promoting it. He intends only his own gains, and he is in this, as in many other cases, led by
an invisible hand to promote an end which was no part of his intention. By pursuing his own
interest, he frequently promotes that of the society more effectively than when he really intends
to promote it”. In the present world where there are monopolies, oligopolies in product and factor
markets and there are externalities, especially detrimental externalities such as environment
pollution by the activities of business enterprises maximization of private profits does not always
lead to the maximization of social benefit. In fact, in such imperfect market conditions, consumers
are exploited by raising of prices much above the cost of production, workers are exploited as
they are not paid fair wages equal to the value of their marginal product. Besides, there are
harmful external effects to which are not given due considerations by private enterprises in making
their business decisions. Therefore, there is urgent need to make business enterprises behave in
a socially responsible manner and to work for promoting social interests.
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Assessment 1
1. Discuss and integrate microeconomics and macroeconomics in making managerial decisions
by citing examples. (5pts.)
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2. How does the scarcity of resources affect the firm’s decision making? Justify your answer
through discussing specific situations. (5pts.)
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3. Does regulating a firm will be significant for making optimal use of the resources and
production of goods and services? (5pts.)
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4. Having said that most firms chose to maximize their profit, do you think it is a hindrance in
their contribution to economic welfare? Justify your answer. (5pts.)
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