MANAGERIAL ECONOMICS
MBA722
Topic 2: The Fundamentals of Managerial Economics
Week 2
Lecturer: Mr. Wagima Christopher.
chriswagima@gmail.com/christopher.wagima@iuea.ac.ug
Recape on Introductory Definitions
Economics
can be defined as a study of the way decisions are made regarding
the optimal/rational way of allocating scarce resources
Managerial
economics is defined as the application of economic analysis to
business and other organizations’ problems. Emphasis is on the firm, the
environment in which it operates, and the decisions that firms have to take
2
The Fundamentals of
Managerial Economics
3
The Fundamentals of Managerial Economics
1. Goals and Constraints
2. The Nature and Importance of Profits
3. Understanding Incentives
4. Understanding Markets
5. The Time Value of Money
6. Marginal Analysis
4
The Fundamentals of Managerial Economics
1.Goals and Constraints
5
The Fundamentals of Managerial Economics
1.Goals and Constraints
A fundamental economic truth is that individual firms or decision
makers respond to economic incentives
(i.e. money, profits, utility, etc.)
and how they influence strategic decision making.
6
Managerial Goals (examples)
Sales, total revenue, gross income, market share
Q sales, Q of output, output per unit of input (production efficiency)
Costs, total costs, cost per unit of output (cost efficiency)
Profits, total profits, profit per unit of output
7
Michael Porter’s “Five Competitive Forces”
Decision-making constraints
= Factors
that influence the sustainability of firm profits
1. Market entry conditions for new firms
2. Market power of input suppliers
3. Market power of product buyers
4. Market rivalry amongst current firms
5. Price and availability of related products including both
‘substitutes’ and ‘complements’
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Managerial Choices (examples)
Output quantity
Output quality
Output mix
Output price
Marketing and advertising
Production processes (input mix)
Input quantity
Production location
Production incentives
Input procurement
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The Concept of Opportunity Cost
Opportunity cost of a decision to produce or to consume one
good is the maximum value of the next best alternative
foregone. Alternatively, opportunity cost is the maximum
sacrifice one has to bear to acquire something of value.
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Numerical illustration on ‘opportunity cost’
in production
Assume with given resources you could produce various
combinations of bicycles (X) and motor-cycles (Y), represented
by the table below.
X
Y
0
8
3
7
6
6
9
5
24
0
11
Information in previous table
can be represented by the line
graph given below
The slope of the line is
is equal to (6 – 5)/(6 – 9) or (-1/3).
Opportunity cost of 3 bicycles (X) is
1 motorcycle (Y). Alternatively, 1
motorcycle is equivalent to 3 bicycles
in terms of resource requirements.
no. of
motor
cycles, Y
6
5
6
Note equation of the line is given by
y = 8 – (1/3)x
A(6,6)
B(9,5)
9
X,
number of bicycles
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Numerical illustration on ‘opportunity cost’ in
consumption
Suppose with a given amount of money a consumer is
able to buy the following combinations of ‘meals’ (X)
and clothing (Y).
No of meals (X) Units of clothing (Y)
10
2
6
3
2
4
13
Note, slope of line = (change in Y)/(change
in X)
OR
Y
(0,4.5)
(4-2)/(2-10) = (2/-8)= -(1/4)
Equation of the line: y = 4.5 – (1/4)x
(2,4)
(10,2)
(0,0)
(18,0)
X
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Numerical illustration on ‘opportunity cost’ in
consumption
Opportunity cost of 4 meals is 1 unit of clothing. Alternatively, 1
unit of clothing is equivalent to 4 meals in terms of money spent.
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The Fundamentals of Managerial Economics
2. The nature and Importance of Profits
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Costs of production
Distinction between accounting costs and opportunity costs:

Opportunity cost may be defined as expected returns from the second
best use of resources which are foregone due to scarcity of resources
(Implicit costs)
 Accounting costs are actual monetary expenses recorded in books of
account (Explicit costs)
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Explicit and Implicit costs
Explicit costs involve a direct money outlay for factors of
production
Implicit costs do not involve a direct money outlay
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Economic and accounting profit
Economists include all opportunity costs when measuring costs
Accountant measure the explicit costs but often ignore the implicit costs
When total revenue exceeds both explicit and implicit costs, the firm earns
economic profit
Accounting profit is difference between total revenue and explicit costs
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Economic profit versus accounting
profit
How economist
views a firm
Implicit
costs
Explicit
costs
Revenue
Economic
profit
How accountant
views a firm
Accoun
ting
profit
Explicit
costs
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The Fundamentals of Managerial
Economics
3. Understanding Incentives
21
Understanding Incentives
Incentive is a measure to promote beneficial activities.
Helps to resolve moral hazards
Principal – agent problem: conflict of interest between manager
and owner of the firm:- ‘Managers are more interested in
maximization of their own benefits, instead of maximizing
corporate profit’
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Understanding Incentives
Asymmetric information
Adverse Selection : Immoral behavior that takes
advantage of asymmetric information before a
transaction.
Hazards : Where the behavior of one party may change
to the detriment of another after a transaction has taken
place.
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Understanding Incentives
Resolve the moral hazard requires one;
To invest in monitoring and surveillance and other
methods of collecting information about the behavior of
the party subject to moral hazard.
To align the incentives of the party subject to moral
hazard with those of the less informed party
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Understanding Incentives
Types of Incentive Schemes
Performance Pay :- Incentive schemes resolve the moral
hazard by tying payments to some measure of performance.
The scheme depends on a link between the unobservable
action and some observable measure of performance.
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Understanding Incentives
The architecture of an organization comprises of:
Distribution of ownership
Incentive schemes and
Monitoring systems
•A positive incentive measure is an economic
institutional
measure designed to encourage beneficial activities.
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and
Understanding Incentives
Performance Quota:
The Minimum standard of performance, below which a worker is
subject to penalties. The penalties could include deferral of
promotion, reduction in pay or even dismissal.
Cost-effective way of inducing the worker to choose the
economically efficient level of effort.
It is cost-effective because it does not reward effort below or
above the economically efficient level.
It focuses the incentive at the economically efficient level of
effort.
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Understanding Incentives
Relative Performance Incentive:In some situations, the moral hazard can be resolved in a very natural
way without imposing risk.
By gauging performance on a relative basis, the incentive scheme
cancels out the effect of extraneous factors to the extent that they
effect all workers equally
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The Fundamentals of Managerial
Economics
4. Understanding Markets
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Analyzing the Structure of a Market
Aim: to understand key aspects of markets:
• Nature of demand for products
• Closeness or otherwise of competitors
• Structure of costs
• Dependence of profits on the level of output
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Demand Curve
Shows amount purchased as a function of price
Depends on:
- income
- tastes
- prices of competitive products
- prices of complementary products
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Supply Curve
Amount offered for sale as a function of price
Depends on costs of production, which in turn
depend on
- costs of inputs
- technology
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The Market Mechanism
S
Price
($ per
unit)
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Quantit
y
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The Market Mechanism
Characteristics of the equilibrium or market
clearing price:
*QD = QS
*No shortage
*No excess supply
*No pressure on the price to change
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Demand Curve -Income Rises
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Demand Shifts
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Supply shifts
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D & S shift
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The Market Mechanism
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The Market Mechanism
A Surplus
*The market price is above equilibrium
* There
is excess supply
* Producers lower prices
* Quantity demanded increases and quantity
supplied decreases
* The market continues to adjust until the
equilibrium price is reached.
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The Market Mechanism
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The Market Mechanism
Shortage
The market price is below equilibrium:
* There
is a shortage
* Producers
raise prices
* Quantity
demanded decreases and
quantity supplied increases
* The
market continues to adjust until the
new equilibrium price is reached.
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The Market Mechanism
Market Mechanism - Summary:
1) Supply and demand interact to
determine the market-clearing price.
2) When not in equilibrium, the market
will
adjust to alleviate a shortage or surplus and return
the market to equilibrium.
3) Markets
must
be
competitive
mechanism to be efficient.
for
the
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Changes In Market Equilibrium
S1998
S1900
Price
S1950
D199
8
D195
D190
0
0
Quantity
Conclusion
Decreases in the costs of
production have increased the
supply by more than enough to
offset the increase in demand.
44
The Fundamentals of Managerial
Economics
5. Marginal Analysis
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Marginal Analysis
Analysis of ‘marginal’ costs and ‘marginal’ benefits
due to a change
Marginal = additional or incremental
Costs and benefits that are constant (i.e. fixed,
don’t change) are excluded from the analysis
Changes occurring at ‘the margin’ are all that
matter
Two important dimensions of change: direction,
magnitude
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“Good” Economic Decisions
Marginal benefits > marginal costs
Examples of marginal benefits:
↑ profit
↑ revenue
↓ cost
↑ safety
↓ risk
Marginal costs = opposite of above examples
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Marginal Analysis (Examples)
Y
Incremental Y/
Incremental X
MR
TR
X
Units of output
TC
Units of output
MC
TP
Units of input
MP
TRP
Units of input
MRP
TC
Units of input
MFC
TU
Units of good
MU
Profit
Units of output
MP
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Assume you are a member of your company’s Marketing Dept. You
believe, and correctly so,
1) the market demand for your firm’s product is linear,
2) if your company charges Ugx 5 for its product, quantity sold would be
200 units and
3) if your company set price is Ugx 3, the number of units sold would be
400.
Develop alternative ways of explaining to upper-level
management more fully the relationship between the
company’s price and the resulting number of units of
product sold.
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Variable Relationships
Example of Alternative Ways of Depicting
Tabular
P
Q
7
0
6
100
5
200
4
300
3
400
2
500
1
600
0
700
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Variable Relationships
Example of Alternative Ways of Depicting
Mathematical
Q = 700 – 100P
P = 7 – 0.01Q
Graphical
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“Ceteris Paribus”
Y = a + b1X1 + …bnXn=> the value of Y depends on the
values of n different other variables; a ‘ceteris paribus’
assumption => we assume that all X variable values
except one are held constant so we can look at how the
value of Y depends on the value of the one X variable
that is allowed to change
52
The Fundamentals of Managerial Economics
6. The Time Value of Money
53
Time Value of Money
(Basic Concept)
Money is worth more (or less) the sooner (later) it is received or paid due to
the ability of money to earn interest.

present value
+ interest earned
= future value
Or

future value
- interest lost
= present value
54
Time Value of Money
(Applications/Uses)
1. To evaluate business decisions where at least some of the cash
2.
3.
flows occur in the future
To project future dollar amounts such as cash flows, incomes,
prices
To estimate equivalent current-period values based on
projected future values
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Time Value of Money Concepts
PV = present value =
the number of currency units you will be able to borrow [or
have to save] presently in order to payback [or collect] a given number of currency units
in the future
FV = future value =
the number of currency units you will have to pay back
[or be able to collect] in the future as a result of having borrowed [or saved] a
given number of currency units presently
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Time Value Equation
FVn
=
PVn =
PV(1+r)n
FV/(1+r)n
Compounding
Discounting
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Net Present Value (NPV)
=
=
an investment analysis concept
PV of future net cash flows – initial cost
=
PV of MR’s – PV of MC’s
=
invest if NPV > 0
=
invest if PV of MR’s > PV of MC’s
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Internal Rate of Return
. an investment analysis alternative
. value of ‘r’ that results in a NPV = 0
. an investment analysis alternative
. period of time required for the sum
of net cash flows to equal the initial cost
It is the value of n such that
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Session References
Prof. Trupti Mishra, School of Management, IIT Bombay --- Lecture notes
Managerial economics – Christopher R Thomas, S Charles Maurice and Sumit
Sarkar
Managerial economics – Geetika, Piyali Ghosh and Purba Roy Choudhury
Managerial economics- Paul G Keat, Philip K Y Young and Sreejata Banerjee
Micro Economics : ICFAI University Press
Professor Geoffrey Heal, 616 Uris Hall --- Lecture notes
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END
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