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Managerial- Economics REVIEWER for BSA
economics (Divine Word College of Legazpi)
Studocu is not sponsored or endorsed by any college or university
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problems they meet within the
firm."
CHAPTER 1
Managerial
Economics
is
the
application of economic theory and
methodology to managerial decision
making problems within
various
organizational settings such as a firm or
a government agency. It is a study of
how the theory of consumer behavior,
firm and market structures can be used
to guide management decision making.
Applications are made under different
market situation. Emphasis on the use of
mathematical tools are given.
 It is the integration of economic
theory with business practice for
the
purpose
of
facilitating
decision making and forward
planning by management –
SPENCER AND SIEGELMAN
 It is the application of economic
concepts and economic analysis
to the problems of formulating
rational managerial decisions. –
Edwin Mansfield
It is the use of economic analysis to
make business decisions involving the
best use of an organization’s scarce
resources.
 Joel Dean, author of the first
managerial economics textbook,
managerial economics as the
“use of economic analysis in the
formulation of business policies.
 William
Baumol,
a
highly
respected
economist
and
industry consultant, stated that
an economist can use his or her
ability to build theoretical models
and apply them to any business
problem, no matter how complex,
break it down into essential
components, and describe the
relationship
among
the
components, thereby facilitating
a systematic search for an
optimal solution.
 William H. Meckling, the former
dean of the Graduate School of
Management at the University of
Rochester, expressed a similar
sentiment
in
an
interview
conducted by The Wall Street
Journal. In his view, "economics
is a discipline that can help
students solve the sort of

Economics
 The study of the problem of using
available economic resources as
efficiently as possible so as to attain
the maximum fulfillment of society’s
unlimited demand for goods and
services.

The study of the behaviour of
human
beings
in
producing,
distributing, and consuming material
goods and services in a world of
scarce resources.

The science which studies human
behaviour as a relationship between
ends and scarce means which have
alternative uses.

It is the branch of study that deals
with the proper allocation of
available resources to satisfy
unlimited wants and needs.
Proper allocation = priority
Two Greek roots of the word economics
are:
oikos
meaning
household;
nomos
meaning
system
of
management.
Oikonomia or oikonomos means
“management of household”. With the
growth of the Greek society until its
development into city-states, the word
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became
known
as
“state
management”. The term “management
of household” pertains to the
microeconomic branch of economics
while “state management” refers to the
macroeconomic branch of economics.
Location,
staff

products,
finances,
and
STAFFING – Manning the
organization structure through
proper and effecting selection,
appraisal and development of
personnel to fill the roles
designed in the structure.
Designating the employees to their
respective potential duties.
Management

DIRECTING – Communication,
leadership,
motivation,
supervision.

CONTROLLING – Measurement
of accomplishment against the
standards and correction of
deviations.
 The disciple of organizing and
allocating
a
firm’s
scarce
resources to achieve its desired
objectives.
 guidance, leadership and control
of the efforts of a group of people
towards some common objective
 Creation and maintenance of an
internal Notes environment in an
enterprise where individuals,
working together in groups, can
perform efficiently and effectively
towards the attainment of group
goals (Koontz and O'Donell)
Budgeting the money. The essence of
controlling is the variances and have
corrective actions.
POSDICON
NATURE
OF
ECONOMICS
 Art of knowing what to do, when
to do, and see that it is done in
the best and cheapest way.
FUNCTIONS OF MANAGEMENT


PLANNING - setting goals (long
term and short term goals)
ORGANIZING – Putting together
physical, financial and human
resources
MANAGERIAL

Coordination

An activity or an ongoing process

A purposive process

An art of getting things done for
other people

Art and science

Microeconomics

Uses of macroeconomics

Multi-disciplinary – all knowledge
entered
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
Prescriptive Disciple – achieve
goal

Pragmatic/Practical
solutions
TYPES
OF
ECONOMICS
–
realistic
MANAGERIAL
Normative Managerialism

The
normative
view
of
managerial economics states
that administrative decisions are
based on real-life experiences
and practices. They have a
practical approach to demand
analysis, forecasting,
cost
management, product design
and promotion, recruitment, etc.
Radical Managerialism


Managers
must
have
a
revolutionary attitude towards
business problems, i.e. they must
make decisions to change the
present situation or condition.
They focus more on the
customer’s requirement
and
satisfaction rather than only profit
maximisation.
Black swan event - an
unpredictable event that is
beyond
what
is
normally
expected of a situation and has
potentially severe consequences.

Example: Covid’s Pandemic

Flexible
Liberal Managerialism

A market is a democratic place
where people are liberal to make
their choices and decisions. The
organisation and the managers
have to function according to the
customer’s demand and market
trend; else it may lead to
business failures.
Principles of How People Make
Decisions
To understand how the decision making
takes place in real life, let us go through
the following principles:

People Face Tradeoffs
To make decisions, people have to make
choices where they have to select
among the various options available.

Opportunity Cost
Every decision involves an opportunity
cost which the cost of those options
which we let go while selecting the most
appropriate one.

Rational People Think at the
Margin
People usually think about the margin or
the profit they will earn before investing
their money or resources at a particular
project or person.

People Respond to Incentives
Decisions making highly depends upon
the incentives associated with a product,
service or activity. Negative incentives
discourage people, whereas positive
incentives motivate them.
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Principles of How People Interact
Communication and market affect
business operations. To justify the
statement, let us see the following
related principles:

Trade Can
Better off
Make
Everyone
This principle says that trade is a
medium of exchange among people.
Everyone gets a chance to offer those
products or services which they are
good at making. And purchase those
products or services too, which others
are good at manufacturing.

Markets Are Usually A Good
Way to Organize Economic
Activity
Markets mostly act as a medium of
interaction among the consumers and
the producers. The consumers express
their needs and requirement (demands)
whereas the producers decide whether
to produce goods or services required or
not.

Governments Can Sometimes
Improve Market Outcomes
Government
intervenes
business
operations at the time of unfavourable
market conditions or for the welfare of
society. One such example is when the
government decides minimum wages for
labour welfare.

Prices
Rise
When
the
Government Prints Too Much
Money
If there are surplus money available with
people,
their
spending
capacity
increases, ultimately leading to a rise in
demand. When the producers are
unable to meet the consumer’s demand,
inflation takes place.

Society Faces a Short-Run
Tradeoff Between Inflation and
Unemployment
To
reduce
unemployment,
the
government brings in various economic
policies into action. These policies aim at
boosting the economy in the short run.
Such practices lead to inflation.
NATURE AND SCOPE OF
MANAGERIAL ECONOMICS
The most important function in
managerial economics is decision
making which involves the complete
course of selecting the most
suitable action from two or more
alternatives. The primary function is
to make the most profitable use of
resources.
GRAPH
Nature and Method of Economics
Principles of How Economy Works
As A Whole

A Country’s Standard of Living
Depends on Its Ability to
Produce Goods and Services
For the growth of the economy of a
country, the organisations must be
efficient enough to produce goods and
services. It ultimately meets the
consumer’s demand and improves GDP
to raise the country’s standard of living.
SCARCITY:
 the basic and central economic
problem confronting every society. It
is the heart of the study of economics
and
the
reason
behind
its
establishment.
 Available resources are not enough to
satisfy wants and needs.
Problems of Scarcity:
Limited Sources
Unlimited Wants
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SUPPLY, DEMAND, AND SCARCITY
3. If so, what price and output levels
should we set in order to maximize
our economic profit or minimize our
losses in the short run? (profit
maximization theory)
Resources
Needs and
wants of the
population
LAND
LABOR
CAPITAL
COPROFO-OUTIN
OPPORTUNITY COST – the amount of
subjective value that must be sacrificed in
choosing one activity over the next best
alternative.
(a) Cost leader?
(b) Product differentiation?
(c) Focus on market niche?
In making these decisions, managers
must essentially deal with the
following q’s listed in abridged form:
(d) Outsourcing, alliances, merger,
acquisitions?
(e) International
dimensions
–
regional or country or expansion
1. What are the economic conditions
in a particular market in which we are
or could be competing? In particular:
Example:
MASUTEGOINFM
Why do people want premium items.
(a) Market structure?
Typical of the types of risk that
businesses face include:
- Marami ba kayong nagcocompete?
(b) Supply and demand conditions?
- Mataas ang supply and demand
(c) Technology?
(d) Government regulations?
- Does the government are strict to
them? Especially cars.
(e) International dimensions?
- Like Mcdo Olds,
international brances
they
do
have
(f) Future conditions?
 Changes in demand and supply
conditions
(like
summer;
customers want aircon)
 Technological changes and the
effect of competition (dvd players
into computers)
 Changes in interest rates and
inflation rates
 Exchange rate changes for
companies
engaged
in
international trade (currency)
 Political risk for companies with
foreign operations
You may not literally see the term risk in
many of the topics that we will study in
this course. However, we really know
that risk is present in most situations.
- Going concern; marginalized;
Economics Divided Into Two Groups:
(g) Macroeconomic factors?
2. Should
business?
our
firm
be
in
this
 Microeconomics concerns the
study of individual consumers
and producers in specific markets
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on how to distribute resources
and how they interact.
Topics in microeconomics include supply
and demand in individual markets, the
pricing of specific outputs and inputs
(also called factors of production, or
resources),
production
and
cost
structures for individual goods and
services, and the distribution of income
and output in the population.




Other examples:
1. The economic concept of opportunity
cost.
 Marketing,
Finance,
Management Science, Strategy
and Managerial Accounting.
 Macroeconomics deals with the
aggregate economy; deals with
the performance and structure
and behaviour of an economy as
a whole.
Topics in macroeconomics include
analysis of the gross domestic product
(also referred to as "national income
analysis"),
unemployment,
inflation,
fiscal and monetary policy, and the trade
and financial relationships among
nations.
Perfect competition – fish market
Pure monopoly – INEC & water
Monopolistic completion – hair
salons, store, clothing, etc.
Oligopoly – apple and samsung
 Theme of strategy and human
resources
in
managerial
economics.
The microeconomic theory of the
behaviour of consumers and firms in
competitive markets.
- show linkages of economics with other
business functions, while maintaining a
focus on the heart of managerial
economics.
MICROECONOMICS
Microeconomics is the category that is
used in managerial economics.
However,
certain
aspects
of
macroeconomics must also be included
because decisions by managers of firms
are influenced by their views of the
current and future conditions of the
macroeconomy.
However, for the most part, managerial
economics is based on the variables,
models, and concepts that embody
microeconomic theory.
Examples drawn form the core of
microeconomics:
1. The economic analysis of demand
and price elasticity.
2. The division of markets into four
types:
Importance of Economics
 Economics deals with vital current
problems
such
as
inflation,
unemployment, monopoly, economic
growth, population, and poverty.

It is a problem-oriented social
science. It also relates to personal
problems
like
wages,
unemployment, cost of living, taxes,
etc.

Economics is attractive because of
its use of the scientific method for
the study of people.

Knowledge of economics and
understanding of current economic
institutions and problems are
essential in certain occupations.

Economics and economic issues
may be your avocation
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Ceteris Paribus
Means “all other things held constant or
all else equal.” This assumption is used
as a device to analyze the relationship
between two variables while other
factors are held unchanged.
Laissez-faire or let alone policy
No government intervention
ALLOCATION DECISIONS:
What to produce?
A society must determine what goods
and services must be produced and in
what quantities. This concerns the
composition of the total output a society
must produce.
(a) Types of goods and services they
are likely to purchase in the
current period and in the future.
(b) Factors
influencing
the
consumption of a particular good
or service
(c) The effect of a change in these
factors on the demand of that
particular good or service.
How to produce?
A society must determine who will do the
production, with what resources, and
what production techniques they will use.
It involves selection of inputs and
techniques of production. Raw materials
to capital equipment.
Capital
Intensive
Labor Intensive
For whom? (Target Market)
This is in terms of the distribution of
income, wealth, and total output among
households, business government, etc.
Additional: How much to produce?
SCOPE
OF
ECONOMICS
MANAGERIAL
▪
RESOURCE ALLOCATION
Scarce resources have to be used with
utmost efficiency to get optimal results.
These include production programming,
problem of transportation, etc.
▪
INVENTORY
PROBLEM
AND
QUEUING
Inventory problems involve decisions
about holding of optimal levels of
stocks of raw materials and finished
goods over a period.
These
decisions
are
taken
by
considering
demand
and
supply
conditions.
Queuing problems involve decisions
about
installation
of
additional
machines or hiring of extra labour in
order to balance the business lost by
not undertaking these activities.
▪
PRICING PROBLEMS
Fixing prices for the products of the firm
is an important part of the decision
making process. Pricing problems
involve decisions regarding various
methods of pricing to be adopted.
▪
INVESTMENT PROBLEMS
Forward planning involves investment
problems. These are problems of
allocating scarce resources over time.
For example, investing in new plants,
how much to invest, sources of funds,
etc
All countries must deal with these three
basic questions because all have scarce
resources.
There are essentially three ways a
country can answer the questions of
what, how, and for whom. These ways,
referred to as processes, are as follows:
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1. Market process: The use of supply,
demand, and material incentives to
answer the questions of what, how, and
for whom,
 Democracy refers to a political
system in which government is by
the people, exercised either directly
or though elected representatives
2. Command process: The use of the
government or some central authority to
answer the three basic questions. (This
process is sometimes referred to as the
political process.)
 Totalitarianism is a form of
government in which one person or
political party exercises absolute
control over all spheres of human
life and opposing political parties are
prohibited
3. Traditional process: The use of
customs and traditions to answer the
three basic questions.
Political Systems



Shapes the economic and legal
systems of a country
Refers to the system of government
in a nation
Composed of two interrelated
dimensions: collectivism as opposed
to individualism; democratic to
totalitarian
–
Collectivism and Individualism
Collectivism refers to a political system
that stresses the primacy of collective
goals over individual goals.
 The needs of society as a whole are
generally viewed as being more
important than individual freedoms
 An individual’s right to do something
may be restricted on the grounds
that it runs counter to the good of
society
Individualism refers to a philosophy that
an individual should have freedom in
his/her economic and political pursuits.
 Stresses that the interest of the
individual should take precedence over
the interests of the state
 Individual
economic
and
political
freedoms are the ground rules on which
a society should be based
Democracy and Totalitarianism
Economic Systems
The way in which economic units and
institutions are organized to solve the
fundamental problems of society
To
address
or
answer
the
fundamental economic questions
Traditional Economy
 A traditional economy is a system
that relies on customs, history, and
time-honored
beliefs.
Tradition
guides
economic decisions such
as production and distribution.

Decisions are based on traditional
practices.

Traditional economies depend on
agriculture,
fishing,
hunting,
gathering, or some combination of
the above.

They
money.

Subsistence economy - produce
what you can consume

The head of the family answers the
Fundamental Economic
Questions.
use
barter instead of
5 Traits of Traditional Economy
1. Centre on family or tribe
2. Exists in a Hunter-Gatherer and
Nomadic Society.
3. Trade relies heavily on barter
Exchange of goods and services to
other goods and services.
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
4. Produce only what you need
(surplus or leftovers are rare)

5. They eventually evolve to form some
form of currency for trade.
Market Economy
 is one in which individuals and
private firms make the major
decisions about production and
consumption.

Firms produce the commodities that
yield the highest profits by the
techniques of production that are
least costly.

Consumption is determined by
individuals’ decisions about how to
spend the wages and incomes

Most democratic form of economic
systems.
A free market economy may lead to
macroeconomic instability.
There is the ethical objection that a
free-market economy by rewarding
self
interests
behavior
may
encourage
selfishness,
greed,
materialism and the
acquisition of power
Command Economy
 is one in which the government
makes all important decisions about
production and distribution.
 It is designed to replace the
interplay of supply and demand
capitalist marketplace with statedictated policy
 The central government/central
planning committee answers the
Fundamental
Economic
Questions
 Enterprises are owned by the
people but represented by the state.
 Communism
(no
private
ownership of resources)
 Government makes all important
decisions (production & distribution)
 Designed to replace the interplay of
supply
&
demand
capitalist
marketplace.
6 Characteristics of a Market
Economy
1. Private property
2. Freedom of choice (they can choose
what to produce)
3. Motive of self-interest (earn profit)
4. Competition
5. System of markets and prices
(supply & demand)
6. Limited government
5 Characteristics of Command Economy
1. The government creates a central
economic plan.
Capitalism:
Pure - no government intervention 2. The government allocates all resources
according to the central plan.
Regulated - minimal intervention
3. The central point sets the priorities for all
production of all goods and services.
Problems of the Market Economy
 Competition between firms is often
4.
limited.
 Lack of competition and high profits
may remove the incentives for firms
5.
to be efficient.
 Power and property may be
unequally distributed.
 The practices of some firms may be
socially undesirable.
 Some socially desirable goods
would simply not be produced by
private enterprise.
The government
businesses.
owns
monopoly
The
government
creates
laws,
regulations, and directives to enforce the
central plan.
Mixed Economy
 Certain sectors of the economy are
left to private ownership and free
market mechanisms while other
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
sectors have significant state
ownership
and
government
planning.
Today, most decisions are made in
the marketplace but the government
plays
an
important
role
in
overseeing the functioning of the
market; governments pass laws that
regulate economic life, produce
educational and police services, and
control pollution.
Combination of the systems
 Market + traditional
 Philippines (mixed but market
oriented)
Prices are dictated by supply +
demand.


costs, total costs, cost per unit of
output (cost efficiency)
profits, total profits, profit per unit of
output
Managerial Choices
 Output quantity
 Output quality
 Output mix
 Output price
 Marketing and advertising
 Production processes (input mix)
 Input quantity
 Production location
 Production incentives
 Input procurement
How
Is
Useful?
2 Characteristics of Mixed Economics
Evaluating Choice Alternatives
 Identify ways to efficiently
achieve goals.
 Specify pricing and production
strategies.
 Provide
production
and
marketing
rules
to
help
maximize net profits.

Making the Best Decision
 Managerial economics can be
used
to
efficiently
meet
management objectives.
 Managerial economics can be
used to understand logic of
company,
consumer,
and
government decisions.
2. Government has a large role in
military,
international
trade,
+
transportation.
Goals, Incentives, Objectives
A fundamental economic truth is that
individual firms or decision makers
respond to economic incentives.
What these incentives are (i.e. money,
profits, utility, etc.) and how they
influence economic decision making are
key topics for study and analysis in
business (or managerial) economics.
Managerial Goals (examples)
 sales, total revenue, gross income,
market share
 Q sales, Q of output, output per unit
of input (production
efficiency)
Economics

1. Federal
government can
safeguard people + markets.
Managerial Economics
Managerial
Economics
is
microeconomics applied to decisions
made by business managers.
Managerial
Michael Porter’s
“Five Competitive Forces”

Decision-making constraints

Factors
that
influence
sustainability of firm profits:
the
1. Market entry conditions for new
firms
2. Market power
of input
suppliers
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3.
4.
5.
Market
power of product
buyers
Market rivalry amongst current
firms
Price and availability of related
products
including
both
‘substitutes’ and ‘complements’
Management Decision
Problems/Strategy






Product selection,
output, and
pricing
Internet strategy
Organization design
Product development and promotion
strategy
Worker hiring and trying
Investment and financing

Economic Concepts/Theory
Marginal analysis
Theory of consumer demand
Theory of the firm
Industrial organization and firm
behavior
Public choice theory






Quantitative Methods
Numerical analysis
Statistical estimation
Forecasting procedures
Game-theory concepts
Optimization techniques
Information systems




Managerial Economics
Use of economic concepts and
quantitative
methods
to
solve
management decision problems
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
change: direction, magnitude
of
“Good” Economic Decisions
Marginal benefits > marginal costs
Examples of marginal benefits:
↑ profit
↑ revenue
↓ cost
↑ safety
↓ risk
Marginal costs = opposite of above
examples.
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.
Perhaps one of the best ways to link the
economic problem of making choices
under conditions of scarcity with the
tasks of a manager is essentially a
person who is responsible for the
allocation of a firm’s scarce resources.
It is the interesting to note that
“managers” or “management skills”
was not delineated as a separate factor
of production by early economic theorists
the four traditional categories of
resources are LAND, LABOR, CAPITAL,
ENTREPRENEURSHIP.
The
last
category can be treated as broad
enough to include management, but the
two classification do involve different
characteristics in skills.
ENTREPRENEURSHIP
Generally associated with the ownership
of the means of production. It implies
willingness to take certain risk in the
pursuit of goals (e.g. starting anew
business, producing a new product, or
providing a different kind of service.)
Management, in contrast, involves the
ability to organize and administer various
tasks in pursuit of certain objective. An
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important part of a manager’s job is to
monitor and guide people in an
organization.
PETER DUCKER – the founding father
of the science of management
It is management that determines what
is needed and what has to be achieved.
Management is work. Indeed, it is the
specific work of a modern society, the
work that distinguishes our society form
all earlier ones. As work, management
has its own skills, it sown tools, its
techniques.
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suppliers. Society is also involved
because businesses use scarce
resources, pay taxes, provide
employment
opportunities,
and
produce much of society's material
and services output
 A firm is a collection of resources
that is transformed into products
demanded by consumers.
 Profit maximization is the traditional
trend
 Today, the emphasis on profits has
been broadened to encompass
uncertainty and the time value of
money. In this more complete model.
the primary goal of the firm is longterm expected value maximization
 The value of the firm is the present
value of the firm's expected future
net cash flows
 The traditional theory of economics
defined the firm as a collection of
resources that is transformed intro
products demanded by consumers.
CHAPTER 2
THE FIRM AND ITS GOALS
Theory of the Firm

 The difference between the revenue
it receives and the cost it incurs is
profit.
A business model where people are
directly involve which includes
customers,
stockholders,
management,
employees,
and
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 It is the aim of the firm to maximize
its profit.
 Why does a firm perform certain
functions internally and others
through the market? It appears the
size of the firm is not determined
strictly
by
technological
considerations.
CONSTRAINTS AND THEORY OF
THE FIRM


Organizations frequen tly face
limited availability of essential
inputs, such as skilled labor, raw
materials, energy, specialized
machinery
and
warehouse
space.

Research shows that vigorous
competition
typically
forces
managers
to
seek
value
maximization in their operating
decisions.

Competition
in
the
capital
markets forces managers to seek
value maximization in their
financing decisions as well.

Managers who their interests
instead of stockholders' interests
run the risk of losing their job.

Unfriendly
takeovers
are
especially hostile to inefficient
management that is replaced.
Moreover, recent studies show a
strong correlation between firm
profits
and
managerial
compensation.
Decisions
can
also
be
constrained
by
contractual
requirements. For example,
labor contracts limit flexibility in  It is unwise to seek the best technical
worker scheduling and job
solution to a problem if the costs of
assignments.
finding such a solution greatly
exceed resulting benefits. (cost
benefit)

Legal restrictions, which affect
both production and marketing
activities, can also play an  As a result, what often appears to be
decisions. Important role in
satisfying
on
the
part
of
managerial.
management can be interpreted as
value-maximizing behavior once the
costs of information gathering and
analysis are considered.
LIMITATIONS OF THE THEORY OF
THE FIRM
 Socially responsible
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LIMITS TO FIRM SIZE
 tradeoff between
transactions and the
internal operations
external 
cost of
 company chooses to allocate
resources so total cost is
minimum
 outsourcing of peripheral, noncore activities
Why some firms are small and
other’s large?
Answer: In 1937, Ronald Coase
postulated that a company compares
costs of organizing an activity
internally with the cost of using the
market system for its transactions.
Transaction costs are influenced by:
1. Uncertainty – inability to know
the future perfectly. Increases
transaction cost, it is not possible
to include all contingencies.
2. Frequency
(number)
of
recurrence
–
3. Asset specificity - If a buyer
contracts for a specialized
product with just one seller, and
furthermore, if the product
necessitates the use of some
specialized machinery, the two
parties become tied to one
another.
Examples:

Trade-off between
costs
and
transactions

Search costs – fuels internet
today; ship directly to the
consumers.
internal
external
Types of Transaction Cost


Reducing the internal costs
and external costs and trying
to breakthrough so that other
business hard to copy it.
In dealing through the market, the
firm incurs transaction costs –
incurred when a company enters
into a contract with other entities.
1. Investigation – doing the due
diligence the legwork to find
out who are the potential
people that can provide those
goods and services and then
sorting through that to a small
number of them and then
having them bid against each
other which who gets the
contract they used to involved
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
such as Freight and other
logistic services.
2. Negotiation – is part of the
proposal bid for proposal and
evaluation;
enforcing
the
contracts to perform their
obligation.
3. Enforcing
contracts
–
Division of labor is limited by
the extent of the market.
- Adam Smith

Future changes in market
conditions (or in production
technology)
may
lead
to
opportunistic behavior, where
one of the parties seeks to take
advantage of the other. In such
cases, transaction costs will be
very high.

When transaction costs are high,
a company may choose to
provide the service or product
itself.

Employers
will
try
to
decrease monitoring costs
by using incentives to
increase employees output.
If transaction costs for a specific
product or service are higher
than the cost of carrying on the
activity
internally,
then
a
company
benefits
from
performing this particular task inhouse.
 George Stigler discussed this point
in a 1951 article, and concluded
that
as
industries
expand.
Companies that previously had
produced everything internally will
tend to experience "vertical
"disintegration.
What
has
happened of course is that
transaction costs have decreased
and that the possibility of
opportunistic behavior" has also
diminished.
THE ECONOMIC GOAL OF THE
FIRM AND OPTIMAL DECISION
MAKING

Stock ownership, stock options
and employee stock plans:
 Every business has a goal.

Bonuses,
benefits,
perquisites ("perks")
and
 The economic theory of the firm
the principal objective of the firm
is to maximize its profits (or
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minimize its losses) this is called
profit
maximization
hypothesis.
long-run time period (expand the
business).
Short run vs. Long run
 To be sure, there are other goals
that a firm can pursue, relating to
market share, revenue growth,
profit
margin,
return
on
investment, technology, customer
satisfaction and shareholder value
(i.e.. maximizing the price of its
stocks).
 Given the goal (or goals) that the
firm is pursuing, we can say that
the
optimal
decision
in
managerial economics is one that
brings the firm closer to this goal

Nothing to do directly with
calendar time .

Short-run: firm can vary
amount of some resources but
not others.

Long-run: firm can
amount of all resources.

At times short-run profitability
will be sacrificed for long-run
purposes.
vary
GOALS OTHER THAN PROFIT
 For example, to maximize its profit
(or minimize its loss), a firm should
price its product at a level where
the revenue earned on the last unit
of a product sold (called marginal
revenue) is equal to the additional
cost of making this last unit (called
marginal cost).
A. ECONOMIC GOALS
 In other words, the optimal price
equates the firm's marginal
revenue with its marginal cost.
.
 One additional concept should be
presented in our discussion of a
firm's goals. In economics, la
distinction is made between the
short-run
time
period
(not
expanding the business)
and the

▪
Market
rate
share,
growth
▪
Profit margin
▪
Return on investment,
return on assets
▪
Technological
advancement
▪
Customer satisfaction
▪
Shareholder value
The
concept
of
profit
maximization
has
been
attacked as incomplete by
many writers. They point out
that companies may have
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objectives,
mentioned
These actions are costly, and at first
glance may seem to interfere with
profit maximization.
For the time being, we omit
discussion of the objective of
"value
or
shareholder
wealth" maximization and
consider some of the other
alternatives
concerning
a
company's activity during a
single period of time (such as
a year).
The company must lessen spending
resources on such noneconomic
activities without contradicting to
profit maximization principle.
other economic
such as those
previously.

DO COMPANIES REALLY TRY
TO MAXIMIZE THE PROFITS?
B. NON-ECONOMIC OBJECTIVES
 The argument is that today's
corporations do not maximize.
Instead, their aim is to "satisfice."
In this complex world, companies
may have objectives that are not
strictly economic or at least do not
appear to be governed by
economic thinking
 Satisficing - a concept in
economics based on the principle
that owners of a firm (especially
stockholders
in
a
large
corporation) may be content with
adequate return and growth
since they really cannot judge
when profits are maximized.
What, then, are some of the guiding
principles such companies publish?
▪
 Provide a good place for our
employees to work.

 Provide good products/services to
our customers.
Two parts of the idea:
1. The position and power
of stockholders in today's corporation
▪
 Act as a good citizen in our
society.
To achieve a satisfactory goal,
one that may not require the
firm ‘to do its best’
Larger firms are owned by
thousands of shareholder
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▪
Shareholders
own
only
minute interests in the firm
and hold diversified holdings
in many other firms.
▪
Shareholders are concerned
with performance of entire
portfolio and not individual
stocks
▪
Less informed about the firm
than management
▪
Stockholders not likely to
take any action if earning a
‘satisfactory’ return.
2. The position and power
of professional management in
today's corporation
representative authorized to act
on their behalf. An agent may act
in a way that is contrary to the
best interests of the principal.

The principal-agent problem is as
varied as the possible roles of
principal and agent. It can occur
in any situation in which the
ownership of an asset, or a
principal, delegates direct control
over that asset to another party,
or agent.

The principal-agent problem is a
conflict in priorities between the
owner of an asset and the person
to whom control of the asset has
been delegated.

The problem can occur in many
situations, from the relationship
between a client and a lawyer to
the
relationship
between
stockholders and a CEO.

Resolving
a
principal-agent
problem may require changing
the system of rewards in order to
align priorities or improving the
flow of information, or both.
▪ High level managers may own
very little of the firms stock
▪ Managers tend to be more
conservative because jobs will
likely be safe if performance is
steady, not spectacular.
▪ Managers may be more
interested in maximizing own
income and perks
▪ Management incentives may
be misaligned (e.g revenue not
profits
▪ Divergence of objective is
known
a
‘principal-agent’
problem
The Problem of PRINCIPAL –
AGENT

DO COMPANIES
PROFIT?
The principal-agent problem is a
conflict in priorities between a
person or group and the
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MAXIMIZE
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
Counter-arguments
which
support the profit maximization
hypothesis
 large stockholdings held
by institutions (mutual
funds, banks, etc.) →
scrutiny by professional
analysts
 stock market discipline if
managers do not seek to
maximize profits, firms
face threat of takeover
 incentive
effect
the
compensation of many
executives is tied to stock
price
MAXIMIZING THE
STOCKHOLDERS
WEALTH
OF
 Views the firm from the perspective
of a stream of profits (cash flows)
over time → the value of the stream
depends on when cash flows occur
 Requires the concept of the time
value of money: says a dollar
earned in the future is worth less
than a dollar earned today
 Future cash flows (D₁) must be
'discounted' to find their present
equivalent value
 The discount
affected by risk
rate
(k)
Consideration the value of the
company's stock to be at a
maximum.
"This consideration in particular is
affected by risk, so risk becomes
another component of the valuation
of the business.
Financial
theorists
differentiate
various types of risks, with the two
major types commonly identified as:
1. Business
Risk
involves
variation in returns due to the ups and
downs of the economy, the industry,
and the firm.
This is the kind of risk that attends all
business organizations, although to
varying degrees.
2.
Financial
Risk
concerns the variation in returns
that is induced by leverage
Leverage signifies the proportion
of a company financed by debt.
→ the higher the leverage,
the greater the potential
fluctuations in stockholder
earnings
→ financial risk is directly
related to the degree of
leverage
The present price of a firm's
stock
should
reflect
the
discounted value of the expected
future cash flows to shareholders
(dividends)
is
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EVA = (Return on total capital –
Cost of capital) x Total Capital
If EVA > 0 shareholder wealth
rising
If EVA < 0 shareholder wealth
falling
 Given an infinetly lived
firm whose dividends grow
at a constant rate (g)
each year, the equation for
the stock price becomes:
ECONOMIC PROFITS

Business profit minus the implicit
costs of capital and the ownerprovided inputs used by the firm.
P = D1/(k-g)
Where D1 is the
dividend to be paid
during the coming year

Accountants and Economist do
not have the same perspective.
Multiplying P by the number of
shares outstanding gives total
value of firm’s common equity
(market capitalization)

An accountant reports costs on a
historical basis as allowed by
GAAP

The economist, however, is
concerned with the costs that a
business considers in making
decisions, that is, future costs.

Basically, economists deal with
something they call opportunity
costs or alternative costs.

This means that the cost of a
resource is what a business must
pay for it to attract it into its
employ or to put differently, what
a business must pay to keep this
resource
from
finding
employment elsewhere.
Another measure of the wealth
of stockholders is called Market
Value Added (MVA) ®
MVA = difference between the market
value of the company and the capital
that the investors have paid into the
company.
 Market value includes value of
both equity and debt
Capital includes book value of
equity and debt as well as certain
adjustments (e.g accumulated
R&D and goodwill)
While the market value of the
company will always be positive,
MVA may be positive or negative.
 Another measure of the wealth
stockholders is called Economic
Value Added (EVA) ®
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would be excluded by an
accountant.
To get down to specific
examples, we can mention the
following:
Economic
profit
=
Total
revenue – all economic costs
1. Historical costs
replacement costs:

Indeed, the economist refers
to the second category of
costs-which are essential to
obtain and keep the owners
resources in the business-as
normal profits, which represent
the return that these resources
demand to remain committed
to a particular firm.

Thus, economic costs include
not only the historical costs
and explicit costs recorded by
the accountants, but also the
replacement costs and implicit
costs (normal profits) that
must be earned on the
owner’s resources.
versus
To
an
economist,
the
replacement cost of a piece of
machinery (and, therefore, the
level of periodic depreciation on
the
replacement
cost)
is
important,
whereas
an
accountant measures cost-and
depreciation on a historic
2. Implicit costs and normal
profits:

The owners' time and interest
on the capital they contribute
are usually counted as profit in
a partnership or a single
proprietorship. However, the
owners
could
work
for
someone else instead and
invest their funds elsewhere.
So these two items are really
costs to the business and not
profit.
Global Application

Other countries, other cultures
o Foreign currencies
o Legal differences
o Language


The preceding item is not
relevant in the case of a
corporation because even to
executives
are
salaried
employees, and interest on
corporate debt is deducted as
an expense before profits are
calculated.
It appears, therefore, that an
economist includes costs that
o Attitudes
o Role of government
WHY
DO
PROFITS
AMONG FIRMS

Disequilibrium
Theories
VARY
Profit
1. Frictional Profit Theory - It
states that markets are sometimes
in disequilibrium because of
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unanticipated changes in demand
or cost conditions.
below-normal
profits
penalize
stagnation and inefficiency
2. Monopoly Profit Theory Some firms earn above-normal
profits because they are sheltered
from competition by high barriers
to entry. Monopoly profits can also
arise because of luck (being in the
right industry at the right time) or
from anticompetitive behaviour.
ROLE OF BUSINESS IN SOCIETY

COMPENSATORY
THEORIES
PROFIT
1. Innovation Profit Theory describes above normal profits
that arise following successful
invention or modernization.
2.
Compensatory
Profit
Theoriesdescribes
abovenormal rates of return that
reward firms for extraordinary
success in meeting customer
needs and maintaining efficient
operations. Compensatory profit
theory also recognizes economic
profit as an important reward to
the entrepreneurial function of
owners and managers
ROLE OF PROFITS
ECONOMY
IN
Firms exist because they are useful.
They survive by public consent to
serve social needs.
CENTRAL
ECONOMY
Expansion by established firms or
entry by new competitors occurs
quickly during high profit periods
Below-normal profits signal the
need for contraction and exit.
Above-normal profits also reward
innovation and efficiency, just as
OF
FOUR DISTINCTIVELY
MACROECONOMIC PROBLEMS
Recession

Defined as a period of two or
more successive.

Quarters
of
production.

In many recession periods,
businesses that announced
they were hiring had long lines
of people who wanted to apply,
with many more people than
they could hire.

Another possibility is that
production
might
drop
because a war or disaster
had destroyed factories and
other capital goods.
THE
Above-normal profits serve as a
valuable signal that firm or industry
output should be increased
PROBLEMS
decreasing
Inflation

Inflation is a rise in the
general level of prices of
goods and services in an
economy over a period of
time. A rising price levelinflation-has
the
following
disadvantages:
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



lt creates uncertainty, in
that people do not know
what the money they earn
today will buy tomorrow.

Causes of Stagnation:
a. Population growth might be
high.
b. Fewer people might choose
to work.
Uncertainty, in turn,
discourages
productive
activity,
saving
and
investing.
Inflation
reduces
the
competitiveness of the
country in international
trade di inflation is a hidden
tax on nominal balances.
c. The growth of
productivity might slow.

labor
Economic growth that, while
positive, is less than the
potential
growth
of
the
economy.
Predictable, people resort
to other means to carry out
their
business,
means
which use up are inefficient
Decision Theory
Unemployment
 Unemployment occurs when a
person is available to work and
currently seeking work, but the
person is without work.
 A status in which individuals are
without job and are seeking a
job
a. Reduction in the Output
b. Reduction in Tax Revenue
c.
Rise
in
Government
Expenditure
Represents a general approach to
decision making which is suitable for
a wide range of management
decisions, including:





Capacity Planning
Location Planning
Product-Mix
Product and Service Design
Equipment Selection Policies
Stagnation

period of many years of slow
growth of gross domestic
product, in which the growth is,
on the average, slower than the
potential growth in the economy
A decision problem is
characterized by decision
alternatives, states of nature, and
resulting payoffs
Decision Alternatives
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 Different possible strategies that
the decision maker can employ
 Courses of action or strategy that
may be chosen by the decision
market.
State of Nature
 Refer to future events, not under
the control of the decision maker,
which will ultimately affect
decision results
 Outcomes over which the
decision maker has little or no
control.
Payoffs
 The consequence resulting from
a specific combination of a
decision alternative and a state
of nature
 Conditional values
 Can be expressed in terms of
profit, cost, time, distance, or any
other appropriate measure
Payoff Table
 A table showing all possible
combinations of decision
alternatives and states of nature
 Represents a range of potential
future events
 Presents the potential economic
outcomes of the alternatives
available to the decision maker
Three Egg Omelet Problem
You are preparing a three-egg
omelet. Having already broken two
good eggs into the pan, you are
suddenly assailed by doubts about
the quality of the third. As yet
unbroken egg, two things may
happen: either the egg is good or it is
rotten.
2. List all possible alternatives.
3. Identify the possible outcomes.
4. List the payoff of each
combination of alternatives and
outcomes.
5. Select one of the mathematical
decision theory model.
6. Apply the model and make your
decision.
Types of Decision-Making
Environments
Certainty
Decision makers know with certainty
the consequence of every alternative
or decision choice
Risk Decision makers know the
probability of occurrence of each
outcome. They tend to maximize their
expected well-being.
Uncertainty
Decision makers do not know the
probabilities of the various outcomes.
Maximization of Expected
Monetary Value
“How much money you canexpect to
make from a certain decision.”
Minimization of Expected
Opportunity Loss
“How much money is lost by not
picking the best alternative.”
6 Steps in Decision Theory
1. Clearly
define the
problem
at hand.
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