Basics of Managerial
Economics*
*Introduction + Ch.1 with emphasis on section1.1
What is Managerial Economics?
Managerial
Economics provides
valuable economics
tools for managers so
that they can take
optimal decisions:
What should be
the pricing and
output policy?
What should be
the input mix?
What product
quality to
choose?
How many
employees to
hire?
How to ensure
quality work
from employees?
How to take into
account the
action of rival
firms?
The Manager!
Who is a
manager?
A person
responsible for
• His/her own
actions
• Actions of
other
resources
such as
individuals,
machines
etc.
Directs
efforts of
others,
buys
inputs
and/or
makes
pricing or
quality
decisions.
Managerial Economics

When the resources are scarce, managers can make
cost-effective decisions by applying the discipline of
managerial economics.

Managerial Economics studies how managers can
direct scarce resources in the most efficient ways and
achieve their goals.
Example

Think about the managerial decisions in a coffee shop:

What varieties of coffee to provide for customers? (think about
all the variety of coffee that you get in a coffee shop)

How to price different glass/cup sizes? (how much do you pay
for a small, medium or tall?)

How many workers to employ? (How many workers do you
typically see in a coffee shop?)

How to ensure quality work from the workers?

How to maintain product quality?

Next month, another coffee shop is opening in the same
shopping complex. How to not lose business to the rival firm?
What new decisions need to be made?
Managerial Decision Making –
Different Managers

There are many decisions made by different managers

A production manager’s objective is normally to achieve a
production target at the lowest possible cost. Of course, the
manager has to use the existing factory and resources.

Human resource managers design compensation systems to
encourage employees to work hard. Of course, the manager has
limited resources available in the firm.

A marketing manager must allocate an advertising budget to
promote the product most effectively. Of course, the manager has a
limited marketing budget.
Managerial Decision Making – The
CEO

The job of the chief executive officer (CEO), is to focus on
maximizing profit.


The CEO is also concerned with how a firm is positioned in a
market relative to its rivals.
Maximizing profit requires coordination!

The CEO asks the production manager to minimize the cost of
producing the particular good or service.

The CEO asks the market research manager to determine how
many units can be sold at any given price, and so forth.

It would be a major coordination failure if the marketing
department set up a system of pricing and advertising based
on selling 8,000 units a year, while the production department
managed to produce only 2,000.
Managerial Decision Making – Trade
Offs

In an environment of scarcity, managers must focus on the tradeoffs that directly or indirectly affect profits.


Evaluating trade-offs often involves marginal reasoning:
considering the effect of a small change.
How to Produce

To produce a given level of output, a firm must use more of
one input if it uses less of another input. Example: Metal and
plastic substitute each other in the production of cars. Small
increments and reductions of them affect the car’s weight,
safety, and cost.
Managerial Decision Making – Trade
Offs

What Prices to Charge


Consumers buy fewer units of a product when its price
rises given their limited budgets. Example: When a
manager sets the price of a product, the manager must
consider whether raising the price offsets the loss from
selling fewer units.
Whether to Innovate

There are short run and long run profits. Example:
Investments in innovation such as designing new
products and better production methods may raise the
long run profit, but these typically lower the short run
profit.
Managerial Decision Making

Other Decision Makers

Consumers purchase products subject to their limited
budgets

Workers decide on which jobs to take and how much to work
given their scarce time and limits on their abilities.

Rivals may introduce new, superior products or cut the
prices of existing products.

Governments around the world may tax, subsidize, or
regulate products.
Managerial Decision Making Strategy

A strategy is a battle plan that specifies the actions or
moves that the manager will make to maximize the firm’s
profit when interacting with a small number of rival firms.

One tool that is helpful in understanding and developing
such strategies is game theory, which we will see in later
in the course.
Managerial Decision-Making Example: Pepsi’s
price-cutting strategy in the 1930s

In 1931, the Pepsi-Cola company was in a desperate condition. The company had entered
bankruptcy for the second time in 12 years.

The president of Pepsi, Charles G. Guth tried to sell Pepsi to its rival Coca-Cola, but Coke
wanted no part of it.

During this period, Pepsi and Coke sold cola in 6-ounce bottles.

To reduce costs, Guth purchased a large supply of recycled 12-ounce beer bottles. Pepsi
priced the 12-ounce bottles at 10 cents, twice the price of 6-ounce Cokes. But this
strategy failed to boost sales!

Then Guth had an idea: to sell 12-ounce Pepsi bottles for the same price as 6-ounce
Cokes. This worked for Pepsi! Pepsi’s sales shot up.

By 1934, Pepsi was out of bankruptcy. Its profits rose to $2.1 million by 1936, and to
$4.2 million by 1938.

Ref: Tedlow, Richard, New and Improved: The Story of Mass Marketing in
America, New York, Basic Books, 1990
Pepsi’s success in the 1930s can be understood
using economics

In 1931, Pepsi’s main objective was to increase profits. But the
president could not just order his subordinates to increase Pepsi’s
profits. The management cannot directly control its profits or market
share. However, the management can control marketing, production
and the administrative decisions that determine profitability.

Pepsi put in use the basic principle of the law of demand. By selling at a
lower price, it could increase the quantity sold.

Will that translate into higher sales revenues? This depends on price
elasticity of demand.
Economic Analysis continued..

As long as Coke didn’t respond to Pepsi’s price cut with its own, we would
expect that the demand for Pepsi would have been relatively sensitive to
price, in other words, price-elastic. (Coke had a large share of the market, it
was more profitable to keep its price high than to respond with a price cut
of its own).

And price-elastic demand implies that price cut leads to higher sales
revenue.

Will higher sales revenue lead to higher profits?

This will depend on the economic relationship between the additional sales
revenue that the price cut generated and the additional cost of producing
more quantity.

That profits increased after the price-cut suggests that the additional sales
revenue far exceeded the additional costs of production.