economics term 2

8/6/2019 Economics Term 2

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What is Economics?

Economics is a social science; a classified body of knowledge concerning human relationshipsclustered about mans effort to earn a living. Economics is quite an old discipline. That is whyProf. Samuelson remarks that Economics is the Oldest of the arts, newest of the sciences, indeedthe Queen of the social sciences.

The origin of the subject could be traced to the works of the Greek philosopher, Aristotle whoconfines the study of economics to household management and acquiring and making proper useof wealth. It is important to note that the word Economics has been derived from the Greek

words Oikos (a house) and nemine (to manage). Thus economics means managing ahousehold with limited funds. Adam Smiths magnum opus bookAn Enquiry into the Natureand Causes of Wealth of Nations published in the year 1776, laid a strong foundation for thegrowth of economics. So Adam Smith is rightly called as the Father of Economics.

Definition:

This can be classified broadly into three categories:1. A science of wealth

2. A science of material welfare; and3. A science of scarcity

A Science of Wealth: Adam smith, J.B.Say, F.A. Walker and other economists of the 18 th and19th centuries have defined economics as that part of knowledge which relates to wealth.

Adam smith considered that the main aim of all economic activities is to amass as muchwealth as possible. It is, therefore, necessary to analyse how wealth is produced andconsumed. Most classical economists supported the Smithian definition of economics. Wealthdefinition gave rise to serious misconceptions at the hands of some literary writers of the 19 th

century like Ruskin, Thomas Carlye, Charles Dickens, William Morris and Mathew Arnold.Economics was branded as the bread and butter science, The Gospel of Mammon, ascience that taught selfishness and love for money, a dark and dismal science

A Science of Material Welfare: Adam Smiths wealth definition made economics a dismalscience. Alfred Marshall was the first neo-classical economist to rescue economics fromridicule, condemnation and misunderstanding. Marshall reoriented economics and placed iton the pedestal of glory, in his classic work principles of Economics published in 1890.

Marshall in his definition shifted the emphasis from wealth to human welfare. According tohim, Wealth is simply a means to an end in all activities, the end being human welfare. InMarshalls own words, political Economy or Economics is a study of mankind in theordinary business of life; it examines that part of individual and social action which is mostclosely connected with the attainment and with the use of the material requisites of wellbeing. He adds that economics is on the one side a study of wealth; and the other the moreimportant side, a part of the study of man. Lionel Robbins led a frontal attack on the welfaredefinition in his immortal work; An essay on the Nature and significance of economicscience published in 1932.In the words of Robbins, The material list definition ofeconomics misrepresents the science as we know it.

A Science of Scarcity: After rejecting the materialist definition of Marshall, Robbins formulatedhis own conception of economics. In the words of Robbins, Economics is the science which

studies human behavior as a relationship between ends and scarce means which havealternative uses. This definition is based on four fundamentals characteristics of humanexistence.

Human Wants Are Unlimited: Ends refer to human wants which are unlimited but theresources available to satisfy them are unlimited.

Scarcity of Means: The resources (time or money or both) at the disposal of a person tosatisfy his wants are limited. If things are available in abundance just like free goods, theeconomic problem will not arise. But as Prof.Meyers says, Alladins lamps exist only inArabian fairy tales.

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Alternative Uses: Economic resources are scarce, but they can be put to alternative uses. Ifwe choose one thing, we must give up others.

The Economic Problem: When the means at the disposal of a person are limited and theresources can be put to several uses, and when wants can be graded on the basis of intensity,human behavior necessarily takes the form of choice.

Recently, Prof.Samuelson has given a definition based on Growth aspects which is known asthe Growth Definition.

What is Managerial Economics?

Managerial economics is the application of economic theory and quantitative methods(mathematics and statistics) to the managerial decision making process. In general, economictheory is the study of how individuals and societies choose to utilize scare productive resources(land, labor, capital, and entrepreneurial ability) to satisfy virtually unlimited wants. Quantitativemethods refer to the tools and techniques of analysis, which include optimization analysis,statistical methods, forecasting, game theory, linear programming, and capital budgeting.

Managerial economics is the science of directing scarce resources to manage cost effectively. Itconsists of three branches: competitive markets, market power, and imperfect markets. A marketconsists of buyers and sellers that communicate with each other for voluntary exchange. Whether

a market is local or global, the same managerial economics apply.

A seller with market power will have freedom to choose suppliers, set prices, and use advertisingto influence demand. A market is imperfect when one party directly conveys a benefit or cost toothers, or when one party has better information than others.

An organization must decide its vertical and horizontal boundaries. For effective management, itis important to distinguish marginal from average values and stocks from flows. Managerialeconomics applies models that are necessarily less than completely realistic. Typically, a modelfocuses on one issue, holding other things equal.

Managerial economics lies on the borderline of management and economics. It is a hybrid of thetwo disciplines and is primarily applied branch of knowledge. The development of the science ofmanagerial economics is of recent origin. After the Second World War and particularly after1950, with rapid expansion of international trade, the Business Managers faced numerous delicate problems. As Professor Ansoff says, since the early 1950s confronted with the growingvariability and unpredictability of the business environment, business managers have becomeincreasingly concerned with rational and foresightful ways of adjusting to an exploitingenvironmental change. There was a gap between economic theory and the correct procedure theyhave to employ to problems. The problems of the business world attracted the attention ofacademicians and gave rise to a special treatment of business problems. As a result managerialeconomics came into being.

Economic theory is concerned with how society answers the basic economic questions of whatgoods and services should be produced, and in what amounts, how these goods and services

should be produced (i.e., the choice of the appropriate production technology), and for whomthese goods and services should be produced. In market economies, what goods and services are produced by society is determined not by the producer, but rather by the consumer. Profit-maximizing firms produce only the goods and services their customers demand. How goods andservices are produced refers to the technology of production, and this is determined by the firmmanagement. Profit maximization implies cost minimization. In competitive markets, firms thatdo not combine productive inputs in the most efficient (least costly) manner possible will quicklybe driven out of business. Thefor whom part of the question designates the individuals who arewilling and able to pay for the goods and services produced.

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The study of economics is divided into two broad subcategories: macroeconomics andmicroeconomics. Macroeconomics is the study of entire economies and economic systems andspecially considers such broad economic aggregates as gross domestic product, economic growth,national income, employment, unemployment, inflation and international trade. In general, thetopics covered in macroeconomics are concerned with the economic environment within whichfirm managers operate. For the most part, macroeconomics focuses on variables over which themanagerial decision maker has little or no control, although they may be of considerableimportance when economic decisions are made at micro level of the individual, firm, or industry.Macroeconomics also examines the role of government in influencing these economic aggregates

to achieve socially desirable objectives through the use of monetary and fiscal policies.

Microeconomics, on the other hand, is the study of the behavior and interaction of individualeconomic agents. These economic agents represent individual firms, consumers, andgovernments. Microeconomics deals with such topics as profit maximization, utilitymaximization, revenue or sales maximization, product pricing, input utilization, productionefficiency, market structure, capital budgeting, environmental protection, and governmentalregulation. Microeconomics is the study of individual economic agents, such as individualconsumers and firms, and the interactions between them.

Unlike macroeconomics, microeconomics is concerned with factors that are directly or indirectlyunder the control of management, such as product quantity, quality, pricing, input utilization, andadvertising expenditures. Managerial economics also explicitly recognizes that a firms

organizational objective, usually profit maximization, is subject to one or more operatingconstraints (size of firms operating budget, shareholders expected rate of return on investment,etc.).

The dominant organizational objective of firms in free-market economies is profit maximization.Other important organizational objectives, which may be inconsistent with the goal of profitmaximization, include a variety of non-economic objectives, satisfying behaviorand wealthmaximization.

The assumption of profit maximization has come under repeated criticisms. Many economistshave argued that this behavioral assertion is too simplistic to describe the complexity of themodern large corporation and the managerial thought processes required. Other theoriesemphasize different aspects of the operations of the modern, large corporation. Despite these

attempts, no other theory of firm behavior has been able to provide a satisfactory alternative tothe broader assumption of profit maximization.

Profit maximization (loss minimization) involves maximizing the positive difference (minimizingthe negative difference) between total revenue and total economic cost, that is, total economicprofit. Total revenue is defined as the price of a product times the number of units sold. Totaleconomic cost includes all relevant costs associated with producing a given amount of output.These costs include both explicit, out-of-pocket expenses and implicit costs.

Economic profit is distinguished from accounting profit, which is the difference between totalrevenue and total explicit costs. Total economic profit considers all relevant economic costsassociated with the production of a good or service. Another important concept is normal profit,which refers to the minimum payment necessary to keep the firms factors of production from

being transferred to some other activity. In other words, normal profit refers to the profit thatcould be earned by a firm in its next best alternative activity. Economic profit refers to profit inexcess of these normal returns.

Non-economic organizational objectives tend to emphasize such intangibles as good citizenship,product quality, and employee goodwill. The achievement of other organizational objectives,such as earning an adequate rate of return on investment, or attaining some minimumacceptable rate of sales, profit, market share, or asset growth, is the result of satisfying behavioron the part of senior management. Satisficing behavior is predicated on the belief that it is notpossible for senior management to know when profits are maximized because of the complexitiesand uncertainties associated with running a large corporation. Finally, maximization of share-

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holder wealth involves maximizing the value of a companys stock by maximizing the presentvalue of the firms net cash inflows at the appropriate discount rate.

Economists analyse and answer because:

Human wants are virtually unlimited and insatiable

Economic resources to satisfy them are limited.

In summary, managerial economics might best be described as applied microeconomics. As anapplied discipline, managerial economics integrates economic theory with the techniques ofquantitative analysis, including mathematical economics, optimization analysis, regressionanalysis, forecasting, linear programming, and risk analysis. Managerial economics attempts todemonstrate how the optimality conditions postulated in economic theory can be applied to real-world business situations to optimize firms organizational objectives.

Definition of Managerial Economics:

Managerial economics has meant different things to different people. In simple terms managerialeconomic means the application of economic theory to the problems of management. Managerialeconomics is the science of directing scarce resources to manage cost effectively.

Application - Managerial economics applies to:(a) Businesses (such as decisions in relation to customers including pricing and advertising;suppliers; competitors or the internal workings of the organization), nonprofit organizations, andhouseholds.(b) The old economy and new economy in essentially the same way except for twodistinctive aspects of the new economy: the importance of network effects and scale and scopeeconomies. i. network effects in demand the benefit provided by a service depends on the totalnumber of other users, e.g., when only one person had email, she had no one to communicatewith, but with 100 mm users on line, the demand for Internet services mushroomed.ii. scale and scope economies scalability is the degree to which scale and scope of a businesscan be increased without a corresponding increase in costs, e.g., the information in Yahoo iseminently scaleable (the same information can serve 100 as well as 100 mm users) and to serve alarger number of users, Yahoo needs only increase the capacity of its computers and links.iii. Note: the term open technology (of the Internet) refers to the relatively free admission ofdevelopers of content and applications.

(c) Both global and local markets.

Scope

a) Microeconomics the study of individual economic behavior where resources are costly,e.g., how consumers respond to changes in prices and income, how businesses decide onemployment and sales, voters behavior and setting of tax policy.

b) Managerial economies the application of microeconomics to managerial issues (a scopemore limited than microeconomics).

c) Macroeconomics the study of aggregate economic variables directly (as opposed to theaggregation of individual consumers and businesses), e.g., issues relating to interest and

exchange rates, inflation, unemployment, import and export policies.

Prof. Spencer and Siegelman, The integration of economic theory with business practice for thepurpose of facilitating decision making and forward planning by the management.

It is clear from this definition that the problems of management are two fold. They are (i)decision making (ii) forward planning. Decision making is a process of selecting a particularcourse of action from among a number of alternative options. Forward planning means preparingplans for the future. Forward planning and decision making goes hand in hand.

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We may define managerial economics as application of economic theory and decision sciencetools to problem of managerial decision. The following chart will make the concept clear.

Distinction between Economics and ME:

Economics has both micro and macro analysis. The roots of managerial economics spring frommicro economic theory.

Economics is both positive and normative incharacter.

Managerial economics is basically normative incharacter.

Economics mainly deals with the theoretical

aspects of the firm.

Managerial economics is concerned with

practical problems of the firm.Micro economics, as part of economics dealswith individual and firms.

Managerial economics deals with firms and notwith individuals.

Economics studies principles underlying wage,rent, interest and profit.

Managerial economics studies mainly theprinciples of profit only.

Economics deals only with economic aspectsof the problem.

Managerial economics deals with both theeconomic and non-economic aspects of theproblem.

The scope of economics is wide. The scope of managerial economics is narrow.

Scope of Managerial Economics:

Demand Analysis And Forecasting - It analyses the various types of demand which enable

the manager to arrive at a reasonable estimate of the demand for the products of his firm.When the current demand is estimated, the next logical step is to ascertain the future demandfor his products. The main areas cover under demand analysis is demand determinantsdemand distinctions and demand forecasting.

Cost And Production Function - Cost and production analysis is vital for the efficientallocation of scare resources. This analysis is also useful for profit planning, project planning,and cost control and pricing of products. While cost analysis is done in monetary terms, production analysis is done in physical units. The major areas cover under cost and

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production analysis are cost concepts, and classification, cost output relationships, economiesand diseconomies of scale and cost control.

Pricing Decisions, Policies And Practices - Pricing is an important area in managerialeconomics. While fixing the price of a commodity, a complete knowledge of the price systemis essential. The success or failure of a firm mainly depends upon its accurate price decisions.Pricing policy has considerable significance for the management only when there is aconsiderable degree of imperfection in the market. The main areas covered are pricedetermination in various market structures, pricing methods and price forecasting.

Profit Management - Profit is the life blood of any organization. An element of uncertaintyexists about profit due to variations in cost and revenues. If knowledge about the future were perfect, profit analysis would be much easier. The important areas covered are profitplanning, profit management, profit forecast and profit measurement.

Capital Management - Capital management means planning and control of capitalexpenditure. Capital measurement is done through capital budgeting. Cost of capital, rate ofreturn and selection of project are the important areas covered under the capital management.

Decision Making - It is the process of selecting a particular course of action from among anumber of alternatives. In arriving at a decision, the alternative courses of action availablehave to be weighted for acceptance or rejection. Operational research has developed many

techniques which are frequently used in managerial economics for this purpose.

Nature of ME:

Special Branch Of Economics - Managerial economics is a special branch of economicsbridging the gap between theory and practice. The relation of managerial economics toeconomic theory is much like that of engineering to physics or of medicine to biology orbacteriology.

Micro Economic in Character: Managerial economics draws heavily on the propositions ofmicro economic theory. For e.g., demand concepts and theories of market structure areelements of micro economics which managerial economics uses. The other concepts widelyused are (i) elasticity of demand, (ii) marginal cost, (iii) marginal revenue, (iv) opportunitycost etc. But some of these concepts however provide only the necessary logical base andhave to be modified in actual practice to suit special circumstances.

Related To Macro Economics: Though, basically managerial economics is microeconomics in nature, it uses macro economics forecasting. A proper understanding of thefunctioning of the economic system is of immense importance to the managerial economist inframing suitable policies. Concepts like business cycles, national income accounting etc arewidely used in managerial economics.

Pragmatic: Managerial economics is pragmatic and essentially an applied branch ofknowledge. In economic theory many abstract issues are analyzed on the basis ofassumptions which are highly unrealistic. Managerial economics, avoids difficult abstract

issues. It is mainly concerned with analytical tools that are useful to firms. Elective in Nature: Managerial economics is integrative or elective in nature. It combines

and synthesizes ideas and methods from various functional fields of business administrationlike accounting, production management, marketing and finance. Thus it is multi-disciplinaryin dimension.

Normative: Managerial economics is prescriptive in character. It recommends what should be done under various alternative conditions. Managerial economists are generallypreoccupied with the optimum allocation of resources among completing ends wit h a view toobtaining the maximum benefit according to pre-determined criteria. To achieve these

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objectives, they do not assume that all other things would remain equal, but try to introducepolicies which if implemented would achieve the desired results. Thus managerial economicsis both light giving and a fruit-bearing one.

Managerial economics and other disciplines:

ME and economics - Micro economics is also known as partial equilibrium analysis deals withthe problem of individuals, firms and industries and is the main source of inspiration to

managerial economics. Concepts like elasticity, marginal revenue, marginal cost, and models,like price leadership, kinked demand curve and price discrimination are made use of inmanagerial economics spring from micro economic theory. Macro economics aids managerialeconomics in the area of forecasting. The aggregates of the economics system such as GrossNational Product, General Price Index and level of employment serve as a useful guide fordevising relevant business policies.

Managerial economics and Statistics - Statistics provides many tools to ME. It is highlyuseful in demand forecasting. A correct estimate of demand is vital for the management inframing a suitable inventory policy. Statistical tools like averages, dispersion, correlation,regression, time series etc are extensively applied in various managerial aspects.

Managerial economics and Mathematics- Operations research is the application of

mathematical techniques in solving business theory, input-output analysis, queuing andsimulation are some of the techniques developed by operational researchers. Thesetechniques are applied in ME.

Managerial economics and Accounting - ME is also related to accounting. For example, theprofit and loss statement of a firm will furnish necessary information to the manager toidentify the specific areas of loss and arrive at suitable decisions. It is very much useful incost control.

Managerial economics and decision making - The theory of decision making too, has asignificant place in ME. It deals with the selection of a particular course of action among thevarious alternatives. In order to choose a particular course of action, many factors are takeninto accounts. Sociological and psychological factors are considered and weighted againsteconomic factor in arriving at a decision.

ROLE OF A MANAGERIAL ECONOMIST IN BUSINESS

A managerial economist has a significant role to play in business by assisting the managements intheir successful decision making and forward planning goals. The factors which influence thebusiness over a period may lie within the firm or outside the firm. In general, these factors can bedivided into two categories. (1) External and (2) Internal

The external factors lie outside the control of the management because they are external to thefirm and are said to constitute the business environment. The internal factors lie within the scopeand operations of a firm and hence within the control of the management and they are known asbusiness operations.

EXTERNAL FACTORS

The function of a managerial economist is to analyze the environmental factors and recommendsuitable policies. The following are the important external factors affecting the firm.

General Economic Conditions

The most important external factor is the general economic conditions of the economy such asbusiness cycles, competitive conditions of the market, size and the rate of growth of the nationalincome, the regional pattern of income distribution, influence of globalization on the domesticeconomy etc. it is the duty of the managerial economist to gather and analyze information with

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regard to these changes, and advise the management regarding their likely effects on theoperations of the firm and recommend suitable ways to pursue the organizational goals.

Nature of Demand

The second important external factor relates to the nature of demand for the product. Sincepurchasing power is an important variable influencing demand, the managerial economist has tostudy the purchasing power trend in general an din the region concerned in particular. Moreover,it is his function to observe whether fashions, tastes and preferences undergo any change andwhether it is likely to have an impact on the demand for the product.

Input Cost

The third external factor influencing the firm is the input cost of the firm. The managerialeconomist has to advise the management on labour market conditions i.e., the cost of labour indifferent occupations. He also studies the money market conditions, the changing scenario ingovernments credit policy and possible ways of achieving the least-cost combination of factorsand so on.

Marketing

Buying of raw materials and selling of finished goods are two important aspects of marketing.The managerial economist has to study the markets from where the firm is buying its rawmaterials and selling its finished goods. The understanding helps him to evolve and frame a

suitable price policy for the firm.

Market share

Market share refers to the share of a firm in the industry for a particular product. Expansion ofmarket share is a good symptom of growth. Therefore, the managerial economist has to examinethe opportunities and strategies which help in the expansion of the firms share in the regionaland international markets.

Economic policies

Last, but not the least, the managerial economist must keep in touch with the governmentsmonetary policy, fiscal policy, industrial policy, budgetary policy trends etc. to advice themanagement.

INTERNAL FACTORS

A managerial economist can also be helpful to the management in making decisions relating tothe internal operations of the firm. The analysis of cost structure, and forecasting of demand arevery essential. Moreover, it is his responsibility to bring about a synthesis of policies relating toproduction, investment, inventories and price.

SPECIFIC FUCTIONS

It involvesI. Sales forecasting

II. Industrial market researchIII. Economic analysis of competing companies

IV. Pricing problems of industryV. Capital projects

VI. Production programmesVII. Security management analysis

VIII. Advice on trade and public relationsIX. Advice on primary commoditiesX. Advice on foreign exchange management

XI. Economic analysis of agricultureXII. Analysis on underdeveloped countries

XIII. Environmental forecasting etc.

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APPLICATION OF THE THEORIES OF ECONOMICS IN BUSINESS DECISIONS

The following are the main theories in economics that help the firm in decision-makingprocess.

THEORY OF DEMAND

Demand theory explains the consumers behavior. The theory helps to understand thebehavior of consumers when the determinants of demand such as income, taste andfashion, prices of substitutes, etc change. A knowledge of demand theory is vital in thechoice of commodities for production.

THEORY OF PRODUCTION

The BASIC function of a firm is to produce goods and services and sell them in themarket. Production requires employment of various factors of production. The factorsare substitute among themselves to a certain extend. To maximize production and profit,it is necessary to achieve the least-cost combination of factors. Production theory is ofimmense use in determining the size of the firm, the size of the total output and theoptimum factor combination.

THEORY OF PRICE

Price theory explains price determination under various different market structures likeperfect competition, monopoly, oligopoly, etc. It is also useful to determine the optimaladvertisement budget that is necessary to maximize sales.

THEORY OF PROFIT

Profit making is the basic objective of business concerns. But, making a satisfactory levelof profit is not always certain, due to the presence of risk and uncertainty in businessoperations. Some of the factors which influence profit are (i) nature of demand for theproduct (ii) prices of the inputs in the factor market and (iii) the degree of competition inthe factor market . An element of risk is always there, even if business activities aresystematically planned .Therefore, minimising risks is of paramount importance tosafeguard the welfare of the firms. Profit theory guides in the measurement of profit andin estimating a reasonable return on the capital employed.

THEORY OF CAPITAL AND INVESTMENT

Capital like all other inputs, is scare and an expensive factor. Rational utilisation ofscarce resources is one of the important tasks of the managers. The major issues relatedto capital are (i) assessing the efficiency of capital (ii) choice of investment projects(iii)

the most efficiency allocation of capital .Knowledge of capital theory can contribute agreat deal in investment decisions ,choice of projects, maintaining capital intact,capital budgeting etc.

MACRO ECONOMIC THEORIES

Though managerial economics is basically micro in nature, macro theories arealtogether irrelevant for decision making at the firm level. This is because, themacroeconomic environment, which includes the behaviour of national aggregates suchas priced level , national income , unemployment, poverty and, microeconomic policyaspects, such as economic policy aspects, such as economic policy ,industrial policysubsidies ,administered prices and controls licensing policy ,etc affect firms decisions.

Glossary:

Above-normal profit A positive level of economic profits (i.e., operating profits are greater than normal profits).

Accounting profit The difference between total revenue and total explicit costs.

Business cycle Recurrent expansions and contractions in overall macroeconomic activity.

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Ceteris paribus Theassertion in economic theory that when analyzing the relationship between two variables,all other variables are assumed to remain unchanged.

Consumption

efficiency The state in which consumers derive the greatest level of happiness,satisfaction, or utility from the purchase of goods and services subject to limited income.

Economic efficiency

Also referred to as Pareto efficiency. An economic outcome in which it is not possible tomake one person in society better off without making some other person in society worseoff. Two related concepts are production efficiency and consumption efficiency.

Economic good Agood or service not available in sufficient quantity to satisfy everyones desire for that goodor service at a zero price.

Factors of production

Inputs that are used to produce goods and services. Also called productive resources,factors of production fall into one of four broad categories: land, labor, capital, andentrepreneurial ability.

Financialintermediaries Institutions that act as a link between those who have money to lend andthose who want to borrow money, such as commercial banks, savings banks, and insurancecompanies.

Fiscal policy Government spending and taxing policies.

Incentive contract Acontract between owner and manager in which the manager is provided with incentives toperform in the best interest of

Macroeconomic

Policy: Monetary and fiscal policy, sometimes referred to as thestabilization policy,macroeconomic policy is designed to moderate the negative effects of the economic cycle.

Macroeconomics: Thestudy of the entire economies. Macroeconomics deals with the broad economic aggregates,such as national product, employment, unemployment, inflation, interest rates andinternational trade. Macroeconomics also examines the role of the government ininfluencing these economic aggregates to achieve some socially desirable objective throughthe use of monetary and fiscal policies.

Manager Worker /

Principal: Agent Problem: Arises when workers do not have a vested interest in a firmssuccess. Without a stake in the companys performance, there will be an incentive for some

workers not to put forth their best efforts. Managerial

Economics: The synthesis of microeconomic theory and quantitative methods to findoptimal solutions to managerial decision making problems.

Market Economy: Aneconomic system characterized by private ownership of factors of production, privateproperty rights, consumer sovereignty, risk taking, entrepreneurship, and a system of pricesto allocate scarce goods, services and factors of production.

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Microeconomic Policy:Government policies designed to promote production and consumption efficiency.

Microeconomics: Thestudy of the behavior of individual economic agents, such as individual consumers andfirms, and the interactions between them. Microeconomics theory deals with such topics asproduct pricing, input utilization, production technology, production costs, marketstructure, total revenue maximization, unit sales maximization, profit maximization, capitalbudgeting, environmental protection and governmental regulation.

Monetary Policy: Thepart of macroeconomic policy that deals with the regulation of the money supply andcredit.

Negative Externalities:Costs of transactions borne by the individuals not the party to the transaction.

Normal Profit: Thelevel of profits required to keep the firm engaged in a particular activity. Normal profitrepresents the rate of return on the next best alternative investment of equivalent risk.

Ockhams razor: The

principle that, other things being equal, the simplest explanation tends to be the correctexplanation.

Opportunity Cost: Thehighest valued alternative forgone whenever a choice is made.

Owner Manager /

Principal Agent Problem: Arises when managers do not share in the success of the day to day operations of the firm. When managers do not have a stake in the companysperformance, some managers will have an incentive to substitute leisure for diligent workeffort.

Positive Externalities:Benefits of a transaction that are borne by an individual not a party to the transaction.

Post hoc, ergo propter

hoc: A common error in economic theorizing which asserts that because event A precededevent B, that event A caused event B.

Principal Agent

Problem: Arises when there are inadequate incentives for agents (managers or workers) toput forth their best efforts for principals (owners or managers). This incentive problemarises because principals, who have a vested interest in the operations of the firm, benefitfrom the hard work of their agents, while agents who do not have a vested interest preferleisure.

Production Efficiency:

The production by a firm of goods and services at the least cost, or the full and productiveemployment of the societys resources.

Pure Capitalism:Describes the economic systems that are characterized by the private ownership ofproductive resources, the use of markets and prices to allocate goods and services, and littleor no government intervention in the economy.

Satisfying Behavior:An alternative to the assumption of profit maximization, satisficing behavior may includemaximizing salaries and benefits, maximizing a market share subject to some minimally

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acceptable (by share holders) profit level, earning an adequate rate of return oninvestment, and attaining some minimum rate of return on sales, profit market share, assetgrowth, and so on.

Scarcity: Describes thecondition in which the availability of resources is insufficient to satisfy the wants and needsof the individuals and the society.

Total Economic Cost:

Includes all relevant costs associated with producing a given amount of output. Economiccosts include both explicit (out of pocket) expenses and implicit (opportunity) costs.

Total Economic Profit:Economic profit is the difference between the total revenue and the total economic costs.

Total Operating Cost:Economic cost less normal profit.

Total Operating

Profit: Economic profit plus normal profit.

Module Questions:

1. Define the concept of scarcity. Explain the significance of this concept in relation to theconcept of opportunity cost. Are opportunity costs and sacrifice the same thing? Would yousay that a sacrifice represents the cost of a particular decision?

2. Explain why the concept of scarcity is central to the study of economics.

3. The opportunity cost of any decision includes the value of all

4. In economics there is no free lunch. What do you believe is the meaning of this statement?

5. Explain how managerial economics is similar to and different from microeconomics.

6. What is the difference between a theory and a model?

7. Bad theories make bad predictions. Do you agree with this statement? Explain.

8. The Law of Demand is not a law. Do you agree with this statement? Explain.

9. Evaluate the following statement: Theories are only good as their underlying assumptions.

10. Explain the difference between a theory and a law.

11. The Museum of Heroic Arts (MOHA) is a not for profit institution. For nearly a century, themission of MOHA has been to extol and lionize the heroic human spirit. MOHAs mostrecent exhibitions, which have featured larger than life renditions of such pulp fiction superheroes as Superman, Wolverine, Batman, Green Lantern, Flash, Spawn and Brenda Starr,have proven to be quite popular with the public. Art aficionados who wish to view the exhibitmust purchase tickets months in advance. The contract of MOHAs managing director, Dr.Xavier, is currently being considered for renewal by the museums board of trustees. Shouldtheories of the firm based on the assumption of profit maximization play any role in theboards decision to renew Dr. Xaviers contract?

12. Many owners of small businesses do not pay themselves a salary. What effect will thispractice have on the calculation of the firms accounting profit? Economic profit? Explain.

13. It has been argued that profit maximization is an unrealistic description of the organizationalbehavior of large publicly held corporations. The modern corporation, so the argument goes,is too complex to accommodate such a simple explanation of the managerial behavior. Onealternative argument depicts the manager as an agent for the corporations shareholders.Managers, so the argument goes, exhibit satisfying behavior; that is, they maximizesomething other than profit, such as market share or executive perquisites, subject to some

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minimally acceptable rate of return on the shareholders investment. Do you believe that thisassessment of managerial behavior is realistic? Do you believe that the description ofshareholder expectations is essentially correct? If not, then why not?

14. Suppose you are attending a shareholder meeting of Blue Globe Corporation. A majorshareholder complains that Robert Redtoe, the chief Operating Officer (COO) of Blue Globe,earned $1,000,000 gross compensation, while Sam Pinkeye, the COO of Blue Globes chiefcompetitor, Green Ball Company, earned only $500,000. Should you support a motion to cutRedtoes compensation? Explain your position.

15. One solution to the Principal Agent Problem in restaurants is the system in which waitersand waitresses in restaurants work for tips as well as for small boss salary. Discuss a potentialfor management with this type of revenue based incentive scheme.

16. Employees of fast food restaurants who work directly with customers do not earn tips likewaiters and waitresses. Discuss possible solutions to the Manager Worker / Principal Agent Problems in fast food restaurants.

17. Explain why frequent spot checks by managers to encourage workers to put forth their besteffort may not always be in the best interest of the firms owners.

18. Under what condition is the assumption of profit maximization equivalent to shareholderwealth maximization?

19. In practice, what is a good approximation of the risk free rate of return on an investment?

20. As a practical matter, how would you estimate the risk premium on an investment?

21. Discuss several reasons why a firm in a competitive industry might earn above normalprofits in the short run. Will these above normal profits persist in the long run? Explain.

22. Firms that earn zero economic profit should close their doors and seek alternative investmentopportunities. Do you agree? Explain.

23. What is likely to happen to the price, quantity and quality of products produced by firms incompetitive industries earning above normal profits? Cite an example.

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economics term 2

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