MANAGERIALECONOMICS

MANAGERIALECONOMICS

A Mathematical Approach

M. J. ALHABEEBL. JOE MOFFITTIsenberg School of ManagementUniversity of MassachusettsAmherst, MA, USA

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Library of Congress Cataloging-in-Publication Data:

Alhabeeb, M. J., 1954–Managerial economics : a mathematical approach / M.J. Alhabeeb, L. Joe Moffitt.

p. cm.Includes bibliographical references and index.ISBN 978-1-118-09136-4 (cloth)

1. Managerial economics. I. Moffitt, L. Joe. II. Title.HD30.22.A39 2013338.5024′658–dc23

2012023746

Printed in the United States of America

ISBN: 9781118091364

10 9 8 7 6 5 4 3 2 1

Good management is the art of making problems so interesting and their solutions soconstructive that everyone wants to get to work and deal with them.

Paul Hawken

The essence of mathematics is not to make simple things complicated, but to make com-plicated things simple.

S. Gudder

There was a young man from Trinity,Who solved the square root of infinity.While counting the digits,He was seized by the fidgets,Dropped science, and took up divinity.

Anonymous

ToOur Students

Our Families, andThe memory of our parents.

CONTENTS IN BRIEF

PREFACE xix

UNIT I METHODOLOGICAL PRELIMINARIES

1 Qualitative Fundamentals 3

2 Quantitative Fundamentals 13

UNIT II DECISIONS AT THE CONSUMER LEVEL

3 Theory of Consumer Choice 47

4 Consumer Demand: Theoretical Analysis 103

5 Consumer Demand: Empirical Estimation 160

6 Consumer Demand: Economic Forecasting 200

UNIT III MANAGERIAL DECISIONS AT THE FIRM LEVEL

7 Production Theory 243

vii

viii CONTENTS IN BRIEF

8 Cost Theory 287

9 Production and Cost: Estimation and Forecasting 349

UNIT IV MANAGERIAL DECISIONS AT THE MARKET LEVEL

10 Market Structure and Business Organization 367

11 Pricing Decisions and Practices 414

UNIT V MANAGERIAL DECISIONS IN THE LONG RUN

12 Capital Budgeting and Investment Project Evaluation 451

13 Risk Analysis and Managerial Decisions under Uncertainty 487

14 Management Consultants and Information 546

APPENDIX 560

FURTHER READING 569

INDEX 573

CONTENTS

PREFACE xix

UNIT I METHODOLOGICAL PRELIMINARIES

1 Qualitative Fundamentals 3

1.1 Economic Theory and Managerial Economics 31.2 Some Methodological Fallacies 51.3 Paradigms, Models, and the Scientific Method 61.4 The Descriptive and Prescriptive Treatments 81.5 The Profit Function: Accounting versus Economics 81.6 Entrepreneurship, Management, and Leadership 9Summary 11Key Terms 12Exercises 12

2 Quantitative Fundamentals 13

2.1 Introduction 132.2 Functions 142.3 Exponents 162.4 Logarithms and the Number e 182.5 Differential Calculus 192.6 Multivariate and Equality Constrained Optimization 222.7 Inequality Constrained Optimization: Linear Programming 302.8 Selected Statistical Concepts 302.9 Maximum Likelihood Estimation 362.10 Ordinary and Nonlinear Least Squares Estimation 37

ix

x CONTENTS

Summary 38Key Terms 40List of Formulas 40Exercises 42

UNIT II DECISIONS AT THE CONSUMER LEVEL

3 Theory of Consumer Choice 47

3.1 Consumer Preferences 473.1.1 Indifference Curve 503.1.2 Marginal Rate of Substitution (MRS) 523.1.3 Nontypical Indifference Curves 55

3.2 Consumer’s Affordability 583.2.1 Budget Line 583.2.2 Slope of the Budget Line 603.2.3 Shift, Swing, and Kink of the Budget Line 60

The Shift 60The Swing 63The Kink 64

3.2.4 Three-Dimensional Budget 663.3 The Optimal Choice 68

3.3.1 Interior and Corner Solutions 693.3.2 Utility and Its Measurability 713.3.3 Utility Maximization 76

3.4 Effects on the Optimal Choice 813.4.1 Change in Income 81

Normal and Inferior Commodities 82Income–Consumption Curve 83Engel Curve: Nominal and Real 83Engel Curve and Income–Consumption Curve for Homothetic

and Quasi-Linear Preferences 85Income Elasticity of Demand 86

3.4.2 Change in Prices 88Giffen and Non-Giffen Commodities 90Price–Consumption Curve 90Price Change and the Demand Curve 91Price Elasticity of Demand 91Substitutes and Complements 93Cross-Price Elasticity of Demand 94

3.5 Income and Substitution Effects 953.6 Slutsky Equation 96Summary 98Key Terms 99List of Formulas 99Exercises 101

CONTENTS xi

4 Consumer Demand: Theoretical Analysis 103

4.1 Demand and Supply: Functions and Laws 1034.2 Deriving a Demand Function from Utility Maximization 1054.3 Homogeneity and the Numeraire 1094.4 Inverse Demand Function 1114.5 Demand and Supply: Table and Curves 1114.6 Market Equilibrium 1144.7 From Individual to Market Demand 1204.8 Demand and Network Externalities 122

4.8.1 The Case of the Bandwagon Effect 1224.8.2 The Case of the Snob Effect 124

4.9 Deriving a Market Demand Function under Externalities 1264.10 Changes in QD and QS versus Changes in D and S 1294.11 Changes in Equilibrium 131

4.11.1 The Case of Thanksgiving Turkey 1324.11.2 The Case of Sales and Excise Taxes 134

4.12 Market Disequilibrium 1384.12.1 The Case of a Price Ceiling 1394.12.2 The Case of a Price Floor 142

4.13 Marshallian versus Hicksian Demand Curves 1444.13.1 Shephard Lemma and the Expenditure Function 145

4.14 Deriving the Hicksian (Compensated) Demand Curve 1474.15 Revealed Preferences 1494.16 Interdependent Demand 152Summary 155Key Terms 157List of Formulas 157Exercises 157

5 Consumer Demand: Empirical Estimation 160

5.1 Simple Market Experimentation 1605.2 Linearity of the Demand Function: From Visual

to Regression 1635.3 Reliability of the Estimation 1685.4 Quality of Fitting 1705.5 Fitting by Computerized Regression 1725.6 Demand Estimation by the Multiple Regression Method 174

5.6.1 Results and Interpretation 1795.6.2 Goodness of Fit 1815.6.3 The Overall Explanatory Power of the Model 1825.6.4 Major Problems to Check On 183

Multicollinearity 183Autocorrelation 184Heteroscedasticity 185

5.7 Nonregression Approaches to Estimation 1865.7.1 Market Experimentation 186

xii CONTENTS

5.7.2 Observational Studies 1875.7.3 Micromarketing and Virtual Shopping 187

5.8 Advanced Demand Estimation: The Pad Model 1885.8.1 Model Specification 188

Desired Demand 188Adjustment Equation 188Estimating Equation 189

5.8.2 Graph of the Linear PAD Model 189Summary 196Key Terms 196List of Formulas 196Exercises 198

6 Consumer Demand: Economic Forecasting 200

6.1 Forecasting Models 2016.1.1 Quantitative Models 2016.1.2 Qualitative Models 202

6.2 Time Series Analysis 2026.2.1 Secular Trends 2026.2.2 Seasonal Variations 2026.2.3 Cyclical Fluctuations 2036.2.4 Random Changes 203

6.3 From Symbolic to Numeric Fitting 2036.4 Adjusting for Seasonality 207

6.4.1 The Simple Average of Errors Method 2086.4.2 The Actual-to-Forecast (A/F) Ratio Method 2106.4.3 The Dummy Variables Method 212

6.5 Smoothed Forecasts 2146.5.1 Simple Moving Average Method 214

The RMSE Check 2176.5.2 The Weighted Moving Average 2186.5.3 Exponential Smoothing 219

Mean Absolute Deviation (MAD) 2236.6 Barometric Forecasting 2246.7 Econometric Models 226

6.7.1 Single-Equation Model 2276.7.2 Multiple-Equation Model 229

6.8 Input–Output Matrix 2316.9 Judgmental Models 233

6.9.1 Opinions and Polls 2336.9.2 Surveys and Market Research 233

6.10 Forecasting Accuracy and Reliability 234Summary 235Key Terms 236List of Formulas 236Exercises 238

CONTENTS xiii

UNIT III MANAGERIAL DECISIONS AT THE FIRM LEVEL

7 Production Theory 243

7.1 Variability of Inputs throughout Time 2437.2 Production Function 2447.3 Graphical Representation of the Production Function 2467.4 Short-Run, One Variable Input Function 2507.5 Dynamic Relations among Production Curves 2527.6 Law of Diminishing Marginal Returns 2607.7 Long-Run, Two Variable Input Function 261

Isoquants 2617.8 Marginal Rate of Technical Substitution (MRTS) 2637.9 The Economically Efficient Region of Production 2667.10 Returns to Scale 2677.11 Elasticity of Substitution 269

7.11.1 Elasticity of the Cobb–Douglas Production Function 2707.11.2 Elasticity of the Leontief Production Function 2717.11.3 Leontief Technology and Linear Programming 2727.11.4 Elasticity of the Linear Production Function 2737.11.5 Elasticity of the CES Production Function 2747.11.6 Graphical Representation of CES 275

7.12 Optimal Employment of an Input 2777.13 Technological Progress, Invention, and Innovation 2787.14 Technological Progress and Production Function 280Summary 282Key Terms 283List of Formulas 283Exercises 285

8 Cost Theory 287

8.1 Cost Concepts and Categories 2878.2 Short-Run Costs 2898.3 The Optimal Combination of Inputs 297

8.3.1 Isocost 2978.4 Minimizing Input Cost and Maximizing Output 2988.5 Long-Run Costs 3018.6 Short-Run and Long-Run Average Costs: Economies of Scale 3038.7 Derivation of the Cost Function 3068.8 Economies of Scope: Basic Concept and Cost Complementarities 3118.9 Economies of Scope: Synergy and Input Indivisibility 3138.10 The Learning Curve 3168.11 Cost–Volume–Profit Analysis and Operating Leverage 321

8.11.1 Break-Even Quantity and Break-Even Revenue 322Fixed Cost 323Variable Cost 323Contribution Margin 324

xiv CONTENTS

8.11.2 Cash Break-Even Technique 3268.11.3 The Break-Even Point and Target Profit 3278.11.4 An Algebraic Approach to the Break-Even Point 3298.11.5 Break-Even Time 3308.11.6 The Dual Break-Even Points 334

8.12 Leverage 3378.12.1 Operating Leverage 3388.12.2 Operating Leverage, Fixed Cost, and Business Risk 341

Summary 342Key Terms 344List of Formulas 344Exercises 347

9 Production and Cost: Estimation and Forecasting 349

9.1 Estimation of the Production Function 3509.2 Estimation of the Cost Function 3529.3 Forecasting Output 3559.4 Forecasting Cost 3599.5 Meeting Obligations through Decisions with Probabilistic Results 360Summary 361Key Terms 361List of Formulas 361Exercises 363

UNIT IV MANAGERIAL DECISIONS AT THE MARKET LEVEL

10 Market Structure and Business Organization 367

10.1 Perfect Competition 36810.1.1 Characteristics of Perfect Competition 36810.1.2 Profit Maximization for Competitive Firms 36910.1.3 The Decision to Shut Down 37310.1.4 The Competitive Firm in the Long Run 377

10.2 Monopoly 38110.2.1 Monopoly’s Equilibrium in the Short Run 38110.2.2 Monopoly’s Equilibrium in the Long Run 38510.2.3 Monopoly Power and the Lerner Index 388

10.3 Monopolistic Competition 38910.3.1 Monopolistic Competition Equilibrium in the Short Run 39010.3.2 Monopolistic Competition Equilibrium in the Long Run 391

10.4 Oligopoly 39310.4.1 The Concentration Ratio and the Herfindahl Index 39410.4.2 Models of Oligopoly 395

Cournot Model 395Stackelberg Model 399Bertrand Model 403Sweezy Model 407

CONTENTS xv

Summary 410Key Terms 411List of Formulas 411Exercises 412

11 Pricing Decisions and Practices 414

11.1 Basics of Price Setting 41411.2 The Markup Rule 41511.3 Multiproduct Pricing Strategies 41811.4 Joint Products with Independent Demands 419

11.4.1 Product Set of Fixed Proportions 41911.4.2 Product Set of Variable Proportions 421

11.5 Transfer Pricing 42311.5.1 The Intermediate Product in a Perfectly Competitive Market 42411.5.2 The Intermediate Product in an Imperfectly Competitive Market 429

11.6 Pricing Strategies and Practices 43011.7 Price Discrimination 433

11.7.1 First-Degree Price Discrimination 43411.7.2 Second-Degree Price Discrimination 43611.7.3 Third-Degree Price Discrimination 437

Summary 445Key Terms 446List of Formulas 446Exercises 447

UNIT V MANAGERIAL DECISIONS IN THE LONG RUN

12 Capital Budgeting and Investment Project Evaluation 451

12.1 What is Capital Budgeting? 45112.2 Basic Model of Capital Budgeting 45312.3 Selection Process and Project Evaluation 45412.4 Methods of Evaluation for Proposed Investment Projects 455

12.4.1 Net Present Value 45512.4.2 Internal Rate of Return 45912.4.3 NPV versus IRR for Mutually Exclusive Projects 46212.4.4 NPV Profile, Crossover Rate, and the Ranking Reversal 465

12.5 Profitability Index and Capital Rationing 46712.6 Payback Method 46912.7 Cost of Capital 471

12.7.1 Cost of Debt Capital 47212.7.2 Cost of Equity Capital 473

The CAPM Estimation 473The Dividend Valuation Estimation 474

12.7.3 The Weighted Marginal Cost of Capital 47612.7.4 Capitalization and Capitalized Cost 47812.7.5 Last Words on the Cost of Capital 481

xvi CONTENTS

Summary 481Key Terms 483List of Formulas 483Exercises 485

13 Risk Analysis and Managerial Decisions under Uncertainty 487

13.1 Risk and Uncertainty 48713.2 Sources of Risk 488

13.2.1 Economic Sources 48813.2.2 Political Sources 48813.2.3 Social Sources 48913.2.4 International Sources 489

13.3 Measurement of Risk 48913.3.1 The Absolute Measure 49013.3.2 The Relative Measure 495

13.4 Risk Aversion 49513.5 Risk Attitudes and Utility of Money 49613.6 Expected Utility of Money versus Expected

Monetary Return 49813.7 Risk Discount and Certainty Equivalent 50113.8 Risk Impact on the Valuation Model 503

13.8.1 Risk Premium Adjustment 50313.8.2 Certainty-Equivalent Adjustment 506

13.9 Diversifiable versus Nondiversifiable Risk 50913.10 Portfolio Risk 51013.11 Risk of Two-Asset Portfolio 51813.12 Lending and Borrowing at the Risk-Free Rate of Return 52013.13 Measuring the Systematic Risk by Beta (β) 52213.14 The CAPM Model 52513.15 The Security Market Line (SML) 526

13.15.1 SML Shift by Inflation 52713.15.2 SML Swing by Risk Aversion 528

13.16 Managerial Decision Tree 53213.17 Mathematical Simulation and Sensitivity Analysis 53313.18 Advanced Choice under Risk, Ambiguity, and Uncertainty 536

13.18.1 Stochastic Dominance 536Assumptions 537Expected Utility 537First-Degree Stochastic Dominance 537Interpretation of FSD Conditions 538Second-Degree Stochastic Dominance 538Interpretation of FSD Conditions 538Applications of SSD Conditions 539

13.18.2 Choice under Ambiguity 53913.18.3 Choice under Uncertainty 539

Summary 541Key Terms 542

CONTENTS xvii

List of Formulas 543Exercises 544

14 Management Consultants and Information 546

14.1 Measuring Information and Its Impact on Uncertainty 54614.2 Perfect Management Information 54814.3 Valuing Perfect Management Information 54914.4 Valuing Less-than-Perfect Management Information 549Summary 556Key Terms 557List of Formulas 557Exercises 558

APPENDIX 560

FURTHER READING 569

INDEX 573

PREFACE

We live in a competitive world. Competition, in all its forms, is the name of the gameeverywhere: across cultures, times, environments, and whether the economy is in boomor recession; it is particularly crucial in a free market economy. Business managers areamong the few, at the forefront, who feel the brunt of having to compete in order to,first, secure their firm’s survival and, second, insure a prosperous and progressive stateof their business. The core of their performance is defined by their ability to make thebest decisions they can and be capable of confronting increasingly complicated conditionsand tangled circumstances, in their own market and beyond. Economic theory and othersupporting fields have proved significantly useful in providing the required efficient toolsto best understand and handle the decision-making process. Managerial economics is anapplication of microeconomics as it is bound with its supportive quantitative methodsof mathematics and statistics, business sciences, and decision sciences, all in pursuit ofrecognizing and utilizing the optimal treatments of and solutions to managerial problems.The ultimate purpose is to maximize the firm’s effectiveness and efficiency. This is onereason why the collective and integrative nature of the material in managerial economicsperfectly reflects the interdisciplinary quality of managerial decisions and the structure ofbusiness firms as a unified whole of different, multifaceted, and multifunctional parts. Allof these parts strive to work in sync for an ultimate collective goal.

This book is reasonably traditional in its scope and coverage, but it is different in its ap-proach, as compared to the rest of the available books in the field. First, there is a centraltheme that encloses all the material together and serves as the spine that tightly holdsthe book’s organization. The theme is decision making at four levels: the consumer, firm,market, and the future. They, along with the preliminary fundamentals, form the five majorunits of the book. Second, the approach is mathematical, to stress the problem-solving andanalytical nature of the decisions, as the theoretical concepts are put to practice and testing.The book is written under the assumption that readers are familiar with micro- and macroe-conomics, algebra, calculus, and statistics. However, Chapter 2 is dedicated to a general and

xix

xx PREFACE

brief review of selected mathematical and statistical topics to refresh the readers’ memory.The exposition of material in this book is intended to strike a good balance between the theo-retical and technical on the one hand, and practical on the other. The material is presented ina straightforward, right-to-the-point manner with no “fluff” or extra “fat,” to avoid making itless relevant or heavy and boring. Concepts and models are presented in multilevel learningforms and styles to enhance the overall comprehension and to fit into the diverse learningpatterns of all students. They are presented in an integrative combination of description,tabular analysis, mathematical and statistical expressions, geometrical representation, anddiagrammatical illustration. A great number of numerical, step-by-step-solved, examplesare given after each concept. Throughout the concepts and their examples, the emphasis isput on economic intuition rather than technical manipulation or mathematical proofs. Withthis level of exposure, we hope that the book would challenge and motivate three-fourthsof the students in a standard class and lift them up to the level of the one-fourth already atthe top. Our central objective is to help students comprehend, develop, and appreciate theultimate connection between the descriptive concepts and their mathematical face, and beable to deal with the real and practical decisions they face every day at work and beyond,particularly in the matter of resource allocation that would lead to maximizing the benefitand minimizing the cost.

Each chapter ends up with a general summary, a list of key terms, a list of formulas usedthroughout the chapter, and review and exercise questions. The main intention behind thisend-of-chapter material is to help students review the concepts, test their comprehension,and verify their ability to apply the theoretical models and realize their usability, as well aspractice and develop their problem-solving skills.

The book is intended for the upper-level undergraduate and first-year graduate in businessand economics majors, MBA, and other related majors such as industrial organizationand engineering. It also serves as an excellent reference material for business managers,executives, and researchers. It covers material for more than one semester, but there is adegree of flexibility in the way this material has been organized so that an instructor canprioritize and choose what can efficiently fit into his or her own single semester agenda.

The book is organized into five units with a total of 14 chapters. The first unit presentsthe methodological preliminaries as an essential introduction to set the tone for the typeof approach and the nature of analytical treatment in this book. It includes two chapters:Chapter 1 addresses the qualitative fundamentals, and Chapter 2 addresses the quantitativefundamentals in a brief review of selected mathematical and statistical topics. The secondunit introduces the managerial decisions at the consumer level. It includes four chapters:Chapter 3 is on the theory of consumer choice, Chapter 4 on the theory of consumer demand,Chapter 5 on the empirical estimation of consumer demand, and Chapter 6 on the economicforecasting of consumer demand. The third unit discusses the managerial decisions at thefirm level. It includes three chapters: Chapter 7 is on production theory, Chapter 8 on costtheory, and Chapter 9 on the empirical estimation and economic forecasting of cost andproduction. The fourth unit addresses the managerial decision at the market level. It consistsof two chapters: Chapter 10 is on market structure and organization, and Chapter 11 onpricing practices, models, and policies. The fifth unit addresses the managerial decisions inthe long run. It includes three chapters: Chapter 12 is on capital budgeting and investment

PREFACE xxi

project evaluation, Chapter 13 on risk analysis and decisions under uncertainty, and Chapter14 on management consultants and information.

Every possible effort has been made to make the book error free, but we believe that therewill always be some flaws and errors that may slip below the radar, despite our diligentattempt to perfect the work. All the flaws and errors remain our sole responsibility, andonly great appreciation goes to those who lent their hands in the preparation of the book.Readers, particularly students and instructors, are invited to submit any error they maycatch or suggestions they may have to improve the quality of this book for the next edition.We are indebted to our senior departmental secretary Peggy Cialek, who typed up theentire manuscript with exceptional patience and efficiency. We are also very grateful to ourformer student, now an architect to be, G. Marius De La Pena, who highly competentlyrendered all the graphs and diagrams, and to our former graduate student Don Hedeman forhis continuous help and support. A special word of appreciation goes to our Wiley editorSusanne Steitz-Filler and associate editor Jackie Palmieri for their professional competency,understanding, and patience. Many thanks and appreciation also to our production editorStephanie Loh and our project manager Baljinder Kaur for their remarkable punctuality andcare. My deep appreciation also goes to our copy editors Asha Kumari and Ammu Ajithfor thoroughly and meticulously checking the manuscript and giving smart and sensibleediting suggestions. The author feels very lucky to have the help and support of his friendsand international artists. Special thanks to the German artist Heike Schenk Arena, whoprovided the beautiful image of the book cover, and the British artist Sevina Yates for herfollow-up and continuous support of the project.

M. J. AlhabeebBelchertown, MA

April 2012

UNIT I

METHODOLOGICALPRELIMINARIES

1QUALITATIVE FUNDAMENTALS

1.1 ECONOMIC THEORY AND MANAGERIAL ECONOMICS

The concept of economic scarcity epitomizes the paradox of the finite nature of resourcesand the infinite nature of human needs and wants. This inherent structural contradiction inour life is not only what characterizes our societies’ natural and human resources in contrastto their needs, but also what stands as the very phenomenon that necessitates choices and,therefore, bears the responsibility for the existence of prices. It is also the best reason thatsignifies the concept of opportunity cost, which is one of the central premises in economictheory, where economists consider all costs as opportunity costs in the final analysis, forthey are nothing more than the foregone opportunities of some other alternatives. Theopportunity cost amplifies the economic notion that for any gain there has to be some loss,for any benefit there is some cost, and for any reward there is a sacrifice. It is because ofthis logic that economics has been described as the science to study and analyze humanchoices, subject to their constraints.

The macroeconomics side of the theory is concerned with the “whole” versus the“parts.” It studies the entire economic system and considers the society’s aggregate nation-wide parameters such as national income and national debt, economic growth, fluctuationof interest and inflation rates, employment, national budget, and international trade. Theother side of the theory is microeconomics, where the main focus is on the “parts,” orthe components and the comprising agents of that whole system. It considers the behav-ior of individuals, families, and firms as they seek to maximize their economic utility.Microeconomics considers consumers’ optimization of their own utility, firms’ maxi-mization of their profits and minimization of cost, and all of what entails, such as eco-nomic efficiency, market structure, capital budgeting, production, distribution, marketing,

Managerial Economics: A Mathematical Approach, First Edition. M. J. Alhabeeb and L. Joe Moffitt.© 2013 John Wiley & Sons, Inc. Published 2013 by John Wiley & Sons, Inc.

3

4 QUALITATIVE FUNDAMENTALS

pricing, revenues, and sales. It is, therefore, the right domain and proper atmosphere to seewhere managerial economics stands, for it is how managers can function and make theirbusiness decisions.

Microeconomics is capable of identifying the nature of economic problems, understand-ing their logic, laying out their structure, and specifying their functions and conditions.However, since all of that cannot be done only verbally or in a qualitatively descriptivemanner, there has been a growing need to quantify the ranges, estimate the parameters,analyze and assess the changes, and hence, the need to employ mathematical and statisticalmethods within microeconomics. Managerial economics is, therefore, an application ofmicroeconomics and its supportive quantitative methods (drawn from mathematics andstatistics) in the decision-making process for managers who are in pursuit of recognizingand utilizing the optimal treatments and solutions to managerial problems and issues inorder to reach a certain level of efficiency in achieving the firm’s objectives.

Managerial economics is concerned with both effectiveness and efficiency of the de-cisions made by managers and management teams regarding the economic function ofthe firm in its utilization of scarce resources. This multifaceted task includes organiza-tional design, management strategies, finances and accounting of capital management, andeconomic analysis of production, distribution, marketing, pricing, consumer demands foroutput, controlling the supply of input, monitoring markets and reacting to competition. Themajor thrust in undertaking these functions is to identify the general and specific problems,analyze the opportunities, and evaluate the alternatives in preparation for making the finalchoices.

Quan�ta�ve economics

Micro Func�onal

fields Decision making

Accoun�ng

Management

Marke�ng

Macro

Math

Stat

Finance

Managerial economics

Alterna�ves Problems Choice Assessment

FIGURE 1.1

Figure 1.1 shows how managerial economics acquires its essential identity through thecontributions of three components: (1) quantitative economics, (2) the scientific procedureof decision making, and (3) the related functional fields. Economic theory, especially mi-croeconomics, provides the foundation for marginal analysis, theory of consumer choice,theory of the firm, industrial organization and behavior, and theory of public choice andpolicy. The quantitative approach would provide many technical tools such as numerical

SOME METHODOLOGICAL FALLACIES 5

analysis, statistical estimation, mathematical optimization, econometrical models, forecast-ing procedures, game-theoretic scenarios and simulations, information system schemes, andlinear programming. The scientific approach to decision making requires four sequencedand integrated steps:

1. Identifying and clearly defining the problems and their contexts, as well as settingclear and feasible objectives to deal with those problems.

2. Exploring all possible ranges of alternatives and their constraints, and evaluatingthem comparatively.

3. Deciding on the best choice among the deliberated alternatives.

4. Assessing the final choice as it is put to test in order to move to the next step, which isbenefiting from the entire experience. This step also includes running some sensitivityanalysis in which the chosen best alternative is examined against the possibility ofchanging the conditions and circumstances around it.

1.2 SOME METHODOLOGICAL FALLACIES

As stated earlier, managerial economics connects primarily to microeconomics because ofits domain that is more relevant to managers and their business decisions. This does notmean a total disconnection from macroeconomics. It is more appropriate to say that therelevance of managerial economics to macroeconomics is not as certain and strong as it isto microeconomics. In some cases, there will be clear evidence of the connection, and inother cases, there would be none. Managers make many important decisions that may haveimplications for public policy and have to conform to state and federal rules and regulations,and abide by the local government codes. Also, many firm-specific decisions may be madein strong connection to macro parameters such as inflation and employment levels. The pointhere is that understanding the nature and level of connection with micro- or macroeconomicsrequires the problems in question to be well defined, their context to be well set, and theobjectives to be correctly placed. Suffice it to say that borrowing the philosophical logicof size fallacies may help here. This fallacy is methodological in nature and is about thepossibility of separating the “whole” from the “parts” (its components) and making themindependent entities. Such entities may have their own characteristics, which may or maynot be associated with each other. What has come to be known as the fallacy of division isabout refuting the common logic that whatever is considered true of the “whole” is also trueof the “parts.” It is a fallacy because it is misleading. It may or may not be correct. Consider,for example, a well-known brand name of a product that has been dominating the marketfor a long time, and has acquired strong consumer loyalty. It is possible that one or more ofits specific product lines may not live up to that whole good reputation and may fail in themarket. On the other hand, the reversed fallacy is the fallacy of composition, which alsorefute the statement that whatever is true of the parts is also true of the whole because it maynot necessarily be correct. Consider one or a few brilliant graduates who went on to becomerenowned scientists, poets, or artists, but their success and fame may not necessarily meanthat the department or school they graduated from is as accomplished, successful, or famousas they are.

Another common methodological fallacy that should be well understood is the fallacyof causation and correlation. It simply refers to the fact that correlated events may

6 QUALITATIVE FUNDAMENTALS

not necessarily stand as causes for each other, since the correlation may only mean thatthey happen to occur at the same time or in the same place, but cause-and-effect relationrequires a much deeper organic connection and more complicated structural ties. Consider,for example, that in inner large cities, there would be a high correlation between high-risebuildings and crime rates but, of course, it would seem preposterous to suggest that theexistence of skyscrapers increases crime (!) or a high crime rate in inner cities motivatesdevelopers to build high-rise constructions (!!). A similar discussion would hold for thereverse statement that events known to be a cause or effect to each other may not necessarilybe found correlated at certain circumstances such as in the case when they just happen to bethere for different independent reasons. An example would be about the well-known factthat Lyme disease is caused by being bitten by a deer tick carrying the bacteria, but it ishighly possible to find none or a weak correlation between being bitten by ticks and havingthe disease simply because it is estimated that the chances of contracting the disease afterbeing bitten by a tick is only 1%.

Considering these fallacies, and going by the logic of serutinizing the generalizedstatements would eliminate the stereotypical conclusions and allow a more careful analysis.The connection of all elements in the economy and their intermingled relations are alwaysthere, but they occur in different degrees and priorities, which need to be tracked downand investigated. Consider, for instance, a macroeconomic decision by the federal or stategovernment to increase taxes on consumption and its implications at micro levels onconsumer demand on one hand and on the firm’s managerial decisions on the other. Alsoconsider the feedback of the firm’s policies on consumers and the effects of both, firms andconsumers, on the public policies in regard to inflation and employment.

1.3 PARADIGMS, MODELS, AND THE SCIENTIFIC METHOD

The overarching paradigm in economics pivots around three major assumptions on marketparticipants, who are the main constituents in the economic activity (consumers, house-holds, firms, and other economic agents). The first assumption is that they are goal-oriented,who tend to engage in a reasonably clear and purposeful participation, centered on the par-ticipants’ own interest. The second assumption is that they have stable and well-definedpreferences, which enable them to make rational choices that would ultimately maximizetheir gain, and to a certain degree, minimize their loss. The third assumption is that thoseparticipants operate in the reality of the scarce resources, which is exemplified by the re-sources’ inability to satisfy all people’s ever-increasing and changing needs and wants. Intheir own right, and as bold assertions as they are about the economic system, those assump-tions serve as the foundation to build our economic models, which are supposed to depictthe essential state of the economic system and the way it works. As basic and fundamentalrepresentation of reality, theoretical models are often simplistic, abstract, conditioned, andmay very well seem unrealistic in their abstraction and intangible depiction. However,simplicity and abstraction are necessary characteristics to make models understandable,as well as make them subject to logical manipulation. Furthermore, such characteristicshave to be reasonable and close enough to reality in order to be credible and capable ofproducing meaningful outcomes.