unit-1 introduction to managerial economics.doc

Unit – 1Introduction to Managerial Economics

Handout-1Instructor: Asmamaw T.

Economics can be divided into two broad categories: micro economics and macro economics. Macro economics is the study of the economic system as a whole. It includes techniques for analyzing changes in total output, total employment, the unemployment rate, and exports and imports. It also focuses on the effect of changes in investment, government spending, and tax policy on exports, output, employment and prices.

Micro economics is the study and analysis of the behaviour of individual segments of the economy: individual consumers, workers and owners of resources, individual firms, industries, and markets for goods and services. Micro economics is concerned with topics such as how consumers choose the goods and services they purchase and how firms make hiring, pricing, production, advertising, research and development and investment decisions.

Managerial economics

Managerial economics focuses on the application of micro economic theory to business problems. Managerial economics provides a systematic, logical way of analyzing business decisions – both today’s decisions and tomorrow’s. It addresses the larger economic forces that shape both day-to-day operations and long-run planning decisions.

Managerial economics is applied micro economics. It is an application of the part of micro economics that focuses on the topics that are importance to managers. These topics include demand, production, cost, pricing, market structure, and government regulation. The rational application of these principles should result in better managerial decisions, higher profits and an increase in the value of the firm.

Managerial economics applies economic theory and methods to business and administrative decisions.

Managerial economics can be used by the goal-oriented manager in two ways:

1. The principles of managerial economics provide a framework for evaluating whether resources are being allocated efficiently within a firm. For example, economics can help the manager determine if profit could be increased by reallocating labour from a marketing activity to the production line.

2. These principles help managers respond to various economic signals. For example, given an increase in the price of output or the development of a new lower-cost production technology, the appropriate managerial response would be to increase output.

Introduction to Managerial Economics1

Importance of Managerial economics A working knowledge of the principles of managerial economics can increase the

value of both the firm and the manager. It prescribes rules for improving managerial decisions. It helps managers recognize how economic forces affect organizations and describes

the economic consequences of managerial behaviour. It links economic concepts with quantitative methods to develop vital tools for

managerial decision making.

Managerial economics is a tool for improving managerial decision making. Managerial economics uses economic concepts and quantitative methods to solve managerial problems.


Management decision problems Product selection, output and pricing Internet strategy Organizational design Product development and promotion strategy Employee hiring and training Investment and hiring

Economic concepts Marginal benefits Theory of consumer demand Theory of the firm Industrial organization and firm

behaviour 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

Optimal solutions to management decision problems

The circular flow of economic activity

Goods and services ($) Goods and services ($)

`

Economic resources Economic resources

Income($) Factor payments ($)

Figure: 1 Circular flow of income, output resources and factor payments

Individuals and firms are the fundamental participants in a market economy. Individuals own or control resources that have value to firms because they are necessary inputs in the production process. These resources are broadly classified as labour, capital and natural resources. Most people have labour resources to sell, and may own capital and natural resources that are rented, loaned or sold to firms to be used as inputs in the production process. The money received by an individual from the sale of these resources is called a factor payment. This income to individuals then is used to satisfy their consumption demands for good and services.

The interaction between individuals and firms occurs in two distinct arenas. First, there is a product market where good and services are bought and sold. Second, there is a market for factors of production where labour, capital and natural resources are traded. These interactions are depicted in figure-1 which describes the circular flow of income, output, resources and factor payments in a market economy.

In the product market shown in the top part of the figure, individuals demand goods and services in order to satisfy their consumption desires. They make these demands known by bidding in the product market for these goods and services. Firms respond to these demands by supplying goods and services to that market to earn profit. The firm’s production technology and input costs determine the supply conditions, while consumer preference and income determine the demand conditions. The interaction of supply and demand determines the price and quantity sold. In the product market,


Product markets

Households

Factor markets

Firms

purchasing power, usually in the form of money, flows from consumers to firms. At the same time, goods and services flow in the opposite direction – from firms to consumers.

The factor market is shown at the bottom of figure -1. Here, the flows are the reverse of those in the product market. Individuals are the suppliers in the factor market. They supply labour services, capital and natural resources to firms that demand them to produce goods and services. Firms indicate the strength of their desire for these inputs by bidding for them in the market. The flow of money is from firms to individuals, and factors of production flow from individuals to firms. The price of these production factors are set in this market.

Prices and profits serve as the signals for regulating the flows of money and resources through the factor markets and the flows of money and goods through the product market.

In the market economy depicted by this circular flow, individuals and firms are highly interdependent; each participant needs the others. For example, an individual’s labour will have no value in the market unless there is a firm that is willing to pay for it. Alternatively, firms cannot justify production unless some consumers want to buy their products. As a result, all participants have an incentive to provide what others want. All participate willingly because they have something to gain by doing so. Firms earn profits, the consumption demands of individuals are satisfied, and resource owners receive wage, rent and interest payments.

Nature and rationale for the firm

In order to earn profits, the firm organizes the factors of production to produce goods and services that will meet the demands of individual consumers and other firms. The concept of the firm plays a central role in the theory and practice of managerial economics.

In a free-market economy, the organization and interaction of producers (i.e. firms) and consumers is accomplished through the price system. There is no need for any central direction by government. Within the firm, transactions and the organization of productive factors are generally accomplished by the central control of one or more managers. Thus, there is an apparent dichotomy in the organization of production in a market economy. The price system guides the decentralized interaction among consumers and firms, whereas central planning and control tend to guide the interaction within firms.

Why do firms exist in a market economy?

Firms exist as organizations because the total cost of producing any rate of output is lower than if the firm did not exist. The costs are lower due to following reasons;


1. There is a cost of using the price system to organize production. The cost of obtaining information on prices and the cost of negotiating and concluding separate contracts for each step of the production process would be burdensome.

2. One general contract covers what usually will be a large number of transactions between the owners and workers. The two parties do not have to negotiate a new contract every time the worker is given a new assignment. The saving of the transactions costs associated with such negotiations is advantageous to both parties, and thus both labour and management voluntarily seek out such arrangements.

Basic principles of effective managementThe nature of sound managerial decisions varies depending on the underlying

goals of the manager. An effective manager must;1. identify goals and constraints2. recognize the nature and importance of profits3. understand incentives4. understand markets5. recognize the time value of money6. use marginal analysis

1. Identify goals and constraintsThe first step in making sound decisions is to have well defined goals because

achieving different goals entails making different decisions. The decision maker faces constraints that affect the ability to achieve a goal. Optimal decisions are taken by the manager to minimize the constraints to maximize the goals.

2. Recognize the nature ad importance of profitsThe overall goal of most firms is to maximize profits or the firm’s value. A

manager should be aware of economic profits, accounting profits and its role.

3. Understand incentivesProfits signal the holders of resources when to enter and exit particular industries.

Changes in profits provide an incentive to resource holders to alter their use of resources. Incentives affect how resources are used and how hard workers work. Managers should understand the role of incentives within an organization and construct incentives to induce maximal effort from people.

4. Understand marketsThe final outcome of the market process depends on the relative power of buyers

and sellers in the market place. The power or bargaining position of consumers and producers in the market place is limited by three sources of rivalry;

a) Consumer- producer rivalry: occurs because of the competing interests. Consumers attempt to negotiate low prices, while producers attempt negotiate high prices.


b) Consumer- Consumer rivalry: reduces the negotiating power of consumers in the market place. When limited quantities of goods are available, consumers will compete with one another for the right to purchase the available goods.

c) Producer-Producer rivalry: functions when multiple sellers of a product compete in the market place; producers compete with one another for the right service the customers available. Those firms that offer the best quality product at the lowest price can earn the right to serve the customers.

5. Recognize the time value of moneyThe timing of many decisions involves a gap between the time when the costs of a

project are borne, and time when the benefits of the projects are received. It is important to recognize that $1 today is worth more than $1 received in the future. The manager must understand present value analysis.

6. Use marginal analysisMarginal analysis states that optimal managerial decisions involve comparing the

marginal (or incremental) benefits of a decision with the marginal (or incremental) costs.

Economic profit versus Accounting profit

Economic profit is the amount by which total revenue exceeds total economic cost.

The total economic cost is the sum of the opportunity costs of each and every resource used by a firm.

Business generally utilize two kinds of resources;

1. Resources owned by others (such as labour services of skilled and unskilled workers, raw materials purchased from commercial suppliers, and capital equipment rented or leased from equipment suppliers). The opportunity cost of using resources owned by others is the dollar amount paid to the resource owners are called explicit costs.

2. Resources owned by the firm ( such as labour services provided to the firm by its owners, money provided to the firm by its owners, money provided to the business by its owners, and any land, buildings, or capital equipment owned and used by the business). For the resources used by the firm that are owned by the firm, the opportunity cost is the largest payment that the owner could have received if those resources that it owns had been leased or sold instead of being held by the firm for its own use. These costs of using a firm’s own resources are called implicit costs since the firm makes no monetary payment to use its own resources.

For both kinds of resources, firms incur opportunity costs to use these resources, and the opportunity cost of the resource use is measured either by the dollar spent by owners to secure the services of a resource owned by others or by the dollars sacrificed by


owners to hold and use a resource they own. Both kinds of opportunity costs of using resources must be subtracted from total revenue to get economic profit;

Economic profit = Total revenue – total economic costs.= Total revenue – Explicit costs – Implicit costs.

Accounting profit is the difference between total revenue and explicit costsAccounting Profit = total revenue – explicit costs.

Thus, economic profit is smaller than accounting profit by the amount of the firm’s implicit costs;

Economic Profit = Accounting profit - Implicit costs

Economists refer to the opportunity cost of using the owner’s own resources as normal profit. Normal profit is another name for the implicit cost that a firm incurs when it employs owner-supplied resources. It represents the payment that business owners must receive for using their own resources in their own business. Normal profit is the implicit part of total economic cost;

Economic Profit = Total revenue – Explicit cost – Normal profit = Accounting profit – normal profit.

Theories of economic profits1. Frictional theory of economic profits

It states that markets are sometimes in disequilibrium because of unanticipated changes in demand or cost conditions. Unanticipated shocks produce positive or negative economic profits for some firms. For example; ATM’s make it possible for customers of financial institutions to easily obtain cash, enter deposits, and make loan payments. A rise in the use of plastics and aluminum in automobiles drives down the profits of steel manufacturers.

2. Monopoly theory of economic profitsThis theory asserts that some firms are sheltered from competition by high

barriers to entry. Economies of scale, high capital requirements, patents, or import protection enable some firms to build monopoly positions that allow above- normal profits for extended periods.

3. Innovation theory of economic profitsIt describes the above-normal profits that arise following successful invention or

modernization. Example, Microsoft Corporation earned superior rates of return because of its Graphical User Interface. Mc Donald’s Corporation earned above normal rates of return as an early innovator in the fast food business.

4. Compensatory theory of economic profitsIt describes above normal rates of return that reward firms for extra ordinary

success in meeting customer needs, maintaining efficient operations etc. If firms that


operate at the industry’s average levels of efficiency receive normal rates of return, it is reasonable to expect firms operating at above average levels of efficiency to earn above normal rates of return. Inefficient firms can be expected to earn unsatisfactory, below normal rates of return. The theory also recognizes economic profit as an important reward to the entrepreneurial function of owners and managers.

Examples:1. Suppose a firm has revenues of $ 5 million and explicit costs of $ 3 million. The owners of the firm have provided $ 1 million of capital to the firm. If the owners could have earned a 10 percent return on the $ 1 million in their best alternative investment (of similar risk), the normal profit is $ 100,000. Economic profit is $ 1.9 million (= $ 5 million - $ 3 million - $ 0.1 million).

Suppose this same firm receives a total revenue of only $ 3.1 million, then the firm would be earning only a normal profit, and economic profit is zero. Even though economic profit is zero, the owners are still “breaking even “because the firm’s accounting profit of $ 0.1 million is just enough to pay the owners a normal profit for the use of their resources.

2. Consider an individual who has an MBA degree and is considering investing $ 200,000 in a retail store that she would manage. The projected income statement for the years as prepared by an accountant is as shown here.

Sales $ 90,000Less: Cost of good sold 40,000

__________Gross Profit $ 50,000

Less: Advertising $ 10,000

Depreciation 10,000Utilities 3,000Property tax 2,000Miscellaneous expenses 5,000

30,000____________

Net accounting profit $ 20,000_____________

The use of this concept may result in making wrong decision.

The economist recognizes other costs, defined as implicit costs. These costs are not reflected in cash outlays by the firm, but are costs associated with forgone opportunities. There are two major implicit costs in the example. First, the owner has $200,000 invested in the business. Suppose the best alternative use for this money is a bank paying a 5 percent interest rate. Therefore, this investment would return $ 10,000 annually. The $10,000 should be considered as the implicit or opportunity cost of having the $200,000 invested in the retail store.


The second implicit cost includes the manager’s time and talent. The annual wage return of an MBA degree from a reasonably good business school may be $ 60,000 per year. This is the implicit cost of managing this business rather than working for some one else. Thus the income statement should be amended in the following way in order to determine economic profit:

Sales $ 90,000Less Cost of goods sold 40,000

Gross profit $ 50,000

Less: Explicit Costs: Advertising $ 10,000Depreciation 10,000Utilities 3,000Property tax 2,000

Miscellaneous expenses 5,000 30,000

Accounting profit (i.e. profit before Implicit costs) $ 20,000Less: Implicit costs:Return on $ 200,000 of invested

Capital 10,000Foregone wages 60,000 70,000

________________________Net economic profit $ - 50,000

________________________

From this broader perspective, the business is projected to lose $ 50,000 in the first year. The $ 20,000 accounting profit disappears when all “relevant” costs are included. Obviously, with the financial information reported in this way, an entirely different decision might be made on whether to start this business.

3. Sharon Smith is a full time home maker and is also an excellent seamstress. She has material for which she paid $5 per yard several years ago. The material has increased in value during that time and could be sold back to the local fabric shop for $15 per yard. Sharon is considering using that material to make dress, which she would sell to her friends and neighbors. She estimates that each dress would require four yards of material and four hours of her time, which she values at $10 per hour. If the dresses could be sold for $90 each, could Sharon earn a positive economic profit by making and selling the dresses?

Solution: The key to this decision is appropriately accounting for both Sharon’s time ($ 10 per hour) and the true opportunity cost of the material, $15 per yard (the amount she could receive by selling it to the fabric shop). The profit calculation per dress would be as follows:


Revenue $90Less: 4 hours of labour at $10/hour 40 4 yards of material at $15/yd 60 _______Economic profit $-10

Clearly, making the dresses is not going to be profitable. If Sharon had not included the value of her time and had used the historic price of $5 per yard as the cost of the material, she would have estimated a “profit” of $70 per dress, that is

Revenue $90Less: 4 yards of material at $5/yd 20

________“Profit” $70

This is not an accurate measure of profit because it fails to account for the true opportunity cost of Sharon’s time and the opportunity cost of a yard of material. She could sell both in the market and make more than she could by producing the dresses.

Market structure and managerial decision making

Managers cannot expect to succeed without understanding how market forces shape the firm’s ability to earn profit. An important aspect of managerial decision making is the pricing decision. The structure of the market in which the firm operates can limit the ability of a manager to raise the price of the firm’s product, without losing substantial amount.

Market structure is a set of market characteristics that determines the economic environment in which a firm operates. The economic characteristics needed to describe a market are;

The number and size of the firms operating in the market. If there are large numbers of sellers, no single firm can influence market price by changing its production level. When the total output of a market is produced by one or a few firms with relatively large market shares, a single firm can cause the price to rise by restricting its output and to fall by increasing its output.

The degree of product differentiation among competing producers. If sellers produce identical products, then buyers will never need to pay more for a particular firm’s product than the price charged by the rest of the firms. By differentiating a product, a firm may be able to raise its price above its rival’s prices.

The likelihood of new firms entering a market when existing firms are earning economic profits. When firms in a market earn economic profits, other firms will learn of this return in excess of opportunity costs and will try to enter the market. Once enough firms enter a market, price will be bid down sufficiently to eliminate any economic profit.

Micro economists have analyzed firms operating in a number of different market structures. Each market structure shapes a manager’s pricing decisions. In perfect competition, a large number of relatively small firms sell an undifferentiated product in a market with no barriers to the entry of new firms. Managers of firms operating in


perfectly competitive markets are price-takers, with no market power. Since price is determined by the market forces of demand and supply, they decide how much to produce to maximize profit. Any economic profit earned at the market-determined price will vanish as new firms enter and drive the price down to the average cost of production. Many of the markets for agricultural goods and other commodities traded on national and international exchanges closely match the characteristics of perfect competition.

In a monopoly market, a single firm, protected by some kind of barrier to entry produces a product for which no close substitutes are available. A monopoly is a price setting firm. The degree of market power enjoyed by the monopoly is determined by the ability of consumers to find imperfect substitutes for the monopolist’s product. The higher the price charged by the monopolist, the more willing are consumers to buy other products. The existence of a barrier to entry allows a monopolist to raise its price. Examples of true monopolies are rare.

In monopolistic competition, a large number of firms that are small relative to the

total size of the market produce differentiated products without the protection of barriers to entry. The product differentiation gives monopolistic competitors some degree of market power. Any economic profit will eventually be bid away by new entrants. The toothpaste market provides one example of monopolistic competition. Many brands of toothpaste are close substitutes. Toothpaste manufacturers differentiate their toothpastes by using different flavorings, abrasives, whiteners, fluoride levels, and other ingredients, along with advertising to create brand loyalty.

In the case of an oligopoly market, just a few firms produce most or all of the market output. So any one firm’s pricing policy will have a significant effect on the sales of other firms in the market. The interdependence of oligopoly firms means that actions taken by any one firm in the market will have an effect on the sales and profits of the other firms.

Work out problems1. During a year of operation, a firm collects $175,000 in revenue and spends $ 80,000 on raw materials, labour expense, utilities and rent. The owners of the firm have provided $ 500,000 of their own money to the firm instead of investing the money and earning a 14 percent annual rate of return.

(a) The explicit costs of the firm are $ ________The implicit cost are $ ____________Total economic cost is $ __________

(b) The firm earns economic profit of $ _________The firm’s normal profit is $ _________

(c) The firm’s accounting profit is $ _________

d) If the firm’s costs stay the same but its revenue falls to $ __________, only a normal profit is earned.


(e) If the owners could earn 20 percent annually on the money they have invested in the firm, the economic profit of the firm would be ___________ (when revenue is $175,000).

2. At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs and maintains custom audio equipment for businesses that require high-quality audio systems. A partial income statement for Sound Devices, Inc is shown below:

Revenues 2001

Revenue from sales of Product and service $ 970,000

Operating costs and expenses Cost of products and services sold 355,000 Selling expenses 155,000 Administrative expenses 45,000

___________________Total operating costs and expenses $ 555,000

___________________

Income from operations $ 415,000Interest expense (bank loan) 45,000Legal expenses to start business 28,000Income taxes 165,000 ____________________Net income $ 177,000

______________________

To get started, the owner of Sound Devices spent $ 100,000 of his personal savings to pay for some of the capital equipment used in the business. In 2001, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new business with risk levels similar to the risk level at Sound Devices.

a) What are the total explicit, total implicit and total economic costs in 2001?b) What are accounting profit, economic profit and normal profit in 2001?c) Given your answer in part (b), evaluate the owner’s decision to leave his job to

start Sound Devices.

3. A recent engineering graduate turns down a job offer at $ 30,000 per year to start his own business. He will invest $ 50,000 of his own money, which has been in a bank account earning 7 percent per year. He also plans to use a building he owns that has been rented for $ 1500 per month. Revenue in the new business during the first year was $ 107,000, while other expenses were


Advertising $ 5,000Rent 10,000Taxes 5,000Employees salaries 40,000Supplies 5,000

Prepare two income statements, one using the traditional accounting approach and one using the opportunity cost approach to determine profit.

4. Tempo Electronics, Inc. has an inventory of 5000 unique electronic chips originally purchased at $2.50 each; the market value is now $5 each. The production department has proposed to use these by putting each one together with $6 worth of labour and other materials to produce a wrist watch that would be sold for $10. Should that proposal be implemented? Explain.

5. Smith, a college sophomore, generally spends his summers working on the university maintenance crew at a wage rate of $6.00 per hour for a 40 hour week. Overtime work is always available at an hourly rate of 1.5 times the regular wage rate. For the coming summer, he has been offered the pizza stand concession at the Student Union building, which would have to be open 10 hours per day, six days a week. He estimates that he can sell 100 pizzas a week at $6 per day. The production cost of each pizza is $2.00 and the rent on the stand is $1.50 per week. Should Smith take the pizza concession? Explain.

6. An executive’s employment contract calls for a salary of $ 400,000 per year, a bonus equal to 2 percent of profits in excess of $ 10,000,000, and an option to buy 5000 shares of common stock at a price of $50 per share. The market price of the stock is $70 per share, and the firm’s profits for the current year are $12,000,000. Assuming the executive exercises the stock option and then sells the stock, what is the total compensation for the year?

7. A manufacture of personal computers has an inventory of 10,000 back-up storage drives that sold for $ 100 per unit last year. The current market price of these drives is now $ 70 per unit. By adding one of these drives to their stock of personal computers, the price of each computer is increased by $ 80 per unit. Should the driver be added? What is the opportunity cost of these drivers? Explain?


unit-1 introduction to managerial economics.doc

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