Chapter 1 Managerial Economics

Chapter 1 Managerial Economics Managerial economics uses economic theory, tools, techniques and methods to solve managerial and administrative problems. Figure 1.1 shows the perspective and descriptive component of managerial economics. It helps manager improve their decision making process to achieve organizational objective efficiently. Managerial economics also helps manager recognize the possible economic outcome of their managerial behavior. Management Decision Problem * Product Price and Output * Make or Buy * Production Technique * Inventory Level * Advertising Media and Intensity * Labor Hiring and Training * Investment and Financing

Economic Concepts

Decision Sciences

Framework and Decision

Tools and Techniques of Analysis

* Theory of Consumer Behavior

* Numerical Analysis

* Theory of the Firm

* Statistical Estimation

* Theory of Market Structure and Pricing

* Forecasting * Game Theory * Optimization

Managerial Economics * Use of Economic Concepts and Decision Science Methodology to Solve Managerial Decision Problem

Optimal Solution to Managerial Decision Problems

Figure 1.1 The Role of Managerial Economics in Managerial Decision Making Managerial economics can provide decision makers to set operating rules that can help in efficient use of scare resources of the organization. The economic environment is a factor that affects business organization. Managers should be able to describe the economic factors that affects their decisions. Managerial economics can describe and predict economic consequence and of such decisions. Theory of the Firm Firms uses the factors of production from the household to produce and distribute goods and services. The firm’s primary goal is to maximize profit. It is presumed that the owners of a firm wanted to maximize profit. Today profit encompass uncertainty and the time value of money. The complete model of the firm, the primary goal is long term expected value maximization. The value of the firm is the present value of the firm’s expected future cash flows. This can be expressed as: Value of the firm = _π1 _ (1 + i)1

N

+ __π2 __ (1 + i)2

+ ......... + __πN__ (1 + i)N

= Σ

t=1

__π__ (1 + i)t

Where, π1, π2........... πN represent expected profit each year, t, and I is the appropriate interest or discount rate. Since Profit is total revenue less total cost the formula above can be written as: Value =

N

Σ

TRt - TCt (1 + i)t

t=1

Constraints of the firm Managers are face with numerous constraints which are imposed by technology, scare resources, obligations and government laws and regulations. In every decisions manager usually have to consider the short run and long run impacts of such decisions. These constraints play an important role in managers decision. Theory of the firm There are some of those who questions the value maximization criterion used in studying firms behavior. Do manager really seek the best result or merely satisfy. It is hard to determine if managers seek to maximize firm value or do they just try to satify the stockowners. It is difficult to answer these questions. There are some alternative theory of the firms that which says that managers are concerned with their own personal utility. There are also models that states: the firms are collection of different individuals with different goals and not a single entity. However, none can replace the maximization model of the firm. The theory of the firm states that managers try to maximize the value of the firm which is subject to constraint of limited resources, technology, and society. This theory only recognize that every action of the manager is for the benefit of the stockholders. This model seems to ignore the possibility of voluntary social responsibility on the part of business. Study shows that due to competition in the market for goods, managers seek value maximization in their managerial decisions. Managers who pursue goals contrary to the desire of stockholders to maximize the value of their business, is at risk of being replaced. Further research also shows that there is a very high correlation between firms profit and managerial compensation, therefore managers have an economic incentive to pursue value maximization. Before making their decisions manager must first analyze their cost benefit analysis. Profit maximization is the central theory of this firm. Profit Profit is the key in free enterprise system. This system will fail to operate if there are no profits. Profit is an incentive that entice managers and firms to improve cost and operation efficiency. Accounting profit or business profit is the revenue less the explicit cost of doing business. However, on the economist point of view, economic profit is the total revenue less the implicit cost and explicit cost of doing business. There are number of theories why profit exist. Frictional profit theory. This states that due to some unexpected changes in demand and cost creates disequilibrium in the market. This events can lead to positive or negative profit. Monopoly theory of the economic profit. This theory states that there are some firms who are protected from competition because of high barrier to entry. Economies of scale, high capital requirements, patents, or import protection allows firms to build above normal profit. Innovation theory of economic profit. This states that profit arise from innovation undertaken by firms. Compensation theory of profit. This states describe the above-normal rates of return that reward firms due to meeting customer needs, maintaining efficient operations.