Managerial Economics (chapter 1)

Managerial Economics Instructor: Maharouf Oyolola

Chapter 1 The nature and Scope of managerial economics

OUTLINE OF THE LECTURE • • • •

Managerial economics -Microeconomics -Macroeconomics -Decision Science ( Mathematical economics and Econometrics) • Theory of the firm • Economic and Business Profits • Business Ethics

What is Managerial Economics? • It refers to the application of economic theory and the tools of analysis of decision science to examine how an organization can achieve its aims or objectives most efficiently • Managerial economics extracts from economic theory (particularly microeconomics) those concepts and techniques that enable the decision maker to allocate efficiently the resources of the organization

• The field of managerial economics has experienced rapid growth over the past three decades. • This growth reflects a realization that managers can use economic theory to make decisions consistent with the goals of the organization.

• Managerial problems arise in any organization that seeks to achieve some goals or objectives subject to some constraints

How can Managerial Economics be used by managers? • Managerial economics can be used by a goal-oriented manager in two ways: • (1) Given an existing economic environment, the principles of managerial economics provide a framework for evaluating whether resources are being allocated efficiently within a firm. • (2) These principles help managers respond to various economic signals.

Example 1 • A hospital may seek to treat as many patients as possible at an “adequate” medical standard with its limited physical resources (physicians, technicians, nurses, equipment, beds) and budget. • What is the problem of the manager in this example?

• (1) objective of the hospital • Treat as many patients as possible at an adequate medical standard • (2) Constraints • -Limited physical resources • -Budget

Example 2 • What is the goal of a state university? • (1) Objective • Provide an adequate education to as many students as possible • (2) Constraints • - budget constraint • -physical constraint

Relationship to Economics • Economic theory refers to Microeconomics and Macroeconomics.

What is economics? • Economics is the study of how society allocates scarce resources and goods • Resources are the inputs that society uses to produce goods. • Inputs: land, labor and capital (physical and financial) • Goods include products such as food, clothing and housing as well as services such as those provided by doctors, police officers and barbers

• Society needs are unlimited but resources are scarce or limited • The term market refers to an arrangement that allows people to trade with one another

Microeconomics • It is concerned with the study of the market system on a small scale. • Microeconomics looks at the individual markets that make up the market system and is concerned with the choices made by small economic units such as individual consumers, individual firms, or individual government agencies.

Examples • .The study of the computer industry • The study of the consumer buying behavior

Macroeconomics • It is concerned with the study of the market system on a large scale • Macroeconomics considers the aggregate performance of all markets in the market system and is concerned with the choices made by the large subsectors of economy- the household sector, which includes all consumers; the business sector, which includes all firms; and the government sector, which includes all government agencies.

Why do we study Macroeconomics in Managerial Economics? • The state of the economy has an impact on each economic agent. • For instance, a recession or an expansion will have an impact on the buying behavior of firms. Therefore, it will affect the demand and supply of firms operating in different industries.

Examples • • • •

Total level of employment in a country Total consumption in the economy Gross Domestic Product Total level of investment

• Although the (microeconomic) theory of the firm is the single most important element in managerial economics, the general macroeconomic conditions of the economy (such as the level of aggregate demand, rate of inflation, and interest rate) within which the firm operates are also very important. • For instance, if the economy is going through a recession, it is going to affect the buying behavior of consumers. Therefore, many firms operating within the country will suffer

• Managerial economics should be thought of as applied microeconomics. That is, managerial economics is an application of the part of microeconomics focusing on those topics of great interest to managers. These topics include demand, production, cost, pricing, market structure, and government regulation.

II. Relationship to Decision Science( Mathematical economics and Econometrics

Economic Theory ( Micro and Macro)

• Managerial econ. Decision Science ( Mathematical Economics and Econometrics)

• Managerial Economics uses the tools of Mathematical Economics and Econometrics to construct and estimate decision models aimed at determining the Optimal behavior of the firm.

Mathematical Economics • Is used to formalize (i.e. to express in equational form) the economic models postulated by economic theory.

Econometrics • A collection of statistical techniques available for testing economic theories by empirically measuring relationships among economic variables

Example • Economic theory postulates that the quantity demanded (Q) of a commodity is a function of or depends on the price of the commodity (P), the income of consumers (Y), and the price of related (i.e. complementary and substitute) commodities (Pc and Ps, respectively). Assuming constant tastes • Q=F(P, Y, Pc, Ps)

• Collecting data on Q, P, Y, Pc and Ps for a particular commodity, we can then estimate the empirical (econometric) relationship.

• The estimation of a demand function using econometric techniques involves the following steps: • -Identification of the variables • -Collection of the data • -Formulation of the demand model • -Estimation of the parameters of the model • -Development of forecasts (estimates) based on the model.

Relationship to The functional areas of business administration studies( Finance, Accounting, Marketing, Management…) • Managerial Economics can be regarded as an overview course that integrates economic theory, decision sciences, and the functional areas of Business Administration studies • It also examines how they interact with one another as the firm attempts to achieve its goals most effectively.

• Managerial Economics is the use of economic theory and management science tools to examine how a firm can achieve its objective most efficiently within the Business environment in which it operates

The Decision-making process in managerial economics follows 5 steps • (1) Establish the objective of the firm or organization • (2) Define the problem or obstacles that the firm or organization faces in trying to achieve its objective. • (3) Identify the range of possible solutions • (4) Select the best solution available • (5) Implement that decision

Theory of the firm • A Firm is an organization that combines and organizes resources for the purpose of producing goods and/or services for sale.

There are millions of firms in the United States • These include: • Proprietorships: firms owned by one individual • Partnership: firms owned two or more individuals • Corporations: owned by stockholders

The Objective and Value of the Firm • The Theory of the firm postulates that the primary goal of the firm is to maximize the wealth or value of the firm. • Firms maximize current or short-term profits. They, however, are often observed to sacrifice short-term profits for the sake of increasing future or long-term profits.

Present value analysis • Many transactions involve making or receiving cash payments at various future dates. • In all of these cases, concepts relating to the time value of money are required to make sound decisions.

Present value analysis • Understanding the following terms is essential for applying time value of money principles: • Annuity: a series of payments per period for a specified length of time. For example, the repayment of a loan by making forty-eight monthly payments of $200 each is a form of annuity. • Amount: a specified number of dollars to be paid or received on a specified date. • Present value: the value today of an amount or an annuity, taking into consideration that interest can be earned.

Present value of an amount • The basic equation for the present value of an amount S is

 1  PV =S  n  (1 +i )  The bracketed term is the present value of $1 in n periods if the interest rate is i percent

Example of the present value of an amount • What is the present value of $100,000 to be received at the end of ten years if the interest rate is 10 percent?

 1  PV = 100000  10   (1.10)  PV= $38,550

Present value of an annuity • An annuity is defined as a series of periodic equal payments. • Examples of annuity: retirement pension, the repayment schedule of a mortgage loan. • An annuity that is paid forever is called a perpetuity.

Value of the Firm • It is given by the Present value of all expected future profits of the firm. • Future profits must be discounted to the present because a dollar of profit in the future is worth less than a dollar of profit today. π π + +.... + • Maximize: PV(π)= 1π +r (1 +r ) (1 +r ) 1

2

n

2

n

Value of the Firm • The present value of all future profits also can interpreted as the value of the firm. That is, it is what a willing buyer would pay for the business.

Constraints on the operation of the firm • Profit maximization is constrained by the limited information available to the manager. • In general, constraints on managerial decisions involve legal, moral, contractual, financial and technological considerations.

Legal constraints • Legal constraints include the array of federal, state, and local laws that must be obeyed by all citizens, both individual and corporate. • Areas where managers seem to be having some legal difficulty include environmental laws, especially those relating to pollution and the disposal of hazardous wastes, and employment laws, including wrongful termination and sexual harassment matters.

Constraints on the operation of the firm • Objective of the Firm: maximize profit • However, it might face many constraints: • - limitations of availability of essential inputs: for instance, the firm might not be able to hire as many skilled workers as it wants, especially in the short-run. • -The firm might not be able to acquire all the raw materials it demands. Example: oil • (More on Next page)

• - Size of the factory and warehouse space • -The quantity of capital funds available for a given project. • Compliance with government regulations • Example: The minimum wage law • health and safety standards

• The existence of these constraints restricts the range of possibilities or freedom of actions of the firm and limits the value of the firm to a level that is lower than in the absence of such constraints (unconstrained optimization).

Limitations of the theory of the firm • The theory of the firm has been criticized for being too unrealistic. Thus, broader theories have been proposed: • (1) The theory of the sales maximization: Which is the most prominent among these new theories was introduced by William Baumol. According to the theory, managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy stockholders

• (2) The theory of management utility maximization was introduced by Oliver Williamson. • The separation of management from ownership in many modern corporations leads to the issue of moral hazard ( when one party detains more information than the other). For instance, the manager of a corporation who deals with the daily operations of the enterprise has more information than the owner. Therefore, the issue of moral hazard arises.

• The theory assumes that managers are more interested in maximizing their utility or satisfaction, measured in terms of their compensation (salaries, fringe benefits, stock options…) or incentives, the size of their staff, extent of control over corporation, lavish offices…, than in maximizing corporate profits. This is referred to as the principal-agent problem.

Principal-agent problem • The agent (manager) may be more interested in maximizing his/her benefits than maximizing the principal’s (the owner’s) interest. • The issue of principal-agent is resolved by tying the manager’s reward to the firm’s performance.

The nature and Function of Profits • Business profits versus Economic profits • Business Profit= Total revenue – explicit cost or accounting cost • Explicit cost: are the actual out-of-pocket expenditures of the firm to purchase or hire the inputs it requires in production.

Example of Explicit costs • • • • •

Wages to hire labor Interest on borrowed capital Rent on land and buildings Expenditures on borrowed capital Expenditures on raw materials

• Economic profit= total revenue- explicit cost-implicit cost • Implicit costs refers to the value of the inputs owned and used by the firm in its own production processes

Implicit costs • Implicit costs are not included in the accounting statements but must be included in any rational decision-making framework.

Example of implicit cost • Salary that the entrepreneur could earn from working for someone else in a similar capacity. • While the concept of business profit may be useful for accounting and tax purposes, it is the concept of economic profit that must be used in order to reach correct investment decisions.

Example • Suppose that a firm reports a business profit of $30,000 during a year, but the entrepreneur could have earned $35,000 by managing another firm and $10,000 by lending out his capital to another firm facing similar. • Business profit = $30,000 • Economic profit= Business profit-implicit cost • Economic profit= $30,000-45,000 • =-$15,000

Example 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 a year as prepared by an accountant is as shown:

The accounting income statement Sales

$90,000

Less: Cost of goods sold

-40,000

Gross profit

Less: Advertising Depreciation

$50,000

($10,000) 10,000

Utilities

3,000

Property tax

2,000

Miscellaneous expenses

5,000

Net accounting profit

30,000

$20,000

Example 2 • There are two major implicit costs in this problem: • First, the owner has $200,000 invested in the business. Suppose the best alternative use for this money is a bank account paying a 5% interest rate. Therefore, this investment would return $10,000 annually. • Second, the implicit cost includes the manager’s time and talent. The annual wage return on an MBA degree from a reasonably good business school may be $40,000 per year. • Economic profit= accounting profit - 40,000 -10,000 • = $-30,000

Accounting income statement with economic profit • See file in Microsoft Excel

BUSINESS ETHNIC • Business ethics seeks to proscribe behavior that businesses, firm managers, and managers, and workers should not engage in. • It is clear and uncontroversial that firms and their workers should not engage in unlawful acts, such as selling harmful and defective products, and ignorance of the law cannot be used as a justification for unlawful actions.

Problems (chapter 1) • • • • •

In-class problems: Problem #3 page 28 Problem #5 page 29 Problem #8 page 29 Written assignment Problem #15 page 30