Part I: Nature and scope of Managerial Economics

Description
This section explores the use of economic theory in making sound management decision.
Like, in choosing what promotional strategies to be used: social media flat form, print ads,
radio or television, and others.
Learning Objective:
After completing the module, the students are expected to:
1. Establish better understanding of the different economic concepts;
2. Understand the role of the firm’s in the Economy;
3. Identify the different objectives of the Firm’s;
4. Pair some of economic theory and common problem areas in the firms’ operations.
Duration:
Start: October 12, 2020 (12:00nn) End: October 23, 2020 (12:00nn)
What is Economics?
One standard definition for economics is the study of the production, distribution, and
consumption of goods and services. A second definition is the study of choice related to the
allocation of scarce resources. The first definition indicates that economics includes any business,
nonprofit organization, or administrative unit. The second definition establishes that economics
is at the core of what managers of these organizations do. (http://www.opentextbooks.org.hk/)
What is Managerial Economics?
Managerial Economics is a subfield of economics that places special emphasis on the
choice aspect. The purpose of managerial economics is to provide economic terminology and
reasoning for the improvement of managerial decisions.
It applies economic theory and methods to understand different business situations and
assist in different business and administrative decision making. Managerial economics
encompasses economic models that prescribes rules for improving managerial decisions, through
the recognition of how economic forces affect organizations and influence the performance of
the firm. Through the proper understanding of economic forces, management can develop tools
for effective forward business planning and in addressing current business situations.
Managerial economics identifies ways to efficiently achieve goals. For example, suppose
an established brand slowly losing to the new entrant firms in the market, thus the management
seeks re- invent its marketing strategies. Managerial economics can be used to identify changes
Managerial Economics by Hirschey, Mark 2
in consumer taste and preferences, project demand given the presents of new competitors and
pricing strategies to help create more customer- relevant marketing strategies.
Managerial Economics in a Fast-Changing Business Environment
The present business world has become very dynamic, complex, uncertain and risky.
Therefore, taking appropriate, correct and timely decision has become a challenging and tedious
task. The existence/ survival and growth of business basically depends on such decisions.
Undoubtedly, Managerial Economics is a friend, philosopher and guide to the business leaders
and managers. Further, the growing complexity of decision-making process, the increasing use
of economic logic, concepts, theories and tools of economic analysis in the process of
decisionmaking and rapid increase in the demand for professionally trained managerial man
power
increased the importance of the study of managerial economics as a separate discipline of
managerial curriculum. (http://Economics/Managerial%20Economics/mp102.pdf)
“Managerial Economics is economics applied in decision-making. It is a special branch of
economics bridging the gap between the economic theory and managerial practice. Its stress is
on the use of the tools of economic analysis in clarifying problems in organizing and evaluating
information and in comparing alternative courses of action.” -W. W. Haynes
“Managerial Economics is the integration of economic theory with business practice for
the purpose of facilitating decision-making and forward planning by management.” - Spencer &
Siegelman
“The purpose of Managerial Economics is to show how economic analysis can be used in
formulating business policies.” -Joel Dean
Why Managerial Economics Is Relevant for Managers
In a civilized society, we rely on others in the society to produce and distribute nearly all
the goods and services we need. However, the sources of those goods and services are usually
not other individuals but organizations created for the explicit purpose of producing and
distributing goods and services. Nearly every organization in our society—whether it is a
business, non-profit entity, or governmental unit—can be viewed as providing a set of goods,
services, or both. The responsibility for overseeing and making decisions for these organizations
is the role of executives and managers.
Managerial Economics by Hirschey, Mark 3
Managerial Economics Is Applicable to Different Types of Organizations
Managerial economics is relevant to non-profit organizations and government agencies
as well as conventional, for-profit businesses. Although the underlying objective may change
based on the type of organization, all these organizational types exist for the purpose of creating
goods or services for persons or other organizations. Economics provides a framework for
analyzing regulation, both the effect on decision making by the regulated entities and the policy
decisions of the regulator.
The role of Managerial Economics to Managerial decision making
To establish appropriate decision rules, managers must understand the economic
environment in which they operate.
For example, a grocery retailer may offer consumers a highly price-sensitive product, such
as milk, at an extremely low mark- up over cost—say, 1%or 2%—while offering less
priceOrganization Management
Decision Areas
Issues
Problems
Strategies and more
Economic
Concepts
Microeconomic
Theories
Macroeconomic
Theories
Labor Economics
Quantitative
Methods
Statistical analysis
Forecasting
Methods
Optimization
analysis
Managerial Economics
Use of economic concepts and quantitative methods to solve management decision problems.
Optimal solutions to management decision problems sensitive products, such as non-prescription
drugs, at mark- ups of as high as 40% over cost. Managerial economics describes the logic of
this pricing practice with respect to the goal of profit maximization. Similarly, managerial
economics can reveal that auto import quotas reduce the availability of substitutes for
domestically produced cars, raise auto prices, and create the possibility of monopoly profits for
domestic manufacturers. It does not explain whether imposing quotas is good public policy; that
is a decision involving broader political considerations. Managerial economics only describes the
predictable economic consequences of such actions. Managerial economics is also a normative
science as it suggests the best course of an action after comparing pros and cons of various
alternatives available to a firm. It also helps in formulating business policies after considering all
positives and negatives, all good and bad and all favours and a disfavours. Besides
conceptual/theoretical study of business problems, practical useful solutions are also found. For
instance, if a firm wants to raise 10% price of its product, it will examine the consequences of it
before raising its price. The hike in price will be made only after ascertaining that 10% rise in
price will not have any adverse impact on the sale of the firm. Managerial economics offers a
comprehensive application of economic theory and methodology to managerial decision making.
It is as relevant to the management of nonbusiness, nonprofit organizations such as government
agencies, cooperatives, schools, hospitals, museums, and similar institutions, as it is to the
management of profit-oriented businesses.
What is a Firm?
A. Nature of the Firm
A firm is a collection of resources that is transformed into products demanded by consumers.
Firm exists to produce final goods and services needed by the society, and at the same
time creates employment for the household, while earning profits to the owners who had taken
the risk in putting up a business. Accordingly, Ronald Coase (1937), explain the economic
reasons
for the existent of the firm, “firms emerge because of transaction costs… Instead, individuals
provide their services to other individuals inside the firm according to the firm’s organizational
structure. This removes transaction costs that would otherwise been encountered in the free
market”.
A firm is an association of individuals who have organized themselves for the purpose of
turning inputs into output. The firm organizes the factors of production to produce goods and
services to fulfill the needs of the households. Each firm lays down its own objectives which is
fundamental to the existence of a firm.
The major objectives of the firm are:
 To achieve the Organizational Goal
 To maximize the Output
 To maximize the Sales
 To maximize the Profit of the Organization
 To maximize the Customer and Stakeholders Satisfaction
 To maximize Shareholder’s Return on Investment
 To maximize the Growth of the Organization
Goals of the Firm
A business enterprise is a combination of people, physical and financial assets, and
information (e.g., financial, technical, marketing). People directly involved include customers,
stockholders, management, labor, and suppliers. Society in general is affected by business
because the business community uses scarce resources, pays taxes, provides employment, and
produces much of society’s material and services output.
The model of business is called the theory of the firm. In its simplest version, the firm is
thought to have profit maximization as its primary goal. The firm’s owner manager is assumed to
be working to maximize the firm’s short-run profits. Today, the emphasis on profits has been
broadened to encompass uncertainty and the time value of money. In this more complete model,
the primary goal of the firm is long- term expected value maximization.
Expected value maximization Optimization of profits in light of uncertainty and the time
value of money
B. Measurement of Profit
Measurement of Profit, is the common and mostly used evaluation tool of the firms’
performance. It is generally the reward of the Capitalist for risk and uncertainty in relation to the
creation of business.
Profit refers to the earnings of the firm after deducting all related cost incurred in the
production and selling of the products, or in other way of stating is the residual of sales revenue
deducting the actual (explicit) cost of doing business. This definition of profit is commonly
referred to as business profit or accounting profit.
Total Sales/Revenue (x) = Number of sold/unit X Selling price of the Commodity
Total Cost (x) = Fixed Cost + Variable Cost
Profit (π) = Total Sales – Total Cost
In economic thought, profit is also defined as the excess revenue after cost. However, the
efforts and time spent of the entrepreneur in the business, the cost related to miss opportunities
of earnings outside the business, and other implicit cost were not part of the Accounting profit
computation. Thus, Economic Profit, try to calculate for the economic value of all related implicit
cost and be added to the total cost of doing business.
Total Economic Cost (x) = Explicit Cost + Implicit Cost
Economic Profit (π) = Total Sales – Total Economic Cost
For example:
Ye Wanwan and Su Quanci both from a Filipino Chinese family, decided to put up their own
Milk Tea Shop. From the business data they had gathered, the average cost of renting a 15square
meter space is Php 15,000.00, while the unit cost of each regular size of milk tea is Php 24.00,
and a total of Php 10,000.00 for the insurance, business associations and other monthly legal fees.
The business will have a sure sale of 10,000 cups in a month at a price of Php 45.00/cup.
Problem details:
Unit cost Php 24.00/cup Variable cost
Rental cost Php 15,000.00 Fixed cost
Other cost Php 10,000.00 Fixed Cost
Sure, Sold out 10,000cups of Milk Tea
Selling Price Php 45.00/ cup

Total cost (x) = Fixed Cost + Variable Cost

Fixed Cost = 15, 000.00 + 10, 000.00
= 25,000.00 Php 25, 000.00 is the monthly total fixed cost that
the owners need to pay, with or without ouput.
Variable Cost (1,000cups) = 10,000 x 24.00
 = 240,000.00 Php 240,000.00 is the monthly total
variable cost incurred with
10,000cups of milk tea.
Total cost (10,000) = 25, 000.00 + 240, 000.00
= 265, 000.00 Php 265, 000.00 is the monthly Total cost
incurred in producing and selling of 10, 000
cups of milk tea.
Total Sales/Revenue (x) = Number of sold/unit X Selling price of the Commodity
TS (10,000) = 10,000 x 45.00
= 450,000.00 Php450, 000.00 is monthly total sales in selling
10,000cups of Milk tea.
Profit (π) = Total Sales – Total Cost
= 450,000.00 – 265, 000.00
= 185, 000.00 Php 185, 000.00 is the monthly total expected profit from the Milk Tea
business venture by Ye Wanwan and Su Quanci, in a month.
If Ye Wanwan and Su Quanci, who are both a Licensed Architecture, will choose to work in an
Architectural firm, both will be given a Junior Architect position and earned Php 60,000.00each
per month.
Php 60, 000.00each opportunity cost (implicit cost)
Total Economic cost (x) = (Fixed Cost + Variable Cost) + implicit cost
Opportunity cost = 60,000 x 2
= 120, 000.00 Php 120, 000.00 is the monthly total
opportunity cost incurred by the owners if
they choose to open a Milk Tea Shop, than
be an employee of a company.
Fixed Cost = 15, 000.00 + 10, 000.00
= 25,000.00 Php 25, 000.00 is the monthly total fixed cost that
the owners need to pay, with or without ouput.
Variable Cost (1,000cups) = 10,000 x 24.00
= 240,000.00 Php 240,000.00 is the monthly total
variable cost incurred with
10,000cups of milk tea.
Managerial Economics by Hirschey, Mark 8
Total Economic cost (10,000) = 25, 000.00 + 240, 000.00 + 120, 000.00
= 385, 000.00 Php 385, 000.00 is the monthly Total cost
incurred in producing and selling of 10, 000
cups of milk tea.
Total Sales/Revenue (x) = Number of sold/unit X Selling price of the Commodity
TS (10,000) = 10,000 x 45.00
= 450,000.00 Php450, 000.00 is monthly total sales in selling
10,000cups of Milk tea.
Economic Profit (π) = Total Sales – Total Economic Cost
= 450,000.00 – 385, 000.00
= 65, 000.00 Php 65, 000.00 is the monthly total expected Economic profit from the
Milk Tea business venture by Ye Wanwan and Su Quanci, in a month.
Firms are established to maximize the value it can provide to all its shareholders and
Managerial Economics can make it happen. Managerial Economics consists of applying
economic principles and concepts towards adjusting with various uncertainties faced by a
business firm, and has a very important role to play by helping managements in successful
decision making and forward planning.
Part II: Demand Theory, Analysis and Estimation
Description
This section deals with understanding the concept of demand; Law of Demand; the impact
of non- price factors to the level of demand and supply to the market equilibrium; and to Estimate
the level of responsiveness of quantity as caused by changes in price, income, and price of other
goods.
Learning Objective:
After completing the module, the students are expected to:
1. Revisit the concept of demand and Law of Demand;
2. Identify and describe the different theories and models of consumers buying behavior.
3. Explain in detail, the impact of demand to different market situations.
Duration:
Start: October 26, 2020 (12:00nn) End: November 13, 2020 (12:00nn)
A. Basis for Demand (Theory, Determinants and Analysis)
Demand is one of the most important economic decision variables. The analysis of
demand for a firm’s product plays a crucial role in business decision- making. Demand
determines
the size and pattern of market. All business activities are mostly demand driven. For instance, the
inducement to investment and production is limited by the size of the market of products. The
firm’s production planning, sales and profit targeting, revenue maximization, pricing policies,
inventory management, advertisement and marketing strategy all are dependent on the demand
of its product.
Demand is a technical economic concept. It is a different and broader concept than the
‘desire’ and “want”. The following five elements are inclusive in it:
1. Desire to acquire a product-willingness to have it,
2. Ability to pay for it-purchasing power to buy it,
3. Willingness to spend on it,
4. Given/particular price, and
5. Given/particular time period.
Demand: is the quantity of a good or service that customers are willing and able to
purchase during a specified period under a given set of economic
conditions.
Law of Demand: The law of demand states an inverse relationship between the price of
a commodity and its quantity demanded, while other things remaining
constant (Ceteris Paribus)
Demand Curve: is the graphical representation of the demand schedule. According
Managerial Economics by Hirschey, Mark 2
0
20
40
60
80
0 20 40 60 80 100
Demand Curve for Milk tea
Price
Quantity Demanded
to Prof. Samuelson, “Picturization of demand schedule is called the
demand curve”
Demand Schedule: is a statistical or a tabular statement showing the different quantities of a
commodity which will be bought at its different prices during a specified
time period. It is a table which represents functional relationship
between price of a commodity and its quantity demanded.
Quantity demanded (Qd): is the total amount of a good that buyers would choose to
purchase under given price and different conditions.
The Demand schedule for Milk Tea
Price of the product (P) and the Quantity demanded (Qd)
4. interactions between Qd and PQ can be best described by the Law of Demand which
states that when the price of a good rises, and everything else remains the same, the
quantity of the good demanded will fall.
↑P → ↓Qd
5. the changes in Qd as a result of changes in Price, was shown as movement along the
demand curve.
“everything else remains the same” is known as the “ceteris paribus” or “other things equal”
assumption. In this context, it means that income, wealth, prices of other goods, population,
and preferences all remain fixed.
Assumptions of the law of demand: The law of demand is based but not limited on the
following, important ceteris paribus assumptions:
Price of
Milk Tea
(12oz) in
Peso
Quantity
Demanded
(Qd)
A. 30.00 70
B. 40.00 60
C 50.00 50
D. 60.00 40
E. 70.00 30
F. 80.00 20
Managerial Economics by Hirschey, Mark 3
• The money income of consumer should remain the same.
• There should be no change in the scale of preference (taste, habit & fashion) of
the consumer.
• There should be no change in the price of substitute goods.
• There should be no expectation of price changes of the commodity in near
future.
• The commodity under question should not be prestigious or of snob appeal.
Law of Demand and Managerial Decision making
For managerial decision making, a prime focus is on market demand. Market Demand is the
aggregate of individual, or personal demand. The demand of an individual for a product over a
period of time is called as an individual demand, whereas the sum total of demand for a product
by all individuals in a market is known as market/collective demand. This can be illustrated with
the help of the table below:
Demand Schedule for a Siopao
Price (piece) of
Siopao Anna Karen Ninna Market
Demand
5 6 9 10 25
10 4 8 7 19
15 3 7 4 14
20 2 6 1 9
25 1 5 0 6
The Law of Demand function as a way that describe how much of a commodity will be
purchased at the prevailing prices of that commodity and assuming other factors (related
commodities, alternative income levels, and alternative values of other variables affecting
demand) are constant.
Non- Price Determinants of Demand
Of course, in the real world other things are rarely equal. Lots of things tend to change
at once. But that is not a fault of the model; it is a virtue. The whole point is to try to discover
the effects of something without being confused or distracted by other things.
Changes in demand or shifts in demand occur when one of the determinants of demand
other than price changes (non- price factors).
Managerial Economics by Hirschey, Mark 4
Changes in Demand: Shift of the Demand curve (Right or Left)
In other words, shifts occur “when the ceteris are not paribus.” Some of these non- price
determinants of demand are the following, but not limited to :
(http://www.pondiuni.edu.in/sites/default/files/Managerial%20Economics.pdf)
1. Price of related goods: The price of related goods like substitutes and complementary
goods also affect the demand. In the case of substitutes, rise in price of one commodity
lead to increase in demand for its substitute. In the case of complementary goods, fall in
the price of one commodity lead to rise in demand for both the goods.
For example:
 The price of a substitute good drops. This implies a leftward shift.
 The price of a complement good drops. This implies a rightward shift.
2. Consumer’s Income: This is directly related to demand. A change in the income of the
consumer significantly influences his demand for most commodities. If the disposable
income increases, demand will be more.
For example: Incomes increase. This implies a rightward shift (for most goods)
3. Taste, preference, fashions and habits: These are very effective factors affecting demand
for a commodity. When there is a change in taste, habits or preferences of the consumer,
his demand will change. Fashions and customs in society determine many of our
demands.
Managerial Economics by Hirschey, Mark 5
For example: Preferences change. This could cause a shift in either direction, depending
on how preferences change. A favorable change: implies a rightward shift of the
demand curve.
4. Population: If the size of the population is more, demand for goods will be more. The
market demand for a commodity substantially changes when there is change in the total
population.
For example: Population change. This could cause a shift in either direction, depending
on how preferences change. A decrease in Population: implies a leftward shift of the
demand curve.
5. Weather Condition: Weather is also an important factor that determines the demand for
certain goods.
For example: Summer season. This implies a rightward shift of the demand curve for
swimwear products.
6. Advertisement and Salesmanship: If the advertisement is very attractive for a
commodity, demand will be more. Similarly, if the salesmanship and publicity is effective
then the demand for the commodity will be more.
For example: Positive/favorable effects of. This could cause a shift in either direction,
depending on how preferences change. A favorable change: implies a rightward shift of
the demand curve.
7. Consumer’s future price expectation: If the consumers expect that there will be a rise in
prices in future, he may buy more at the present price and so his demand increases.
For example: Price decrease of Gasoline by midnight. This could cause a decrease in
demand for gasoline before midnight: implies a leftward shift of the demand curve.
Managerial Economics by Hirschey, Mark 6
0
20
40
60
80
100
30 40 50 60 70 80
Qd1 Qd2 Qd3
Demand Curve for Milk Tea
Price
Quantity Demand
Sample Illustration:
Demand schedule with changes in income Shift in the Demand Curve
while Price is fixed
Price is not the only factor which determines the level of demand for a good. Other
important factor is income. The rise in income will lead to an increase in demand for a normal
commodity. A few goods are named as inferior goods for which the demand will fall, when
income rises.
Demand versus Quantity Demanded
Remember that quantity demanded is a specific amount associated with a specific price.
Demand, on the other hand, is a relationship between price and quantity demanded, involving
quantities demanded for a range of prices. “Change in quantity demanded” means a movement
along the demand curve. “Change in demand” refers to a shift of the demand curve, caused by
something other than a change in price.
Knowledge of the different factors that may affect the purchase decision of the customers’ may
provide better understanding to whom the firms’ product are more likely to have a positive
appeal; what may be lacking to existing strategies to capture the customer attention; what will
the current community situations may likely affect consumer purchase and a lot more about
consumer buying behavior
Price
of
Milk
Tea
Qd1
(no changes
in Income)
Qd2
(decreased
in salary)
Qd3
(increased
in salary)
30 70 50 90
40 60 40 80
50 50 30 70
60 40 20 60
70 30 10 50
80 20 5 40
Managerial Economics by Hirschey, Mark 7
B. Elasticity
- is the concept use to measure the magnitude of changes. The concept of elasticity is
useful for the managers for the following decision-making activities, but not limited to:
(http://www.pondiuni.edu.in/sites/default/files/Managerial%20Economics.pdf)
o In production i.e. in deciding the quantity of goods to be produced
o Price fixation i.e. in fixing the prices not only on the cost basis but also on the basis
of prices of related goods.
o In distribution i.e. to decide as to where, when, and how much and more
o In international trade i.e. what to export, where to export
o In foreign exchange
Assumption:
1. Percentage change or Arc is being measured not the actual change
2. All negative answers will be turn to absolute value of positive. The negative, denotes the
inverse relations of the variables.
Degree of Elasticity
1. Elastic – demand and supply elasticity is considered elastic when the percentage change
in the quantity demanded/supplied is greater than the percentage change in prices and
income. The elasticity coefficient is greater than one.
Characteristics of Elastic commodities
1. Luxury goods- in excess of the basic requirements
2. Goods with close substitute
3. Period of time: long- run
2. Inelastic – demand and supply elasticity is considered elastic when the percentage
change in the quantity demanded/supplied is less than the percentage change in prices
and income. The elasticity coefficient is less than one.
Characteristics of Inelastic commodities
1. Basic necessities
2. Goods with no close substitutes
3. Period of time: short- run
3. Unitary – demand and supply elasticity is considered elastic when the percentage
change in the quantity demanded/supplied is equal to the percentage change in prices
and income. The elasticity coefficient is equal to one.
Managerial Economics by Hirschey, Mark 8
Types of Elasticity
1. Price elasticity of Demand (Ped)- measured the percentage change in quantity
demanded divided by the percentage in price.
Qty 2 – Qty 1
(Qty1+Qty2) /2
Ped = %∆ in Qty. Demand =
%∆ in Price P 2 – P 1
(P1+P2) /2
For Example:
Su Quanci and Ye Wanwan can sell 25cups of milk tea at the price of Php30.00, while
40cups at the price of Php 20.00. Compute for the Price Elasticity of Demand for Milk Tea.
Given:
P1 = 30 Q1= 25
P2 = 20 Q2= 40
40 – 25 15
(25+40) /2 32.5 0.46154
Ped = %∆ in Qty. Demand = = = = -1.15 = 1.15
%∆ in Price 20 – 30 -10 -0.4
(30+20) /2 25
2. Income elasticity (Ied) - measured the responsiveness change in demand brought about
by the change in income.
Qty 2 – Qty 1
(Qty1+Qty2) /2
Ied = %∆ in Qty. Demand =
%∆ in Income I 2 – I 1
(I1+I2) /2
Step 1: Identify
the given values
Step 2: Substitute the
values to the formula
Step 3: Start solving
Elastic
Managerial Economics by Hirschey, Mark 9
For Example:
Sheldon is willing to purchase 25cups of milk tea if her income is Php200.00, while
40cups when her income is Php 30.00. Compute for the Income Elasticity of Demand for Milk
Tea.
Given:
I1 = 200 Q1= 25
I2 = 300 Q2= 40
40 – 25 15
(25+40) /2 32.5 0.46154
Ied = %∆ in Qty. Demand = = = = 1.15
%∆ in Income 300 – 200 100 0.4
(200+300) /2 250
3. Cross Price Elasticity (CPxy)- measured the responsiveness change in demand for good x
brought about by the change in price of good y or vice versa.
Qty X2 – Qty X1
(QtyX1+QtyX2) /2
CPxy = %∆ in Qty Good X =
%∆ in Price of Good Y PY2 – PY1
(PY1+PY2) /2
For Example:
25cups of milk tea could be sold when the price of fruit shake is at the price of
Php20.00, while when the price of fruit shake at the price of Php 30.00. Compute for the Cross
Price Elasticity of Demand for Milk Tea.
Given:
X: Mil teak PY1 = 20 QX1= 25
Y: Fruit shake PY2 = 30 Q2X= 40
Step 1: Identify
the given values
Step 2: Substitute the
values to the formula
Step 3: Start solving
Step 1: Identify
the given values
Managerial Economics by Hirschey, Mark 10
y – y1 = ( x – x1)
y – 50 = ( x – 40)
y – 50 = ( x – 40)
y – 50 = ( x – 40)
y – y1 = ( x – x1)
40 – 25 15
(25+40) /2 32.5 0.46154
CPxy = %∆ in Qty Good X = = = = 1.15 = 1.15
%∆ in Price of Good Y 30 – 20 10 -0.4
(20+30) /2 25
C. Demand Estimation
Demand estimation is a prediction focusing on future consumer behaviour. It predicts
demand for business’s goods and services by applying a set of variables that show, for example
promotional efforts, climate change, price changes and others. There several ways to conduct
Demand estimation, big firms are using sophisticated software to statistically conduct
forecasting: multiple regression and others, while some makes use of simple algebraic formula,
one of which is the Standard Equation of a line: Two- Point form:
y2 – y1
x2 – x1
For example
A dealer can sell 40 shavers per day at P 50.00, but he can sell 60 units if he charges P 40.00 per
item.
1. Determine the demand equation, assuming it is linear.
y2 – y1
x2 – x1
40-50
60-40
-10
20
-1
2
2 (y – 50) = -(x – 40)
Step 2: Substitute the
values to the formula
Step 3: Start solving
Elastic/Milk Tea
and Fruit shake are
substitute goods.
Managerial Economics by Hirschey, Mark 11
2y – 100 = -x + 40
2y + x -100 -40 = 0
x + 2y – 140 = 0, Demand equation
2. What is the highest price to be paid for this product?
0 + 2y – 140 = 0
2y – 140 = 0
2y = 140
y = 70; Php 70.00, the highest price to be paid for the shaver.
3. How many units would be demanded if the product were free?
x + 2y – 140 = 0
x + 2(0) – 140 = 0
x – 140 = 0
x = 140 units; 140 units, the quantity to be demanded if the shaver were
free.
4. How many shavers will be bought if the unit price is P 30.00?
x + 2y – 140 = 0
x + 2(30) – 140 = 0
x + 60 -140 = 0
x – 80 = 0
x = 80 units; 80 units, the quantity to be bought if the unit price is Php 30.00
5. How much will be paid for each shaver if 57 units are demand?
x + 2y – 140 = 0
57 + 2y – 140 = 0
2y – 83 = 0
y = Php 41.50; Php 41.50 is the u nit price when demand is 57 units.
Managerial Economics by Hirschey, Mark 12
Demand Forecasting
All organizations operate in an atmosphere of uncertainty but decisions must be made
today that affect the future of the organization. There are various ways of making forecasts that
rely on logical methods of manipulating the data that have been generated by historical events.
A forecast is a prediction or estimation of a future situation, under given conditions. Demand
forecast will help the manager to take the following decisions effectively.
Source: http://www.pondiuni.edu.in/sites/default/files/Managerial%20Economics.pdf
Three major Forecasting Technique
1. Qualitative Method: An intuitive judgmental approach to forecasting based on
opinion.
A. Expert Opinion Method: Under this method the researcher identifies the experts on
the commodity whose demand forecast is being attempted and probes with them on
the likely demand for the product in the forecast period. The word ‘Expert’ is a high
powered term but it should be taken to stand for those who possess the requisite
expertise on the subject.
Types:
a. Personal Insight- forecast method based on personal or organizational
experienced.
b. Panel Consensus- from informed opinion of several individuals.
c. Delphi Method- from the independent analysis of expert opinion.
B. Survey Method:- According to this method a few consumers are selected and their
views on the probable demand are collected. The sample is considered to be a true
representation of the entire population. The demand of the sample so ascertained is
Managerial Economics by Hirschey, Mark 13
then magnified to generate the total demand of all the consumers for that commodity
in the forecast period. The selection of an opinion sample size is crucial to this method,
while a small sample would be easily managed and less costly.
2. Trend Analysis: A firm which has been in existence for some time will have
accumulated considerable data on sales pertaining to different time periods. Such data
when arranged chronologically yield time series. Time series relating to sales represent
the past pattern of effective demand for a particular product.
3. Regression Method: Under this method relationship is established between Quantity
demanded and one or more independent variables such as income, price of the related
goods, price of the commodity under consideration, advertisement cost etc. In regression
a Quantitative relationship is established between demand which is a dependent variable
and the independent variable i.e., determinants of demand.
Let us suppose that we have two variables Y and X where Y is dependent on X. it
can be expressed in the form of an equation as follows:
Y=a+bx
We will examine a simple example of a model of consumer demand. Suppose a
business is selling broadband services in a community. The managers of the business have
identified four key determinants of demand: (a) the price they charge for the service, (b)
their advertising expenditure, (c) the price charged by the competition, and (d) the
disposable income of their potential customers. They define four variables to measure
these determinants:
P = the price per month of their service, in Peso, A = advertising expenditure per
month, in Peso, CP = the price per month of the competitor’s service, in Peso, DIPC = the
disposable income per capita, in dollars, as measured by the Philippines Department of
Trade for that month.
Using past data, they estimate the following equation to relate these variables to
number of broadband subscribers to their service during a month, symbolized by Q: Q =
25,800 − 800 P + 4 A + 200 CP + 0.4 DIPC. This relationship is called a demand function.
One application of the demand function is to estimate the consumption quantity
Q for specific values of P, CP, and DIPC.
Suppose P = Php30, A = Php 5000, CP = Php 25, and DIPC = Php 33,000:
Q = 25,800 − 800(30) + 4(5000) + 200(25) + 0.4(33,000) = 40,000 subscribers

Part III: Production and Cost Function

Description
This section deals with understanding of the production function and explores its
relations to cost function. Information of these is the basis for organizational short run and long
run procurement and production scheduling.
Learning Objective:
After completing the module, the students are expected to:
1. Identify and explain each components of production process.
2. Discuss the different types of cost related to production.
3. Determine the cost relationships with outputs.
4. Describe and illustrate the behavior of cost function in the short and long run period of
time.
Duration:
Start: November 16, 2020 (12:00nn) End: November 27, 2020 (12:00nn)
What is Production?
Production in economic terms is generally understood as the transformation of inputs into
outputs. The inputs are what the firm buys, namely productive resources, and outputs are what
it sells.
it refers to the transformation of resources to form goods and services
Production is also defined as producing goods which satisfy some human want. Production
is a sequence of technical processes requiring either directly or indirectly the mental and physical
skill of craftsman and consists of changing requiring either directly or indirectly the mental and
physical skill of craftsman and consists of changing the shape, size and properties of materials
and ultimately converting them into more useful articles. Production, therefore, is the combined
resources and equipment needed to come up with goods or services.
a. Factors of Production: include resource inputs used to produce goods and
services. Economist categorise input factors into four major categories such as land,
labour, capital and organization.
Managerial Economics by Hirschey, Mark 2
1. Land- naturally: occurring goods like water, air, soil, minerals, flora and fauna that
are used in the creation of products. The payment for use and the received income of a
land owner is rent.
2. Labor: human effort used in production which also includes technical and
marketing expertise. The payment for someone else's labor and all income received from
one own labor is wages. Labor can also be classified as the physical and mental
contribution of an employee to the production of the good(s).
3. Capital: human-made goods which are used in the production of other goods.
These include machinery, tools, and buildings.
4. Entrepreneur: responsible in combining the other three factors of production.
Factors of Production Payment
Final Goods 1. Land Rent
And 2. Labor Wages/ Salary
Services 3. Capital Interest Rate
4. Entrepreneur Profit
b. Production Function: indicates the maximum amount of commodity ‘X’ to be
produced from various combinations of input factors. It decides on the maximum output
to be produced from a given level of input, and how much minimum input can be used to
get the desired level of output. The production function assumes that the state of
technology is fixed. If there is a change in technology then there would be change in
production function.
Output = f (capital, labor)
Q = f ( K, L )
Two Classification of Inputs
1. Fixed Input: inputs, the quantity of which cannot be readily be changed when
market conditions indicate that a change in output is desirable.
e.g. land, CEOs
2. Variable Input: inputs, the quantity of which may be changed quite readily in
response to desired changes in output.
e.g. Raw materials, labor
Production Function according to Period of time
1. Short- run Production function: period of time in which the input of one or more
productive agents is fixed.
Managerial Economics by Hirschey, Mark 3
For example
if we change the variable input namely (labor) the production function shows how
much output changes when more labor is used. In the short run producers are faced with
the problem that some input factors are fixed. The firms can make the workers work for
longer hours and also can buy more raw materials. In that case, labor and raw material
are considered as variable input factors. But the number of machines and the size of the
building are fixed. Therefore, it has its own constraints in producing more goods. Initially
output per worker will increase up to an extent. This is known as the Law of Diminishing
Returns. To understand the law of diminishing returns it is essential to know the basic
concepts of production.
2. Long- run Production function: period of time in which all inputs are variable The
producer can appoint more workers, purchase more machines and use more raw
materials. Initially output per worker will increase up to an extent. This is known as the
Law of Diminishing Returns. To understand the law of diminishing returns it is essential
to know the basic concepts of production.
No. of
laborer’s
Total
Output/
Total
Product
Q
Marginal
Product
(MP)
Average
Product
(AP)
0 0 ---- ------
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 78 8 13
7 84 6 12
8 88 4 11
9 90 2 10
10 88 -2 8.8
Total production (TP): the maximum level of output that can be produced with a given
amount of input.
Average Production (AP): output produced per unit of input AP = Q/L
Marginal Production (MP): the change in total output produced by the last unit of an input
Marginal production of labor: Δ Q / Δ L (i.e. change in the quantity produced to a given
change in the labor)
Marginal production of capital: Δ Q / Δ K (i.e. change in the quantity produced to a given
Managerial Economics by Hirschey, Mark 4
change in the capital)
Characteristics of TP, MP, and AP
1. Both MP and AP will first increase than decrease with MP becoming negative.
2. When AP is rising/ falling, MP is greater/ less than the average.
3. MP reaches its peak, before the peak of AP is achieved.
4. At the peak of AP, AP is equal to MP.
The Law of Variable Proportions
If one input is variable and all other inputs are fixed the firm's production function exhibits
the law of variable proportions. If the number of units of a variable factor is increased, keeping
other factors constant, how output changes is the concern of this law.
Suppose land, plant and equipment are the fixed factors, and labor the variable factor.
When the number of laborers in increase successively to have larger output, the proportion
between fixed and variable factors is altered and the law of variable proportions sets in. The law
states that as the quantity of a variable input is increased by equal doses keeping the quantities
of other inputs constant, total product will increase, but after a point at a diminishing rate. This
principle can also be defined thus:
When more and more units of the variable factor are used, holding the quantities of
fixed factors constant, a point is reached beyond which the marginal product, then the average
and finally the total product will diminish.
The law of variable proportions (or the law of non-proportional returns) is also known as
the law of diminishing returns. But as we shall see below, the law of diminishing returns is only
one phase of the more comprehensive law of variable proportions.
Returns to Scale: In the long run the fixed inputs like machinery, building and other factors
will change along with the variable factors like labor, raw material etc. With the equal percentage
of increase in input factors various combinations of returns occur in an organization. The change
in percentage output resulting from a percentage change in all the factors of production. They
are increasing, constant and diminishing returns to scale.
Managerial Economics by Hirschey, Mark 5
3 types of Returns to scale
1. Increasing Return to Scale: if the output of a firm increases more than in
proportionate to an increase in all inputs
For example: the input factors are increased by 30% but the output has doubled to 60%
2. Decreasing Return to Scale: if the output of a firm increases more than in
proportionate to an increase in all inputs
For example: the input factors are increased by 30% but the output lead to just 20%
increased
3. Constant Return to Scale: when all inputs are increased by a certain percentage the
output increases by the same percentage.
For example: input factors are increased by 50% then the output has also increased by
50 percentages.
Types of Cost
Two major Categories of Cost
1. Explicit Cost (Total Cost)- refers to the actual cash outlay
-payment to the factors of production.
a. Fixed Cost- total Peso expense even without an output produced.
FC = fixed inputs x Price of fixed inputs
b. Variable Cost- expenditures that varies based on the output produce.
VC = variable inputs x Price of variable inputs
c. Marginal Cost- the additional cost incurred in additional unit of product
produced.
MC = ∆in Total Cost / ∆in Q
2. Implicit Cost- synonymous to opportunity cost
- the opportunity cost incurred when for an instance the owner of the factory
employs the factor in one use rather than its best alternative cost.
Q
Fixed
Cost
Variable
Cost
Total
Cost
Marginal
Cost
Average
Fixed
Cost
Average
Variable
Cost
Average
Total
Cost
0 55 0 55 --- ---- -----
1 55 30 85 30 55 30 85
2 55 55 110 25 27.50 27.50 55
3 55 75 130 20 18.33 25 43.33
4 55 105 160 30 13.75 26.25 40
5 55 155 210 50 11 31 42
6 55 225 280 70 9.17 37.5 46.67
7 55 315 370 90 7.86 45 52.86
8 55 425 480 110 6.88 53.13 60
Managerial Economics by Hirschey, Mark 6
Sample Computations:
Total Cost (TC) = FC + VC
TC = 55 + 0
= 55
Marginal Cost (MC) = TC2 – TC1 = 110 – 85 = 25 = 25
Q2 – Q1 2 – 1 1
Average Fixed Cost (AFC) = FC/Q = 55/3 = 18.33
*****AFC will continue to decrease as the firms produce more outputs.
Revenue, Cost and Profit Function
There is a relationship between the volume or quantity created and sold and the resulting
impact on revenue, cost, and profit. These relationships are called the revenue function, cost
function, and profit function.
In a case where a business sells one kind of product or service, revenue is the product of the
price per unit times the number of units sold. If we assume ice cream bars will be sold for
Php1.50
a piece, the equation for the revenue function will be:
TR = Php 1.5 Q, where R is the revenue and Q is the number of units sold.
The cost function for the ice cream bar venture has two components: the fixed cost
component of Php40, 000 that remains the same regardless of the volume of units and the
variable cost component of Php0.30 times the number of items. The equation for the cost
function is:
T C = Php40, 000 + Php0.3 Q, where TC is the total cost. Note we are measuring
economic cost, not accounting cost. Since profit is the difference between revenue and cost, the
profit functions will be
π = TR − TC = Php1.2Q − Php40, 000
Here π is used as the symbol for profit. (The letter P is reserved for use later as a symbol for
price.)
Managerial Economics by Hirschey, Mark 7
The average cost is another interesting measure to track. This is calculated by dividing the
total cost by the quantity. The relationship between average cost and quantity is the average cost
function. The equation for this function would be AC = C/Q
Breakeven Analysis
As the sales volume increases, revenue and cost increase and profit becomes progressively
less negative, turns positive, and then becomes increasingly positive. There is a zone of lower
volume levels where economic costs exceed revenues and a zone on the higher volume levels
where revenues exceed economic costs.
There are a number of ways to determine a precise value for the breakeven level
algebraically.
One is to solve for the value of Q that makes the economic profit function equal to zero:
0 = Php1.2 Q − Php40,000 or Q = Php40,000/Php1.2 = 33,334 units.
An equivalent approach is to find the value of Q where the revenue function and cost function
have identical values.
Fixed cost Fixed cost
Break-even Quantity (BEQ) = =
Contribution Margin Selling Price – Variable cost
Other types of Cost
There are various classifications of costs based on the nature and the purpose of calculation.
A. Sunk cost: Are retrospective (past) costs that have already been incurred and cannot
be recovered.
B. Historical cost: The price paid for a plant originally at the time of purchase.
C. Replacement cost: The price that would have to be paid currently for acquiring the
same plant.
D. Incremental cost: Is the addition to costs resulting from a change in the nature of
level of business activity. Change in cost caused by a given managerial decision.
E. Social cost: Total cost incurred by the society on account of production of a good or
service.
F. Transaction cost: The cost associated with the exchange of goods and services.
Managerial Economics by Hirschey, Mark 8
Diseconomies of scale, when
average cost begins to
increase as a result of
inefficiency and other factors.
Long run Cost Behavior:
A. Economies of scale: Decreasing long- run average cost of the company through the
expansion of production capacity. It is a long run concept and refers to reductions in unit
cost as the size of a facility and the usage levels of other inputs increase. The common
sources of economies of scale are purchasing (bulk buying of materials through long-term
contracts), managerial (increasing the specialization of managers), financial (obtaining
lower-interest charges when borrowing from banks and having access to a greater range
of financial instruments), marketing (spreading the cost of advertising over a greater
range of output in media markets), and technological (taking advantage of returns to scale
in the production function). Each of these factors reduces the long run average
costs(LRAC) of production by shifting the short-run average total cost (SRATC) curve down
and to the right. Economies of scale are also derived partially from learning by doing.
There are four main categories of internal economies of scale:
1. Technical economies: These arise mainly from increased specialization
and indivisibilities. Larger firms can make use of more specialized equipment and
labor in the production process, for example by using assembly lines. Virtually every
product that is produced for the mass market, from jeans to CDs, computer chips to
bottled soft drinks, is produced on some kind of assembly line. This has the advantage
of increasing both labor and capital productivity. Such processes need a large initial
investment, because they cannot perform the relevant functions on a small scale; thus
indivisibilities are involved.
2. Managerial economies: Large firms find it easier to attract and use more specialized
managers, who are more skilled and productive at performing specific managerial
functions. Thus a small firm may employ a general manager for all managerial
functions; a mid-sized firm may employ separate managers for the main managerial
Managerial Economics by Hirschey, Mark 9
functions of production, marketing, finance and human resources; a large firm may
employ various managers within the marketing department.
3. Marketing economies: These relate mainly to obtaining bulk discounts; by buying
in bulk larger firms can often enable their suppliers to obtain the technical economies
of scale above. These discounts relate not just to buying raw materials and
components but also to buying advertising. This type of economy of scale is obviously
of a monetary nature.
4. Financial economies: The most obvious factor here is that large firms can
often borrow at a lower interest rate, because they have a better credit rating,
representing a lower default premium. In addition, they have more sources of finance;
they can use the capital markets, for example by issuing commercial paper, bonds and
shares. These forms of raising finance often involve a lower cost of capital
B. Learning curve: average cost reduction overtime due to production experience. It
refers to improved production efficiencies stemming from the knowledge gained
through production experience.
Minimize turn- over keeping employees motivate to stay in their workplace,
rather than seek employment in outside.
C. Economies of Scope: cost reduction from producing complementary products. There are
two main causes of this:
1. The products may use common processing facilities; for example, different car
models being produced at the same plant.
2. There may be cost complementarity, especially when there are joint products
or by-products, for example petrochemicals.
Strategic implications of Cost Analysis
- Learning must be significant
- Cost effective strategies
- Produce products faster..cheaper..and better

Part IV: Economics of Organization

Description
This section deals with exploring the internal behavior of the firm in dealings with
organizational issues and expansion strategies.
Learning Objective:
After completing the module, the students are expected to:
1. To discuss the different considerations for business expansion
2. To identify the different classifications of business expansion.
3. To identify the dimensions of market structure characteristics.
4. To discuss the differences in each types of market structures.
Duration:
Start: December 07, 2020 (12:00nn) End: January 08, 2021 (12:00nn)
A. Factors to expand an Enterprise
Businesses usually sell multiple products or services, and they alter the collection of goods
and services provided over time. Several factors motivate changes in this composition and can
result in decisions either to expand an enterprise by increasing the range of goods and services
offered or to contract the enterprise by suspending production and sale of some goods and
services. In this section, we will list some key motivations for expanding the range of an
enterprise. Bear in mind that when these motivations are absent or reversed, the same
considerations can lead to decisions to contract the range of the enterprise.
Product lines of Samsung Corporation Robinsons Group of Companies
Tan Caktiong Gropu of Companies
1. Earlier, we discussed the concepts of economies of scale (cost per unit decreases as volume
increases) and economies of scope (costs per unit of different goods can be reduced by producing
multiple products using the same production resources). Businesses often expand to exploit
these economies.
2. Markets with few sellers that each provide a large fraction of the goods or services
available, the sellers possess an advantage over buyers in commanding higher prices. Businesses
Managerial Economics by Hirschey, Mark 2
will often either buy out competitors or increase production with the intent to drive competitors
out of the seller market in order to gain market power.
3. Many businesses sell products that are intermediate, rather than final, goods. Their
customers are other businesses that take the goods or services they purchase and combine or
enhance them to provide other goods and services. As a result, the profit that is earned in the
production of a final product will be distributed across several firms that contributed to the
creation of that good. However, the profit may not be evenly distributed across the contributing
firms or proportional to their costs. Sometimes a firm will recognize the higher profit potential of
the firms that supply them or the firms to which they are suppliers and will decide to participate
in those more lucrative production stages.
4. Due to the considerable uncertainties of future costs, revenues, and profits and the need
for firms to commit resources before these uncertainties are resolved, business is a risky
prospect. Just as investors can mitigate the inherent risk of owning stocks by purchasing shares
in different firms across somewhat unrelated industries, large firms can reduce some of their risk
by producing unrelated products or services. Additionally, there may be increased efficiencies in
movement of resources between different production operations when done by the same
company.
a. Classifying Business Expansion in terms of Value Chains
Many of the goods we consume as individuals are the result of a sequence of production
operations that may involve several firms. If the final goods are traced backward through the
intermediate goods that were acquired and utilized, we can usually envision the participant firms
in a creation process as a network of production activities or a sequence of production stages.
For example, consider a loaf of bread purchased at a grocery store. The grocery store may
purchase the loaf from a distributor of bakery products. The distributor likely purchased the loaf
Managerial Economics by Hirschey, Mark 3
from a baking company. In order to produce the loaf of bread, the bakery would need flour and
yeast, along with packaging material. These may be purchased from other businesses. The flour
came from a grain grinding process that may have been done by a different business. The
business that ground the grain would need grain that may have come from an agricultural
cooperative, which in turn was the recipient of the grain from a farmer. In order to grow and
harvest the grain, the farmer needs seed, tractors, and fuel, which are usually obtained from
other sources.
Each of the firms or production operations that contributes to the creation of the final
product can be considered as adding value to the resources they acquire in their completion of a
stage of the creation process. Since the network of operations that account for the creation of a
product can often be represented by a sequence of stages, the network is commonly called the
value chain for the product.
This value chain begins with the raw materials that eventually go into the product that must
be acquired, possibly by mining (e.g., metal) or harvesting (e.g., wood). Next, the raw material is
processed into a material that can be used to create parts in the next stage. Using these parts,
the next stage of the value chain is the assembly of the product. Once assembled, the product
must be distributed to the point of sale. In the final stage, a retailer sells the finished product to
the consumer. Business expansions are classified based on the relationship of the newly
integrated activity to prior activities engaged in by the firm. If the new activity is in the same
stage of that value chain or a similar value chain, the expansion is called horizontal integration. If
the new activity is in the same value chain but at a different stage, the expansion is called vertical
integration. If the new activity is part of a quite different value chain, the new combined entity
would be called a conglomerate merger.
b. Horizontal Integration
In horizontal integration, a firm either increases the volume of current production activities
or expands to similar kinds of production activities. Consider a television manufacturer that
operates at the assembly stage of its value chain. If that company bought out another
manufacturer of television sets, this would be horizontal integration. If the company were to
decide to assemble computer monitors, the product would be a form of horizontal integration
due to the high similarity in the two products and type of activity within those value chains. Cost
efficiencies in the form of economies of scale from higher volumes or economies of scope from
producing related products are primary driving factors in horizontal integration. When a firm
expands to a new product that is similar to its current products, usually there is a transfer of
knowledge and experience that allows the expanding firm to start with higher cost efficiency than
a firm that is entering this market with no related experience. If an enterprise possesses core
competencies in the form of production processes that it can perform as well or better than
Managerial Economics by Hirschey, Mark 4
others in the market, and can identify other products that can employ those core competencies,
the enterprise can enter new markets as a serious competitor.
Market power from holding a higher share of all sales in a market is the other major
motivation for horizontal integration. The possible gains from increased market power are often
so significant that the governments in charge of overseeing those markets may limit or forbid
horizontal mergers where one company buys out or combines with a competitor.
Source: Google.com
Since most firms are buyers as well as sellers, horizontal integration can create an advantage
for large firms in demanding lower prices for goods and services they purchase.
c. Vertical Integration
Vertical integration occurs when a firm expands into a different stage of a value chain in which
it already operates. For example, suppose the television manufacturing firm had been purchasing
the electronic circuit boards that it uses in its television set products but decides to either buy
the supplier or start a new operation to make those parts for itself. This would be vertical
integration.
Usually vertical integration will extend to a neighboring stage in the value chain. When a
business expands into an earlier stage in the value chain, the business is said to be doing
upstream integration. When the expansion is to a later stage of the value chain, the result is
downstream integration.
A major motivation for vertical integration is the potential for improved profitability. As
noted earlier, firms at some stages of the value chain may enjoy better market conditions in
terms of profitability and stability. If two stages of the value chain are performed by two divisions
Managerial Economics by Hirschey, Mark 5
of the same company rather than by two separate companies, there is less haggling over price
and other conditions of sale. In some cases, through a process that economists call double
marginalization, it is possible that a single vertically integrated firm can realize higher profit than
the total of two independent firms operating at different stages and making exchanges. An
independent partner may not conduct its business the way that the firm would prefer, and
possibly the only means to make sure other stages of the value chain operate as a firm would like
is for the firm to actually manage the operations in those stages.
Another possible motivation for vertical integration is risk reduction. If a firm is highly
dependent on the goods and services of a particular supplier or purchases by a particular buyer,
the firm may find itself in jeopardy if that supplier or buyer were to suddenly decide to switch to
other clients or cease operations.
Source: Google.com
For example, if the supplier of electronic circuit boards were to cancel future agreements to
sell parts to the television manufacturer and instead sell to a competitor that assembles
television sets, the television company may not be able to respond quickly to the loss of supply
and may decide it needs to either buy out the supplier or start its own electronic parts division.
From the circuit board supplier’s perspective, there is also risk to them if they invest in
production
capacity to meet the specific part designs for the television company and then the television
company decides to get the circuit boards elsewhere. By having both operations within the
boundaries of a single enterprise, there is little risk of unilateral action by one producer to the
detriment of the other producer.
d. Transaction Costs and Boundaries of the Firm
At first glance, it may seem that expanding a business is often a good idea and has little
downside risk if the larger enterprise is managed properly. In fact, during the last century
successful businesses often engaged in horizontal and vertical integration and even became
conglomerates due to such reasoning. However, as many of these large corporations learned, it
is possible to become too large, too complex, or too diversified. One consequence of a
Managerial Economics by Hirschey, Mark 6
corporation growing large and complex is that it needs a management structure that is large and
complex. There needs to be some specialization among managers, much as there is specialization
in its labor force. Each manager only understands a small piece of the corporation’s operations,
so there needs to be efficient communication between managers to be able to take advantage
of the opportunities of integration and conglomeration. This requires additional management to
manage the managers. Large firms usually have some form of layered or pyramid management
both to allow specialization of management and to facilitate communication. Still, as the number
of layers’ increases, the complexity of communication grows faster than the size of the
management staff.
Information overload results in the failure of key information to arrive to the right person at
the right time. In effect, at some point the firm can experience diseconomies of scale and
diseconomies of scope as the result of management complexity increasing faster than the rate of
growth in the overall enterprise.
Another problem with expansion, especially in the cases of vertical integration and
conglomerates, is that different kinds of businesses may do better with different styles of
management. The culture of a successful manufacturer of consumer goods is not necessarily the
culture of a startup software company. When many kinds of businesses are part of the same
corporation, it may be difficult to synchronize different business cultures.
Economists have developed a theory called transaction cost economics to try to explain when
a firm should expand and when it should not, or even when the firm would do better to either
break apart or sell off some of its business units. A transaction cost is the cost involved in making
an exchange. An exchange can be external or internal. An external exchange occurs when two
separate businesses are involved, like the television manufacturer and its parts supplier in the
earlier example. Prior to the actual exchange of parts for cash, there is a period in which the
companies need to come to agreement on price and other terms. The external transaction costs
are the costs to create and monitor this agreement.
If a firm decides to expand its boundaries to handle the exchange internally, there are new
internal transaction costs. These would be the costs to plan and coordinate these internal
exchanges. If exchanges of this nature have not been done before, these internal transaction
costs can be significant.
Nobel Prize laureate Ronald Coase introduced the concept of transaction costs and also
proposed a principle for determining when to expand known as the Coase hypothesis. Essentially,
the principle states that firms should continue to expand as long as internal transaction costs are
less than external transaction costs for the same kind of exchange.
Managerial Economics by Hirschey, Mark 7
e. Employee Motivation
The traditional approach to motivation inside a division or modest-sized business was
typically regarded as matters of organizational design and organizational behavior. Once the
employee agreed to employment in return for salary or wages and benefits, his services were
subject to direction by management within the scope of human resource policies in terms of
hours worked and work conditions. Ensuring good performance by employees was basically a
matter of appropriate supervision, encouragement, and feedback. In cases where employees
were not performing adequately, they would be notified of the problem, possibly disciplined, or
even dismissed and replaced. From this perspective, managing employees is much like managing
military troops, differing largely in terms of the degree of control on the individual’s free time
and movements.
The new perspective on employee motivation is to consider the employee more like an
individual contractor rather than an enlisted soldier. Just as microeconomics viewed each
consumer as an entity trying to maximize the utility for his household, an individual employee is
a decision-making unit who agrees to an employment relationship if he believes this is the best
utilization of his productive abilities. The challenge for business management is to structure
compensation, incentives, and personnel policies that induce employees to contribute near their
productive capacities but not over reward employees beyond what makes economic sense for
the business.
One contribution from this economic perspective is the notion of an efficiency wage. The
classical approach to setting wages is that the wage paid to an employee should be no more than
the marginal revenue product corresponding to her effort. However, if an employee is paid barely
what her efforts are worth to the firm at the margin and if there is a competitive market for the
employee’s services in other firms, the employee may not be motivated to work at maximum
capacity or avoid engaging in behaviors that are detrimental to the firm because she can earn as
much elsewhere if she is dismissed. An efficiency wage is a wage that is set somewhat above the
marginal revenue product of the employee to give the employee an incentive to be productive
and retain this job because the employee would sacrifice the difference between the efficiency
wage and marginal revenue product if she sought employment elsewhere. This incentive is
worthwhile to the firm because it avoids the transaction costs of finding and hiring a new
employee.
Another contribution of this economic viewpoint of employee motivation is an examination
of employee contracts to deal with what is called the principal-agent problem. In this context,
the hiring business is a principal that hires an employee (agent) to act on its behalf. The problem
occurs when the agent is motivated to take actions that are not necessarily what the employer
Managerial Economics by Hirschey, Mark 8
would want, but the employer is not able to monitor all the activities of the employee and has
insufficient information.
In the employment relationship the employer evaluates the employee on the basis of her
contribution to profit or other objective of the firm. However, the employee evaluates her
activities based on the amount of effort involved. To the degree that employees see their
compensation and incentives connected to the intensity of effort, the more likely the employee
will invest additional effort because there is reduced risk that her efforts will go unrewarded.
For example, if employee incentives are based on the overall performance of a team of
employees without any discrimination between individual employees, there is an incentive for
employees to shirk in performance of their jobs because they still benefit if others do the work
and they do not risk putting in an extra effort to see the reward diminished by sharing the
incentives with others who did not put in the same effort. The in formativeness principle suggests
that measures of performance that reflect individual employee effort be included in employee
contracts.

Market Structure
Market is a place where people can buy and sell commodities. It may be vegetables
market, fish market, financial markets or foreign exchange markets. In economic language
market is a study about the demand for and supply of a particular item and its consequent fixing
of prices, example bullion on market and foreign exchange market or a commodity market like
food grains market and more.
Market Structures- refers to the competitive environment
 It describes the four important industry characteristics in terms of:
A. Number and size of distribution of active buyers and sellers and potential new
entrants.
B. The degree to which products are similar or dissimilar.
a. Product Differentiation depends to the real or perceived differences in the
quality of goods and services.
b. Possible areas of differences: physical or the impact of promotions.
c. Price competitions tend to be more vigorous for homogenous products.
d. Availability of goods substitutes increase the degree of substitution, thus
increase the level of competition.
C. The amount and cost of information about price and quality.
D. Conditions of entry and exit in the industry.
Barriers to Entry- any factor or industry characteristics that creates ad
advantage for incumbents over the new arrivals.
e. Legal rights
1. Patents- exclusive right to the invention of product
2. Tariffs- taxes imposed on imported goods
3. Quotas- amount in terms of quantity of imported goods to enter the
country.
4. Franchise Monopoly- exclusive right to provides the service
f. Substantial Economies of Scale
1. Large Capital
2. Skilled labor Requirements
3. High technology
Barriers to Exit- any restrictions on the ability of incumbents to redeploy
assets from one industry or line of business to another.
Managerial Economics by Hirschey, Mark 2
Types of Market Structure: Competition
A. Perfect Competition- type of market competition which considered as desirable for
social welfare.
Characteristics:
i. Large number of buyers and sellers
ii. Product homogeneity
iii. Free entry and exit
iv. Perfect dissemination of information
v. No one holds the market power
vi. All are price taker
vii. Demand curve is perfectly elastic
In a perfect competition, firms maximize its profit at quantity level 5 at which the firm achieved
the profit of 7 for the second time.
C. Imperfect Competition- prevails in an industry whenever individual seller have some
measured of control over the Market Price.
i. Firms are large enough to affect the price
ii. Differentiated products
iii. Different numbers of sellers
Sources of Market Imperfections
1. When there are barriers to entry and exit, some of these barriers are:
- legal restrictions: patents, tariffs, quotas
- cost of capital investment
B. Q TR AR MR TC MC Profit
0 0 0 -- 3 -- -3
1666521
2 12 6 6 8 3 4
3 18 6 6 12 4 6
4 24 6 6 17 5 7
5 30 6 6 23 6 7
6 36 6 6 30 7 6
7 42 6 6 38 8 4
8 48 6 6 47 9 1
Managerial Economics by Hirschey, Mark 3
- high switching cost
- Sophisticated technology
- Professional labor force
2. When there are significant economies of large scale production
3. Imperfect information
Kinds of Imperfect competition
A. Monopoly- Greek word: Mono meaning one
Polist meaning seller
a. Some Monopoly are Regulated some are Deregulated.
b. Single seller with complete control over an industry.
c. No close substitute
d. In the long run, no monopoly is secured from the attack of competitors.
e. Monopoly firm are Price Maker
B. Oligopoly- Few but Big sellers
Characteristics:
a. Its important feature is that each individual firm cannot affect price if act alone; but
if the firms acts as one they can affect the level of price.
b. Individually: Price Taker
c. As group: Price Maker
d. Each firm can affect other firm; there is some degree of strategic intervention.
e. They will always charge price lower than that of a Monopoly firm but higher than
Perfect Competition market.
f. Conditions to entry may be block or free
Collusion – they occurs when two or more firms jointly set their Price of outputs,
divide the markets among themselves or make decision jointly.
Cartel- individual firms, act as unison
C. Monopolistic Competition- there are many sellers but produces differentiated products.
Firms in this industry has little market power to influence the level of market price.
Local retail and service markets often have these characteristics. Consider, for
example, the restaurant market within the area of Angeles City. The market is highly
fragmented—the local business office had listed numerous number of restaurants
Managerial Economics by Hirschey, Mark 4
offering different special cuisines from local to foreign tastes. Each variety of restaurants
are further fragmented depending on the level of services they offer. For example some
restaurants that specialize in steaks are segmented catering to lower middle income
earners to high income earners. Some of these Steak house restaurants offer the stone
cooking of wagyu beef at aan average of Php 2,000.00 per slab, this specifically targets
the high income earners, while some steak house offer unlimited steak to as low as 399
Pesos, that targets low middle to high middle income earners.
Market fragmentation and free entry and exit are also characteristics of perfectly
competitive markets. But unlike perfectly competitive firms, Evanston restaurants are
characterized by significant product differentiation. There are many different types of
restaurants (Chinese, Thai, Italian, vegetarian) that cater to the wide variety of buyer
tastes in Evanston. Some restaurants are formal, while others are casual. And each
restaurant is conveniently located for people who live or work close to it but might be
 inconvenient for people who have to drive several miles to get to it.

Market Segment 1. Division or fragment of the overall market.

Market Power 2. Ability to set prices and obtain above normal profits for
extended periods.
Potential Entrants 3. Person or firm posing a sufficiently credible threat of market
entry to affect market price- output decisions.
4. Oligopoly has Few but Bigger sellers.
Legal Restriction 5. Patent is an example of ___________________, barriers to
entry.
Monopolistic Competition 6. Monopolistic products are highly differentiated as a result of
__________________.
Monopoly 7. No ________________________ is safe from competition in
the long- run.
Collusion 8. It occurs when two or more firms jointly set their Price of
outputs, divide the markets among themselves or make
decision jointly.
Imperfect Competition 9. It prevails in an industry whenever individual seller have some
measured of control over the Market Price.
Perfect Competition 10. Type of market competition which considered as desirable for
social welfare.

Demand Curve 1. Graphical presentation of Price and Quantity Demand.

Desire to acquire a product 2. -6. Five properties of Demand
Ability to pay for it 3.
Willingness to spend on it 4.
Given/ Particular price5.
Given/ Particular Time 6.
Demand Schedule 7. _______________ is a tabular representation of the relationship
between price and quantity demanded.
Demand Curve 8. _____________ is a graphical representation of the relationship
between price and quantity demanded.
Rightward shift, Leftward Shift 9. Increase in population will ___________, the demand curve to the
____________.
Quantitative Method 10. An intuitive judgmental approach to forecasting based on opinion.
Price elastic of demand11. It measures the percentage change in quantity demanded divided by the
percentage in price.
Personal Insight12. Forecast method based on personal or organizational experienced.
Luxury goods 13. Goods that exhibit elastic demand curve.
Short-run 14. Inelastic demand for products are usually under _________ period of
time.
Cross Price Elasticity15. It measures the percentage change in quantity demanded for good x over
the changes in the price of other goods.

Total Cost 1. It refers to all actual cost incurred in the production of goods and
services.
Time Value of money 2. The goal of the firm refers to the maximization of the expected value of
the firm with risks, uncertainty and ______________.
Economic Cost 3. It refers to the value forgone for choosing the other best alternative.
Economic Profit …….. 4. Complete formula of Economic profit.
Resources 5. A firm is a collection of ___________ that is transformed into products
demanded by consumers.
Value 6. According to Ronald Coase, the “firms emerge to minimize the
transaction costs in the market, and to achieve higher ______________.
Normative Science 7. __________________ helps in formulating business policies after
considering all positives and negatives, all good and bad and all favors
and a disfavor.
Theory of the firm8. The model of business is called the _____________________.
Profit 9. ______________________ is the excess revenue after cost.
Managerial Economics 10. _____________________ is a subfield of economics that places special
emphasis on the choice aspect.