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Introduction To Managerial Economics

What do Telus, Global, B.C. Hydro and Island

Farms have in common?

Just like thousands of other Canadian firms, they have used

the principles of managerial economics to improve their
profitability.
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Managerial economics is concerned with the ways in which

business executives and other policy makers should make
decisions.

Managerial Economics:

draws on economic analysis for such concepts as cost,

demand, profit and competition.

attempts to bridge the gap between economic theory and

the day-to-day decision making process of managers.

provides a set of tools and approaches for managerial

policymaking.
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Relationship Between Managerial Economics and Other Disciplines

How is managerial economics related to other disciplines?

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Managerial economics provides a link between

economic theory and the decision sciences in the
analysis of managerial decision making.
Traditional economic theory consists of:

(i) microeconomics: ( unlimited wants / limited resources)

(efficient resource allocation)

individual consumers
individual firms
individual industries

(ii) macroeconomics: (aggregates)

total output
income
employment
inflation
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Such theory contains a large amount of material that is

drawn upon for managerial decision making.

However, managerial economics is actually quite different

from microeconomics.

The role of microeconomics is employed relatively more so

than macroeconomics for managerial decision making.
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Microeconomics attempts to describe how the

economy operates.

Managerial economics attempts to establish how the

economy should operate.

That is, managerial economics attempts to establish and use

techniques to achieve specified goals.

Microeconomics is “descriptive”

Managerial economics “prescriptive”

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vThe decision sciences are also used in managerial

economics.

The decision sciences provide ways to analyze the impact of

alternative courses of action.

Optimization techniques, such at differential calculus and

mathematical programming, are used to determine the
optimal course of action for decision makers.

Using econometric techniques (i.e. applied statistics),

decision makers can develop models that estimate
relationships between relevant variables and that forecast
their values.
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vManagerial economics plays two fundamental roles in the

study of business administration:

(1) provides ‘tools’ that can be applied in areas of

marketing, finance and production.

(2) integration of marketing, finance and production in

order to view the “total picture” to fulfill the objectives
of the firm.

vFinally, keep in mind that managerial economics plays a

part in both business and non-business organizations.

Management of non-business operations still require

efficient allocation of resources.
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The process of decision making can be divided into five

basic steps:
Step 1: Establish the Objectives: Management should determine the firm’s objectives.
Example: Increase company’s profit by expanding into the global market.

Step 2: Define the Problem It is very important to determine exactly what the problem
is.
Example: Too much international competition. Regulations in foreign market
establishing potential safety restrictions.

Step 3: Identify Possible Solutions

Once the problem is defined, management should try to create possible solutions.
Example: Purchase an established firm in the market you are trying to enter that would
be in direct competition. (Merger)

Step 4: Select the Best Possible Solution

Taking your set of alternative possible solutions, you must evaluate each one and
determine which is best, conditional on the objectives of the firm.

Step 5: Implement the Decision

The solution must be implemented properly in order to be effective.
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The Theory of the Firm

In order to apply managerial economics to business

management we need a theory describing how firms
behave and what their objectives are.

Since firms vary enormously, any model will be a

simplification of reality.

But, it is possible to create a model that includes the

most important elements and neglects the irrelevant
factors in order to present a picture that illustrates the
manager’s problem.

The basic model originates from what we refer to as

the theory of the firm.
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The theory assumes that the firm tries to maximize its wealth
or value.

Value can be defined in many ways, but for now we will

define it as the present value of its expected future cash
flows or profit.

n
Πt n
TRt − TCt
P.V. Future Profits
∑t =1 ( 1 + i) t = ∑t =1 ( 1 + i) t
TC=total cost
TR=total revenue
t goes from 1 (next year) to n, the last year in the planning horizon
i= interest rate
π =expected profit in year t
t
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Although we assume that firms want to

maximize their value, this does not
mean that a firm has complete control
over its value and can set it at any level
it chooses. Firms are faced with many
constraints on what they can achieve.
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Factors that Constrain the Ability of a Firm to Increase

Its Value:

1) Amount of certain types of inputs may be limited

(especially in the short-run).

Example: Labour shortage Specialized equipment

2) Legal or contractual constraints

Example: paying taxes minimum wage laws forcing the firm

to pay higher wages

Because there are constraints on a firm’s actions, we employ

constrained optimization techniques, such as linear
programming to analyze a firm’s problems.
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Reasons For the Existence of Profit:

There are three central reasons why economic profit exists:
1) Innovation
2) Risk
3) Monopoly power
In a perfectly competitive market economic, profit will be
zero.
Everyone has perfect information and all technology is
shared. In the real world, this does not occur and new
innovations occur continuously. Profits are the reward for
innovation.
Risk also exists in the real world and profit is the reward for
risk taking. To motivate people to take the risks involved in
owning a firm, a profit must be paid to them.
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Finally, profits are made because markets are not perfectly

competitive. Under perfect competition, long run economic
profits tend towards zero.

But if the industry is a monopoly or an oligopoly, profits

may exist in the long run.

So, having described the nature of managerial

economics, we turn now to an overview of the
basic principles of calculus!