MANAGERIAL

ECONOMICS
PREPARED BY:
PROFESSOR: DR. SAID A.OSSMAN
INTRODUCTION:

 Managerial economics is the study of how to

direct scarce resources with the most efficient
way to achieve the managerial goal.
 This course is designed to managers of the
firms in public and private sectors.
 Before embarking this course and special use
of managerial economics, the overview of the
basic principles of (comprise) effective
management is essential.
Economics in general and managerial economics
particular is "the science of making decisions in
the presence of scarce resources'? The scarcity
of resources puts a constraint on the
manager's decisions.
 ECONOMICS
Why should we study economics in
general and managerial economics particular?
 Will it tell us what stock market will do tomorrow?

 Will it tell us where to invest our money?

 Will it tell us how to get rich?

Unfortunately managerial economics itself is

unlikely to provide definitive answers to such
questions, but managerial economics is a valuable
tool for analyzing business situations.
 MANAGER
Manager is a person who directs resources to
achieve a stated goal and has responsibility for
(his or her) actions as will as for the actions of
individuals, machines and other inputs under the
manager's control. The main task of the manager
is maximizing the profits.
Note: Billion of dollars are lost each year
because some existing managers fail to use
basic tools of managerial economics to shape
pricing and output decisions, optimize the
production process and input mix, and guide
horizontal and vertical merger
decisions…etc.
 ECONOMICS OF EFFECTIVE
MANAGEMENT:
1. Identify goals and constraints.
2. Recognize the nature and importance of profits.
3. Five forces model.
4. Understand incentives.
5. Understand markets.
6. Recognize time value of money
7. Use marginal Analysis.
 IDENTIFY GOALS & CONSTRAINTS

* Sound decision making

involves having well
defined goals.

* Identify goals leads to

making the “right”
decisions.
The first step in making sound decisions is
to have well defined goals. In all cases the
decision maker will face a lot of
constraints related to budget, related to
time, related to human resources, related
to technology….etc, that affect the ability
to achieve manager goals and the priority
of these goals.
EXAMPLES:
The 24 hours day affects on your ability to earn
A in this course, budget constraint affects on
the abilities of food bank to distribute food to
the needy in rural areas or inner cities areas or
both.
Economic decision involves the allocation of
scarce resources with
efficient way

and the manager task is to allocate scarce

resources to achieve firm's goal in general and
maximizing profit in particular.
Time to achieve your goals, considers the
scarcest resources of all.
Resources are simply any thing used to
produce goals and services.
 ECONOMIC DECISIONS
Economic decision is affected by many
factors:
1- Goals
2- Constraints
3- Incentives
4- Market rivalry
 GOALS
1- Maximize profit.
2- Increasing market share.
3- Minimize cost of operation.
4- Minimize risk of market, risk of
operation …etc
In general different units of
firm have different
objectives.
 CONSTRAINTS
There are a lot of constraints such as:
1- Financial constraints
2- Time constraints
3- Technology constraints.
4- Price of products and its quality.
5- Price of inputs and its quality.
6- Government constraints ….etc.
Achieving firm's goal under these
constraints requires from the manager to
decide:
1- what the optimal price to charge?
2- How much to produce?
3- How to react to decisions that made by
competitors?
4- Which technology to use? And so on.
Recognize the nurture and importance
of profits
Q: What are the natural and importance of
profits in the free market economy?
NATURAL PROFIT:

The mangers should distinguish between to

concepts of the profits:
Accounting profit Economic profit
is the difference between the is the difference
total revenue (sales value) and between the total
the total cost that is required revenue (sales value)
for producing goods and and the total
services. This type of profits opportunity cost of
shows up of the firm's income producing goods and
statement. services.

= TR - TC = TR – OPP.C
Eco. Profit = TR – OPP.C
= TR - (Acc. cost + implicit cost)
= TR – (explicit cost + implicit cost)

Opportunity cost include both explicit costs of

resources (accounting cost) and the implicit of
giving up the best alternative use of resources.
NOTE:
 Opportunity cost of producing goods and
services generally is higher than accounting
costs; it includes both explicit and implicit
costs.

 Implicit costs are very hard to measure, but

the effective managers seek for data and
information to identify and quantify these
costs.
EXAMPLES:

 What does it cost you to read managerial

economics book?
Explicit cost = the price of the book
Implicit cost = highest sacrificed benefits to read
book
Read book alternatives:
 watching TV

 Read some other books

 work additional time

Each alternative has a value to
you; the highest value of these
alternatives is opportunity cost
of reading managerial
economics book.
What is the opportunity cost to join
EMBA program?
Cost of tuition, cost of books….etc
Give some examples in business
field and determine the
accounting cost items and the
opportunity cost?
 PROFIT SIGNAL
Profits give the owner of resources signals
or indicators that the resources are most
highly valued by society.
Profit signal refers to resource holders
that their resources highly valued by
society. This signal
Of profits reallocates
economic resources
towards industries or
activities with highly valued of
resources by society.
Profit signal leads to making the “right”
decisions.
 THE FIVE FORCES FRAMEWORK
•Entry Costs Entry •Network Effects
•Speed of Adjustment •Reputation
•Sunk Costs •Switching Costs
•Economies of Scale •Government Restraints

Power of Power of
Input Suppliers Buyers
•Supplier Concentration •Buyer Concentration
•Price/Productivity of Sustaina •Price/Value of Substitute
Alternative Inputs ble Products or Services
•Relationship-Specific •Relationship-Specific
Investments
Industry Investments
•Supplier Switching Costs Profits •Customer Switching Costs
•Government Restraints •Government Restraints

Industry Rivalry Substitutes & Complements

•Concentration •Switching Costs
•Price/Value of Surrogate •Network Effects
•Price, Quantity, Quality, or •Timing of Decisions
Products or Services •Government
Service Competition •Information
•Price/Value of Complementary Restraints
•Degree of Differentiation •Government Restraints
Products or Services
Recognize the time value of money
The Manager Should Understand The
Present Value Analysis. It Is Important To
Recognize That 1$ Today Is Worth More
Than 1$ Received In The Future. The
Opportunity Cost Of Invested Money
Reflects The Time Value Of Money, For
This Reason The Present Value Analysis Is
Essential For Effective Managers.
PRESENT VALUE ANALYSIS (PV):

The present value of an amount received in

the future is the value of this amount
today with take in consideration the
opportunity cost (compound interest).
GENERAL FORMULA OF THE PRESENT
VALUE:
The present value (PV) of the future values ( FV)
received in n years is:
PV = FV * 1 = FV * PWFn,i
‫ــــــــــــــــــــــ‬

(1 + n)n

Where i is the interest rate and PWF the present

worth factor in the year n.
PV = FV1 * PWF1 + FV2 * PWF2 +…… FVn * PWFn
Where, FV1 = The future value in the first year.
FV2 = The future value in the second year.
FV3= The future value in the n year.
Pwf1, pwf2, ………. Pwfn refers to discount factor in
different years, 1,…..,n.

The value of the discount factor depends on the

value of the interest rate and the number of years.
This value will change from year to year and
decrease with time,
Pwf1 < pwf2, < .......... <Pwfn
We can distinguish between:

1- If the stream of the future value is a regular and

fixed during the years, the general formula will
be:
PV = uspwf * fv
Where Uspwf refers to uniform series present worth
factor, i: interest rate, n: number of years. We
depend on this formula if the stream of the future
value is constant; the value of this factor is given
through calculated tables.
2- If The stream of the future values changes from
year to year, the general value of the present
value will be:

PV = FV1 * PWF1 + FV2 * PWF2 + ……. FVn * PWFn

n
PV = ∑ = FV
( 1 + i) t
T =1
Demonstration problem:
Suppose, the manager of automated product is
contemplating the purchase of a new machine
that will cost $300000, and has a useful life of
five years. The machine will yield (year – end)
cost reduction to automated products of $50,000,
$60,000, $75,000 and $90000, in years 4 and 5,
what is the present value of the cost savings of
the machine if the interest rate is 8%

should the manager

purchase the machine ?
 Answer
1- determine the present value of the cost reduction
during the machine life:
PV = 50 * pwf1 + 60 * pwf2 + 75 * pwf3 + 90 * pwf4 + 90
* pwf5
= 50 + 60 + 75 + 90 + 90
(1.08)1 (1.08)2 (1.08)3 (1.08)4 (1.08)5
= $ 284,679
2- determine the present value of the new
machine through:

NPV = PV – C0
Where C0 is the cost of the new machine
= 284679 – 300000 = - $ 15311
Since the NPV negative value, purchasing the
new machine will be wrong decision.

According to this result of NPV, the manager

should not purchase the new machine.
In general if,
NPV <0 Positive value accepted project
NPV = 0 accepted project at margin level
NPV > 0 negative value, rejected project.
PRESENT VALUE OF INDEFINITELY LIVED
ASSET:
Some assets generate infinity stream of
cash flow, under this assumption, the PV
of the future stream will change suppose
an asset generates a cash flow of CF0
today, CF1 one year from now, CF2 two
years from today and so on for an infinity
period of time. If the interest rate (i), the
value of the asset could be given by
present value of the cash flow.
PVasset = CF0 + CF1*pwf1 + CF2 *pwf2 + CF3 *pwf3 +…

Cf0 reflects the current profit before distributing its to

shareholders.

In general, we can depend on the stream of cash flow

is generated in the future to determine the value of
the asset or the firm.

PV= CF
i
Suppose an asset generates a perpetual stream of
identical cash flows at the end of each period and
current profit zero. Under this conditions, the
present value of perpetuity =

PV = CF1 * pwf1 + CF2 * pwf2 + CF3 * pwf3 + …..

PV = Cf
i
Suppose, an asset (perpetual bond or preferred
stock), this asset paid to the owner a fixed
amount at the end of each year indefinitely, if the
perpetual stream is estimated by $100 and the
interest rate is 5%. According to these data
information what is the value of the perpetual
asset?
The asset value determined by the present value of the
stream of cash flow in the infinity years.

PV = CF = 100 = $2000
i 5%
NOTE:
Present value analysis is useful to determine the
value of the firm, considering maximizing the
value of the firm is one of the main goals. The
firm value equals the present value of the
expected stream of the profit, in the future.
VALUE OF THE FIRM:

The value of the firm now is the present value of

current and future profits. To extent that the
firm is a “going concern” that levies on forever
even after its founder dies.
Notice:
When economists say that the goal of the firm is to
maximize profits, it should be understood to
mean that the firm goal is to maximize its value
which is the present value of current and future
profits.

PV = CF0 + CF1 * pwf1 + CF2* pwf2 + CF3* pwf3 + ….

Suppose:
1- CF reflects the net profit in current (CF0) and net
profits in the future ( CF1, CF2, ……).
2- The annual profits grow at a constant rate of G%
each year and the profit growth is less than the
interest rate ( g > i). profit now is P0, profit after one
year will be P0 (1+g)1, profit after two years is P0
(1+g)2, and so on.

The value of the firm in case perpetuity stream of

profit and current profit before distributed it (P0)
and growth rate of the annual profit g%
PV = P0+ P0(1+g)1*pwf +P0(1+g)2*pwf + P0(1+g)3*pwf

PV = P0 1+i
i-g
if the current profit paid out, the present value of
the firm will equal the present value of the future
profit ( current profit have been paid out as
dividends).
PV ex dividends = PV firm current profit
PV ex dividends = PV firm – P0

RESULT: maximizing short term profit may

maximize long term profits, if growth rate in the
profit is less than interest rate and both are
constant through time.
 DEMONSTRATION PROBLEM:

Suppose: a firm achieves annual profit estimated

by $100 millions, the interest rate is 10%.
According to these data, answer the followings:
1- Determine the value of the firm.
2- Suppose there is a growth of the perpetual
profit
annually by 5%, and determine the value of the
firm.
* If the Current profit equal $100 million
* Determine the value of the firm if the current
profit is zero.
 Answer
The value of the firm:
PV = P1*pwf1 + P1*pwf2+………..
PV of perpetuity =
= P = 100 = $1000 million
i 0.1
2- PV with growth of the profit and with current profit:
PV = P0+ P0(1+g)1*pwf +P0(1+g)2*pwf + P0(1+g)3*pwf

PV = P0 1+i = 100 * 1.1 = 100 * 22 =2200 million

i–g 0.05
3- PV current profit paid out as, dividends:

= PVFIRM - p0 = 2200 – 100 = 2100 million

 MANAGERIAL ANALYSIS
Managerial analysis is one of the most important
managerial tools. The optimal decisions are based
on the managerial analysis. The optimal decisions
involve comparing between marginal benefit and
marginal cost.

The optimal decision required:

Marginal benefit = marginal cost

MB = MC
Marginal benefit is the benefit of the last units of
consumption certain amount of goods and
services. If you consumed five units, the marginal
benefit is the benefit from the unit number five
but the total benefit of the consuming five units.

TB equals the summation of the marginal benefits

at all level of consumption
Total cost reflects the cost paid to produce certain
amount of goods and services.

Marginal cost reflects the cost unit of production.

Profit reflects the difference between total benefits
and total cost.

P = TB – TC
Discrete variables:
The units of production or consumption cannot be
fractioned as represented in table (1)
Units TB TC NB MB MC MNB
0 0 0 0 - - -
1 90 10 80 90 10 80
2 120 30 140 80 20 60
3 240 60 180 70 30 40
4 300 100 200 60 40 20
5 350 150 200 50 50 0
6 390 210 180 40 60 -20
7 420 280 140 30 70 -40
8 440 360 80 20 80 -60
9 450 450 0 10 90 -80
10 450 550 100 0 100 -100
The manager should decide how much units to
produce, considering the units of production not able
to fractionate.

The optimal decision maximizes the profit according

to table (1), this condition will be satisfied at unit
(5), where the profits are 200 at the maximum
amount.

At the maximum level of profit, the marginal benefit

equals marginal cost, each one equals $50.
Notice:
1- The optimal decision will be satisfied under the
following condition : MB = MC
2- The total benefit increases with the increasing of
consumption by decreasing rate ( increased by
80, 140, 180, 200) to reach the maximum level at
unit 5, any increasing of consumption leads to
decreasing of TB.
3- MB decreases with increasing of consumption to
be at unit 10.
4- Total cost increasing with increasing of
production with increasing rate (increased by 10,
20, 30, 40, 50). For this reason, the marginal cost
increases with the increase of production.
 MB = Changes in the total benefit
Changes of the quantity

MC = Changes in the total Cost

Changes of the quantity

Marginal net benefit = MNB = MB – MC

Decreases with increasing of units of production or

consumption to be zero and negative values.
NOTE:

you have to know the difference between

maximizing total benefit and maximizing net
benefit. Maximizing total benefit doesn’t take the
cost paid to generate theses benefits, but
maximizing net benefits take the cost of
production in its account.
Marginal benefit:
MB = d TB OR σ TB
dQ σQ
Where, TB = F (Q) TB Function
The marginal benefit is the first derivative of total
benefit function.
If TB = a Q + b Q2
= d TB = a + 2 b Q = MB
dQ
Marginal benefit decreases continuously with
increasing of consumption as represented in
figure
FIGURE (1) TOTAL BENEFIT
TB TB

Quantity

MB
M1

M2

q1 q2 Quantity
Marginal cost:
MC = = d TC OR σ TC
dQ σQ
The marginal cost is the first derivative of total cost
function.

TC = F (Q)
TC = CQ + d Q2
MC = C + 2d Q
Where C and d are parameters of total cost
function, but Q refers to the quantity of
production.
FIGURE (2) TOTAL COST
TC
TC

Quantity

MC

C1

C2

q1 q2 Quantity
Net benefit:

will be at maximum level at Q*, where

the difference between TB and TC will
be at the maximum level, and the
marginal benefit curve intersects with
marginal cost curve.
 FIGURE (3) EFFICIENT OUTPUT
A
MC
P1 B
C
Price, Benefit, and
E
Cost (Dollars)
P*

P2 A D
MB
Q1 Q* Q2 Quantity
TC
B TB
Z

TB – TC
Total Benefit
and Cost

0 Q* Quantity
Demonstration problem:

The control variables are infinitely divisible for

this reason the relationship between the total
benefit and consumption is continuously positive
relationship, also the relationship between total
cost and production is continuously positive
relationship. These relation are represented in
figure