Managerial Economics –ECO404 VU

Lesson 1

INTRODUCTION TO MANAGERIAL ECONOMICS

The heart of Managerial economics is the micro economic theory. Much of this theory was
formalized in a textbook written more than 100 years ago by Professor Alfred Marshall of
Cambridge University. The world has changed a great deal since Marshall’s ideas were
developed. Yet, basic micro economic principles such as supply and demand, elasticity, short-
run and long-run shifts in resource allocation, diminishing returns, economies of scale, and
pricing according to marginal revenue and marginal cost continue to be important tools of
analysis for managerial decision makers.

Economics is divided into two broad categories: Micro and Macro.

Microeconomics is the study of the economic behavior of individual decision-making units. It

has a great relevance to Managerial Economics. On the other hand, Macroeconomics is the
study of the total or aggregate level of output, income, employment, consumption, investment,
and prices for the economy viewed as a whole. In economics, the key term is Scarcity. In the
presence of a limited supply relative to demand, countries must decide how to allocate their
scarce resources. This decision is central to the study of economics:

• What to produce?
• How to produce?
• And for whom to produce?

These are the well known what, how and for whom questions found in the introductory chapter
of all economics textbooks.

DEFINITION OF MANAGERIAL ECONOMICS

Joel Dean, author of the first managerial economics textbook, defines managerial economics as
“the use of economic analysis in the formulation of business policies”.

Douglas - “Managerial economics is the application of economic principles and methodologies

to the decision-making process within the firm or organization.”

Pappas & Hirschey - “Managerial economics applies economic theory and methods to
business and administrative decision-making.”

Salvatore - “Managerial economics refers to the application of economic theory and the tools of
analysis of decision science to examine how an organization can achieve its objectives most
effectively.”

The meaning of this definition can best be examined with the aid of Figure 1-1

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RELATIONSHIP TO ECONOMIC THEORY

Economic theories seek to predict and explain economic behavior. Economic theories usually
begin with a model. For example, the theory of the firm assumes that the firm seeks to maximize
profits, and on the basis of that it predicts how much of a particular commodity the firm should
produce under different forms of market structure. The profit-maximization model accurately
predicts the behavior of firms, and, therefore, we accept it. Thus, the methodology of economics
is to accept a theory or model if it predicts accurately.

RELATIONSHIP TO THE DECISION SCIENCES

Managerial economics is also closely related to the decision sciences. These use the tools of
mathematical economics and econometrics to construct and estimate decision models aimed at
determining the optimal behavior of the firm. Mathematical economics is used to formalize the
economic models in equational form postulated by economic theory. Econometrics then applies
statistical tool (particularly regression analysis) to real-world data to estimate the models
postulated by economic theory and for forecasting.

SCOPE OF MANAGERIAL ECONOMICS

Managerial economics has applications in both profit and not-for-profit sectors. For example, an
administrator of a nonprofit hospital seeks to provide the best medical care possible given

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Managerial Economics –ECO404 VU

limited medical staff, beds and equipment. Using the tools and concepts of managerial
economics, the administrator can determine the optimal allocation of these limited resources. In
short, managerial economics helps managers arrive at a set of operating rules that help in the
efficient use of scarce human and capital resources. By following these rules, businesses,
educational institutions, hospitals, other nonprofit organizations, and government agencies are
able to meet their objectives efficiently.

THEORY OF THE FIRM

The theory of firm is the center-piece and central theme of Managerial economics. A firm is an
organization that combines and organizes resources for the purpose of producing goods and/or
services for sale.

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. Today, the emphasis on profits has been
broadened to include 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

The value of the firm is the present value of all expected future profit of the firm. Future profits
must be discounted at an appropriate interest rate .to the present because a dollar of profit in
the future is worth less than today. This model can be expressed as follows:

Formally the wealth or value of the Firm = Present Value of Expected Future Profits

π π π n
π
PV =
(1 + r )
1
1
+
(1 + r )
2
2
+L +
(1 + r )
n
n
= ∑
t =1
t

(1 + r ) t

Here, π1, π2, . . . πn represent expected profits in each year, t, and r is the appropriate interest,
or discount, rate.

n
π n
T Rt − T C
V a lu e o f F ir m = ∑
t=1
t

(1 + r ) t
= ∑
t=1 (1 + r ) t
t

CONSTRAINTS AND THE THEORY OF THE FIRM

Managerial decisions are often made in light of constraints imposed by technology, resource
scarcity, contractual obligations, laws, and regulations. Organizations frequently face limited
availability of essential inputs, such as skilled labor, raw materials, energy, specialized
machinery, and warehouse space.

LIMITATIONS OF THE THEORY OF THE FIRM

Some critics question why the value maximization criterion is used as a foundation for studying
firm behavior. The theory of the firm which postulates that the goal of the firm is to maximize
wealth or the value of the firm has been criticized as being much too narrow and unrealistic.

Hence, broader theories of the firm have been purposed. The most prominent among these are:
• Sales maximization ( Adequate rate of profit)

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Managerial Economics –ECO404 VU

• Management utility maximization ( Principle-agent problem)

• Satisfying behavior

These alternative theories, or models, of managerial behavior have added to our understanding
of the firm. Still, none can replace the basic value maximization model as a foundation for
analyzing managerial decisions.

DEFINITIONS OF PROFIT

• Business or Accounting Profit: Total revenue minus the explicit or accounting costs of
production.

• Economic Profit: Total revenue minus the explicit and implicit costs of production.

THEORIES OF PROFIT

• Risk-Bearing Theories of Profit

• Frictional Theory of Profit
• Monopoly Theory of Profit
• Innovation Theory of Profit
• Managerial Efficiency Theory of Profit

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