Managerial Economics

Adam Smith- Father of Economics

Economics- the social science that studies the choices that individuals, businesses, government, and
entire societies make as they cope with scarcity, the incentives that influence those choices, and the
arrangements that coordinate them.

Scarcity- the point that wants exceed the ability of resources to satisfy them.

The field Economics is divided into Microeconomics, the study of choices that individuals and businesses
make and the way these choices interact and influenced by governments, and Macroeconomics the
study of the aggregate effects on the national economy and global economy of the choices of the
businesses and government make.

Economics studies how choices wind up determining what goods and service get produced? How good
and services are produced? And for whom goods and services are produced?

Economics also studies when choices made in a person self interest serve the social interest. For
instance, do the self interested choices made about globalization, the information age, climate change
and social security also promote social interest.

1.Managerial Economics- Stream of management studies which emphasizes solving business problems
and decision making by applying the theories and principles of microeconomics and macroeconomics. It
is specialized stream dealing with the organization internal issues by using various economic theories.

2.Acording to Baye- managerial economics is the study of how to direct scarce resources in the way that
most efficiently achieves a managerial goal. In line with this, a manager is seen as a person who direct
resources to achieve a stated goal.

2.Accoding to Salvatore- managerial economics is described as the application of economic theory and
the tools of analysis of decision science to examine how an organization can achieve its aims or
objectives most efficiently.

3.Managerial economics- defined as the utilization of managerial skills in the business by applying
economic theories and concept to maintain efficiency in costing and production and its effectiveness on
every decision making by the firm to fully maximize their profits.

Basic Principle of Effective Management

1.Identify goals and constraint

2.Recognize the nature and importance of profits

3.Understand incentives

4.Understand Markets

5.Recognized the time value of money

Choice is a Tradeoff; people make a rational choices by comparing benefits and costs.

Benefit- what you gain from something

Cost- what you must give up to get something

Most choices are “how much” choice made at the margin; and choices responds to incentives.

Choices are tradeoffs- giving up one thing to get another

Rational Choice- uses the available resources to most effectively meet the objective of the person
making the choice.

Rational choices- compare the marginal benefit of an activity to its marginal cost and undertake it if the
marginal benefit exceeds or equals the marginal cost.

The benefit from something is the gain or pleasure it brings. Benefit is measured by what someone is
willing to give up to get something.

Opportunity Cost of something is the best thing that must be given up.

Making choices on the margin means comparing all the relevant alternatives systematically and the
incrementally to determine the best choice.

Marginal Cost- is the opportunity cost of a one unit increase in an activity;

Marginal Benefit- is the gain from one unit increase in and activity.

Statement about “WHAT IS” are positive statement

Statement about “WHAT OUGHT TO BE” are normative statements.

Economist are interest in positive statements about cause and effect so they develop economic models.

Economists are natural experiments, statistical, investigations, and economic experiments to test if their
models are making correct predictions.

Goal of the Firm

1.To Earn and Maximize Profit

2.To increase its own value as an economic activity

3.To improve the quality of life in the community

1.Earning Profit- Profit is defined as the difference that arises when a firm’s total revenue is greater than
its cost. It is the difference between the income an entrepreneur receives from the sale of his goods and
services and the expenses he incur to produce them (income-expense) Profit is the prime motivator in a
capital system.

Accounting Profit v.s Economic Profit

-Accounting Profit total sales minus cost of producing goods or service

-Economic Profit difference between total revenue minus total opportunity cost of producing the firms
goods or services. The opportunity cost of using a resource includes both the explicit (accounting) cost
of resources and the implicit cost of giving up the best alternative use of the resource. It is generally
higher than accounting costs because it includes both the dollar value of cost(explicit) and any implicit
cost.

Accounting Profit

1.Determined by GAAP

2.Includes explicit cost only

3.Single entity- accounting period view

4.Used for income tax and financial performance

Economic Profit

1.Determined by economic principle

2.Includes explicit and implicit costs

3.Macro market/whole project timeline view

4.Used to determine market entry, stay or exit

Opportunity Cost- represent the potential benefits an individual, investor or business MISSED OUT when
choosing one alternative over another.

Key points:

1.Whenever a choice is made, something is given up.

2.The opportunity cost of a choice is the value of the best alternative given up
3.Choices involve trading off the expected value of one opportunity against the expected value of its best
alternative

Five Forces Framework- created by Harvard Business School professor Michael Porter, to analyse an
industry attractiveness and likely profitability. Since its publication in 1979, it has become one of the
most popular and highly regarded business strategy tools. Porter recognized that organization likely a
close watch on their rivals, but he encouraged them to look beyond the actions of their competitors and
examine what other factors could impact the business environment. He identified five forces that make
up the competitive environment, and which can erode your profitability. These are

Five Forces

1.Barriers to Entry/Threat of new entry- Entry cost, Speed of Adjustment, Sunk cost, Economies of
Scale, Reputation, Government Restraints

2.Power of Input Suppliers- Supplier concentration, Price/Productivity of alternative inputs, Supplier

switching costs, Government restraints

3.Power of Buyers- Buyer Concentration, Price/Value of substitute products, customer switching cost,
government restraint.

4.Industry Rivalry- Concentration, Price, Quantity of Service Competition, Degree of Differentiation,

Switching Cost, Timing of Decisions, Information, Government Restraint.

5.Substitutes and Complements- Price/Value of Surrogate Products/Services, Price/Value of

Complementary Products/Services, Network Effects, Government Restraint

1.Competitive Rivalry- This Looks at the number and strength of your competitors. How many rivals do
you have? Who are they, and how does the quality of their products and services compare with yours?
Where rivalry is intense, companies can attract customers with aggressive price cuts and high impact
marketing campaigns. Also in markets with lots of rivals, your supplies and buyers can go elsewhere if
they feel that they’re not getting good deal from you.

2.Supplier Power- Determined by how easy it is for your supplier to increase their prices. How many
potential suppliers do you have? How unique the product or service they provide, how expensive would
it be to switch from one supplier to another? The more you have to choose from the easier it will be to
switch to a cheaper alternative.

3.Buyer Power- Ask yourself how easy it I for buyers to drive your prices down. How many buyers are
there, and how big are their orders? How much would it cost them to switch from your products an
services to those of a rival? Are your buyers strong enough to dictate terms to you? When you have few
savvy customer, they have more power, but power increases if you have many customers

4.Threat of Substitution- This refers to the likelihood of your customer finding a different way of doing
what you do. For example, if you supply a unique software product that automates an important
process, people may substitute it by doing the process manually or by outsourcing it. A substitution that
is easy and cheap to make can weaken your position and threaten your profitability.

5.Threat of New Entry- Your position can be affected by people’s ability to enter your market, so think
about how easy it could be done, How easy is it to get a foothold in your industry or maket? How much
would it cost and how tightly is your sector regulated? If it takes a little money and effort to enter your
market and compete effectively, or if you have little protection for your key technologies, then rivals can
quickly enters your market and weaken your position.

THREE SOURCE OF RIVALRY

1.Consumer-Producer Rivalry

-This rivalry occurs because of the competing interests of customers and producers. Consumers attempt
to negotiate or locate low prices while producers attempt to negotiate high prices.

2.Consumer-Consumer Rivalry

-This rivalry negotiating power of customers in the marketplace. It arise because of economic doctrine of
scarcity. When limited quantities of goods are available, customers will compete with one another for
the right to purchase the available goods.

3.Producer-Producer Rivalry

-This discipling device functions only when multiple sellers of a product compete with one another for
the right to service the customers available.

Marginal Analysis- One of the most important managerial tools. Simply put, marginal analysis states that
optimal managerial decisions involve comparing the marginal(or incremental) benefits of a decision with
the marginal(or incremental cost).

Marginal Benefit- refers to the additional benefits that arise by using an additional unit of variable

Marginal Cost- the additional cost incurred by using an additional unit of managerial control variable

Marginal Principle

-To maximize net benefits, the manager should increase the managerial control variable up to the point
where marginal benefits equal marginal costs. This level of control variable corresponds to the level
wherein marginal net benefits are ZERO. Nothing more can be gained by further changes in that variable

Rule: The profit maximizing level of input/output is where marginal benefit is equal to marginal cost or
marginal net benefit is equal to zero. MB= MC;MNB= 0
Column

1.Control Variable- This is given. It may pertain to number of workers, machines, or other variables. It
can be in the increments of 1,5, or 10 depending on the problem

2-3. Total Benefit and Total Cost- This is given

4.Net Benefits- This can be computed by simply deducting the total cost from the total benefit NB= Total
Benefit-Total Cost

5.Marginal Benefit- This will be computed by dividing the change in total benefits over the change In
control variable MB= Current-Previous Total Benefit Divide Current-Previous Control Variable

6.Marginal Cost- This will be computed by dividing the change in total costs over the change in control
variable. MC= Current- Previous Total Cost Divide Current-Previous Control Variable

7.Marginal Net Benefit- This can be computed by simply deducting thr total marginal cost from marginal
benefit MB-MC

Scatter Diagram- plots a graph of one variable against the variable of another

Time Series- measure time along the x axis and the variable(or variables) of interest along the y axis.

Cross Section Graph- shows the values of an economic variable for different groups in the population at
a point in time.

Graph- can show the relationship between two variables in an economic model.

Variables that move in the same direction have positive, or direct relationship

Variables that move in the opposite direction have a negative, or inverse relationship.

Law of Demand

-A fundamental building block in any economic analysis is the concept of demand. It is one of the
elements that make the market economies work. When people in economic profession refers to
demand, they are talking about the quantity of a good or service that consumer are willing and able to
purchase during a specified period of time.

Note: Buyer should not only be willing but have the capacity to purchase the good or service. Otherwise
it is not considered as demand

Demand- Behavior of potential buyers in the market it is defined as the entire relationship price and
quantity.
Change in Demand(Shift) of Demand curve

-A change in demand refers to an increase or decrease in demand that is brought about by a change in
the other factors, except price. Thus a change in demand is a result of non price determinants coming
into force.

-A change in demand entails a shift in the demand curve; either to the left of to the right of the original
demand curve.

Change in Quantity Demanded

-A change in quantity demanded refers to the variation in the customers’ demand of a commodity due to
a change in its price, other factors remaining constant. Thus, the only factor that causes a change in
quantity demanded is price.

-There is upward or downward movement along the same demand curve.

Demand Shifters

Numerous non price determinants of demand that lead to a change in demand, some of these are
discussed below

1.Change in Total Income- if the income of consumer increase, it is expected that the demand will
increase, even if the price remains the same. On contrary, if income falls, demand will also fall.

Inferior Goods- An economic term that describes a good whose demand drops when the people’s
incomes rise. This occurs when a good has more costly substitutes that see an increase in demand as
incomes and economy improve.

Normal Good- A good that experiences an increase in demand due to a rise in customer’s income. In
other words, if there’s an increase in wages, demand for normal goods increases while conversely, wage
declines or layoffs lead to a reduction in demand.

2.Prices Related Product- There exist products in the market that may be substitutes or compliments to
the product in questions. It is reasonable to expect that the price of these related products have a
bearing on the demand of a particular product.

Complementary Goods or Service- An item used in conjunction with another goods or service. Usually
complimentary good has little to no value when consumed alone, but when combined with another
good or service, it adds to overall value of the offering. A product can be considered a complement when
it shares beneficial relationship with another product.

Substitute or Substitute Goods- In Economics and consumer theory refers to a product or service that
consumers see as essentially the same or similar enough to another product. Simply a substitute is a
good that can be used in place of another.
3.Future Expectations- If the market sentiments suggest that the price of a commodity is expected to
rise in the future, it may lead to an increase in the current demand and vice-versa.

4.Taste and Preference- Plays a pivotal role in shaping the demand for a product or commodity. In fact,
the endeavor of any marketer of goods or services is to alter the taste and preferences of a consumers
so that they like the product that being sold.

5.Environmental Factors- The political, economic, social, cultural, and technological environment
prevailing in the country/region may have a direct bearing on demand.

6.Population- The population has a direct bearing on demand for a commodity. More the number of
people, higher the likely demand. The demographic profile and changes thereon also significantly affect
the demand of particular product.

Demand Function- A demand function is a mathematical equation which expresses the demand of a
product or service as a function of its price and other factors such as the prices of the substitutes and
complementary goods, income. Etc.

-A demand function create a relationship between the demand(in quantities) of a product(which is a

dependent variable) and factors that affect the demand such as the price of the product, the price of
substitute and complementary goods, average income etc.( which are independent variables)

Qx^d=f(Px,Py,I,H)

Where:

Qxd= Quantity Demanded for product X

Px= Price of Good X

Py= Price of Related Good Y

H= Other variable Affecting Demand

An economic researcher proposed this functional form for the demand for inexpensive headsets
designed for smart phones.

Qxd= -5Px + 4Py + 8I + 10A + 2N

As you can see the coefficient of Px is negative. This negative sign denotes the negative relationship of
the price and quantity demanded for product/service

This equation helps us to determine or estimate the number of units demanded considering the impact
of its price, price of its related goods, income level and other determinants.
Requirements:

1.Setup the demand function if the price of Bluetooth speaker is 100 income level is 2,000 advertising
expenditure is 1,000 and population size is 5,000

Qxd= -5x + 4Py + 8I + 10A + 2N

Qxd= -5Px + 4(100) + 8(2,000) + 10(1,000) + 2(5,000)

Qxd= -5Px + 400 + 16,000 + + 10,000 + 10,000

Qxd= -5Px+ 36,400 or Px= 7,280 – 0.2 Qxd

2.Refer to the answer in #1. Sketch a graph of the demand function with quantity demanded in
horizontal axis and price Is plotted on the vertical axis. Is it downward sloping?
Using the equation Qxd= -5Px + 36,400, let the value of Px = 0

Qxd= -5(0) + 36,400

Qxd= 36,400

3.Refer to the answer in #1 and #2, determine the choke price or highest price buyers are willing to pay
for this commodity

To get choke price we set Qxd= 0 thus we have

Px= 7,280-0.2 Qxd

Px= 7,280- 0.2(0)

Px= 7,280

4.Plot the price and quantity demanded for good X on the graph

Px= 7,280(7,280, 0) → Coordinate or pair #1

Qxd= 36,400(0, 36,400) → Coordinate #2

The graph shows the negative or inverse relationship or downward sloping demand curve

5.Suppose the prices of headset is 50, determine the quantity demanded for headset.

Qxd= -5Px + 36,400

Qxd= -5(50) + 36,400

Qxd= -250 + 36,400

Qxd= 36,150

TIPS ON THE DEMAND FUNCTION

1.(-) Negative sign of the coefficient of Px implies the inverse relationship of price and quantity
demanded

2.(+) Positive sign of the coefficient of Py or price of the related goo means that if the price of Good Y
increases, quantity demanded for good X increases. Hence, good Y is a substitute for good X Negative
sign means they are complementary goods.

3.(+) Positive sign of the coefficient of I or income means that if the income of the consumer increases
quantity demanded for good X increases. Hence the good is a normal good. Negative sign means inferior
goods.
Another element that is essential to the market economy is supply. Supply describes the behavior of firm
that are producing and selling goods and services.

Supply- refers to the relationship between the price of a particular good and the quantity of the good
that firms are willing to sell at that price, all other things remaining the same.

Law of Supply: Other things remaining the same, quantity supplied of a commodity is directly related to
the price of the commodity. When a price of a commodity increases, its quantity supplied increases and
when the price falls, quantity supplied also falls.

High Price- High Supply → Producer will supply more goods if the price is high because it will generate
higher profits

Low Price- Low Supply → Producers will supply less/few goods if the price is low because it will generate
lower profits. Some producers keep their goods out of the market temporarily and wait for its price to
increases to earn higher profit.

Individual Supply- refers to supply of a commodity by an individual firm in the market.

Market Supply- refers to a supply of a commodity by all the firms in the market. If there are only two
firms in the market and one of them is selling 50 units and the other Is selling 70 units at a given price,
the market supply at this given price will be 120 units.

Note the difference between Supply and Quantity Supplied

Supply refers to the entire supply schedule showing various quantities of a commodity offered for sale
corresponding to different possible prices of that commodity, at a given time. On the other hand,
quantity supplied refers to a specific quantity(like 15 units) offered for sale against a specific price
Change in Supply

-A change in supply refers to an increase or decrease in supply that is brought about by a change in the
other factors, except price. Thus a change in supply is a result of non- price determinants(supply shifters)
coming into force

-A change in supply entails a shift in the supply curve; either to the left(S1 to S2 ) or to the right (S1 to
S3) of the original supply curve(S1)

Change in Quantity Supplied

-A change in quantity supplied refers to the variation in producers supply of a commodity due to a
change in its price, other factors remaining constant. Thus, the only factor that causes a change in
quantity supplied is price

-There is upward or downward movement along the same supply curve.

Determinants of Supply

1.Technology- Anything that changes the amount of outputs that a firm can produce with a given amount
of inputs can be considered a change in technology. Technology gets better with time because of new
ideas and discoveries. Technological Improvements shift the supply curve to the right and increase
supply.
2.Input Prices- The supply curve reveals how much producers are willing to produce at alternative price.
As production cost change the willingness of producers to produce output at a given price changes. In
particular as the price of an input rises, producers are willing to produce less output at each given price.
This decreases in supply depicted as a leftward shift in the supply curve.

3.Number of Firms- The number of firms affects the position of the supply curve. As additional firms
enter an industry, more and more output are available at each given price. This is reflected by a
rightward shift in the supply curve.

4.Substitute in Production- Many firms have technologies that are readily adaptable to several different
products for example. Automakers can convert a truck assembly plant into car assembly plant by altering
its production facilities.

5.Government- An increase in sales tax and other forms of taxes is an added cost to production and will
decrease supply. Government regulation, which can increase or lower the cost of production, also affect
the supply output of firms

6.Producer Expectation/ Expectation of Future Prices- Producer expectations about future prices also
affect the position of the supply curve. In effect selling a unit of output today and selling a unit of output
tomorrow are substitutes in production firms suddenly expect prices to be higher in the future. And the
product is not perishable, producers can hold back output today and sell it later at a higher price.

Supply Function

-The supply function of a good describes how much of the good will be produced at alternative prices of
the good, alternative prices of inputs, and alternative values of other variables that affect supply

Qxs= f(Px,Pr,W,H)

Where:

Qxs= Quantity Supplied for Product X

Px= Price of Good X

Pr= Price of Technological related goods

W= Price of Inputs such as wage on labor

H= Other Variables Affecting Demand

The supply function explicitly recognizes that the quantity produced in a market depends not only in the
price of the good but also on all the factors that are potential supply shifters

Example:

Your research department estimates that the supply function for high definition televisions(HDTVs) is
given by

QxS= 2,000 + 3Px -4Pt – Pw

Where Px Is the price of HDTVs, Pt represent the price of the tablet, and Pw is the price of an input used
to make HDTVs. Suppose HDTVs are sold for 400 per unit, tablets are sold for 250 per unit, and the price
of an inout is 1400 how many HDTVs are produced?

Answer:

QxS= 2,000 + 3(400) – 4(250) – 1 (1,400)

QxS= 800

Adding up the numbers, we find that the total quantity of HDTVs produced is 800 units

Market Equilibrium

-Market Equilibrium is a market state where the supply in the market is equal to the demand in the
market.

Equilibrium Price- Price of good or service when the supply of it is equal to the demand for it in the
market. If a market is at equilibrium the price will not change unless an external factor changes the
supply or demand, which results in a disruption of the equilibrium.

If the market price is above the equilibrium value, there is an excess supply in the market( a surplus)
which means there is more supply than demand. In this situation seller will tend to reduce the price of
their goods or service to clear their inventories. They also probably slow down their production or stop
ordering new inventories. The lower price entices more people to buy.

If the market price is below the equilibrium value, then there id excess in demand( Supply Shortage). In
this case ,buyers will bid up the price of the good or service in order to obtain good or service in short
supply. As the price goes up , some buyer will quit trying because they don’t want to, or can’t pay the
higher price.