CHAPTER ONE

INTRODUCTION

This chapter discusses more about meaning and importance of managerial economics, phases in
business decision making process furthermore it describes about the scope of managerial
economics.

1.1 Definition of Managerial Economics

Economics is the science of choice in the face of unlimited ends and scarce
resources which have alternative uses. Since resources are scarce and the
uses to which they can be put to are unlimited, one is required to choose the
best amongst the available alternatives. The crux of the problem which
economics tries to address is the choice of the best uses of resources among
the alternative uses. Generally, economics can be divided into two broad
categories: microeconomics and macroeconomics. Macroeconomics is the
study of the economic system as a whole. It includes techniques for
analyzing changes in total output, total employment, the consumer price
index, the unemployment rate, and exports and imports. Only aggregate

levels of these variables are considered. But concealed in the aggregate

data are countless changes in the output levels of individual firms, the
consumption decisions of individual consumers, and the prices of particular
goods and services. These all fall under the domain of microeconomics.
Microeconomics focuses on the behavior of the individual actors on the
economic stage, that is, firms and individuals and their interaction in
markets.

Managerial economics is the discipline that deals with the application of economic concepts,
theories and methodologies to the practical problems of businesses/firms in order to formulate

rational managerial decisions for solving those problems. It uses the tools and techniques of

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Economic analysis to solve managerial problems or to achieve the firm’s desired objective. It is
that branch of economics, which serves as a link between abstract theories and managerial
practices. It is based on economic analysis for identifying problems, organizing information and

evaluating alternatives. Managerial economics borrows theories from traditional economics i.e.
microeconomics where as it borrows tools from decision science i.e. mathematics and statistics
and it tries to find out optimum solution of business problems.

Managerial economics has been generally defined as the study of economic theories, logic and
tools of economic analysis, used in the process of business decision making. It involves the
understanding and use of economic theories and techniques of economic analysis in analyzing
and solving business problems.

Managerial economics, meaning the application of economic methods in the managerial

decision-making process, is a fundamental part of any business or management course.
Economic principles contribute significantly towards the performance of managerial duties as
well as responsibilities. Managers with some working knowledge of economics can perform their
functions more effectively and efficiently than those without such knowledge. Taking
appropriate business decisions requires a good understanding of the technical and environmental
conditions under which business decisions are taken. Application of economic theories and logic
to explain and analyze these technical conditions and business environment can contribute
significantly to the rational decision-making process.

Following diagram shows how the managerial economics provides the link between traditional
economics and decision sciences.

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 Management Problems

Economic Theory
Decision Sciences

Managerial Economics

Economic Methodology:
Descriptive Model Prescriptive Model Study of Functional Areas: Accounting, Fina
Optimal Decision

Managerial Economics can be defined as combination of economic theory with business

practices so as to ease decision-making and future planning by management. Managerial
Economics assists the managers of a firm in a rational solution of obstacles faced in the firm’s
activities. It makes use of economic theory and concepts. It helps in formulating logical
managerial decisions. The key of Managerial Economics is the micro-economic theory of the
firm. It lessens the gap between economics in theory and economics in practice. Managerial
Economics is a science dealing with effective use of scarce resources. It guides the managers in
taking decisions relating to the firm’s customers, competitors, suppliers as well as relating to the
internal functioning of a firm. It makes use of statistical and analytical tools to assess economic
theories in solving practical business problems.

Managerial economics uses both Economic theory as well as Econometrics for rational
managerial decision making. Econometrics is defined as use of statistical tools for assessing
economic theories by empirically measuring relationship between economic variables. It uses
factual data for solution of economic problems. Managerial Economics is associated with the
economic theory which constitutes “Theory of Firm”. Theory of firm states that the primary aim
of the firm is to maximize wealth. Decision making in managerial economics generally involves
establishment of firm’s objectives, identification of problems involved in achievement of those

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objectives, development of various alternative solutions, and selection of best alternative and
finally implementation of the decision.

1.2 Factors that contributed for the emergence of Managerial Economics

Managerial Economics as a course required for effective resource management was put in place
due to the following developments in the global business environment:

a. Growing complexity of business decision-making processes.

b. Increasing need for the use of economic logic, concept, theories, and tools of economic
analysis in the process of decision-making.
c. Rapid increases in the demand for professionally trained managerial manpower.

These developments have made it necessary that every manager aspiring for good leadership and
achievement of organizational objectives be equipped with relevant economic principles and
applications. Unfortunately, a gap has been observed in this respect among today’s managers. It
is therefore the aim of this course to bridge such gap.

It is a general knowledge that there exists a gap between theory and practice in the world of
economic thinking and behavior. By implication, a theory which appears logically sound might
not be directly applicable in practice. Take for instance, when there are economies of scale, it
seems theoretically sound that when inputs are doubled, output will be more or less doubled, and
when inputs are tripled, output would be more or less tripled. This theoretical conclusion may
not hold in practice. Economic theories are highly simplistic because they are propounded on the
basis of economic models based on simplifying assumptions. Through economic models,
economists create a simplified world with its restrictive boundaries from which they derive their
conclusions. Although economic models are said to be an extraction from the real world, the
closeness of this extraction depends on how realistic the assumptions of the model are. It is a
general belief that assumptions of economic models are unrealistic in most cases. The most
common assumption of the economic models, as you may recall, is the ceteris paribus
assumptions (that is all other things being constant or equal). This assumption has been alleged
to be the most unrealistic assumption.

Though economic theories are, no doubt, hypothetical in nature, in their abstract form however,
they do look divorced from reality. Abstract economic theories cannot be simply applied to real
life situations. This however, does not mean that economic models and theories do not serve

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 useful purposes. Microeconomic theory, for example, facilitates the understanding of what would
be a complicated confusion of billions of facts by constructing simplified models of behavior that
are sufficiently similar to the actual phenomenon to be of help in understanding them. It cannot,
nevertheless, be denied the fact that there is a gap between economic theory and practice.

The gap arises from the fact that there exists a gap between the abstract world of economic
models and the real world. It suffices to say that although economic theories do not directly offer
custom-made solutions to business problems, they provide a framework for logical economic
thinking and analysis. The need for such a framework arises because the real economic world is
too complex to permit consideration of every bit of economic facts that influence economic
decisions. Economic analysis presents the business decision makers with a road map; it guides
them to their destinations, and does not take them to their destinations. Managerial economics
can bridge the gap between economic theory and real world business decisions. The managerial
economic logic and tools of analysis guide business decision makers in:

 identifying their problems in the achievement

 collecting the relevant data and related facts;
 processing and analyzing the facts;
 drawing the relevant conclusions;
 determining and evaluating the alternative means of achieving the goal; and,
 Taking a decision.

Without the application of economic logic and tools of analysis, business decisions may likely be
irrational and arbitrary. Irrationality is highly counter-productive.

1.3 Scope of Managerial Economics

Managerial economics comprises both micro and macro-economic theories. Generally, the scope
of managerial economics extends to those economic concepts, theories, and tools of analysis
used in analyzing the business environment, and to find solutions to practical business problems.
In broad terms, managerial economics is applied economics. The areas of business issues to
which Managerial economics can be directly applied are divided into two broad categories:

 Operational or internal issues; and,

 Environment or external issues.

A. Operational problems are of internal nature. These problems include all those problems which
arise within the business organization and fall within the control of management. Some of the
basic internal issues include:

 choice of business and the nature of product (what to produce);

 choice of size of the firm (how much to produce);
 choice of technology (choosing the factor combination);
 choice of price (product pricing);

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  how to promote sales;
 how to face price competition;
 how to decide on new investments;
 how to manage profit and capital; and,
 how to manage inventory.

B. Environmental issues: These are issues related to the general business environment. These are
issues related to the overall economic, social, and political atmosphere of the country in which
the business is situated. The factors constituted under environmental aspect issues include the
following:

 the existing economic system

 General trends in production, income, employment, prices, savings and investment, and
so on.
 Structure of the financial institutions.
 Magnitude of and trends in foreign trade.
 Trends in labor and capital markets.
 Government’s economic policies.
 Social organizations, such as trade unions, consumers’ cooperatives, and producer
unions.
 The political environment.
 The degree of openness of the economy.

Managerial economics is particularly concerned with those economic factors that form the
business climate. In macroeconomic terms, managerial economics focus on business cycles,
economic growth, and content and logic of some relevant government activities and policies
which form the business environment in general.

1.4. Economic Analysis and Business Decisions

Business decision-making basically involves the selection of best out of alternative opportunities
open to the business organization. Decision making in managerial economics
generally involves establishment of firm’s objectives, identification of
problems involved in achievement of those objectives, development of
various alternative solutions, and selection of best alternative and finally
implementation of the decision.

Decision making processes involve four main phases, including:

Phase One: Determining and defining the objective to be achieved (identifying target
objectives).

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Phase Two: Collection and analysis of information on economic, social, political, and
technological environment.

Phase Three: Inventing, developing and analyzing possible course of action.

Phase Four: Selecting and implementing a particular course of action from available alternatives
which best confirm with the target objective.

Note that phases two and three are the most crucial in business decision-making. They put the
manager’s analytical ability to test and help in determining the appropriateness and validity of
decisions in the modern business environment. Personal intelligence, experience, intuition and
business acumen of the manager need to be supplemented with quantitative analysis of business
data on market conditions and business environment.

It is in fact, in this area of decision-making that economic theories and tools of economic
analysis make the greatest contribution in business. If for instance, a business firm plans to
launch a new product for which close substitutes are available in the market; one method of
deciding whether or not this product should be launched is to obtain the services of a business
consultant. The other method would be for the decision-maker or manager to decide.

1.5. Basic Economic Problems

As it has been discussed earlier, human wants are practically unlimited, but the resources
available to produce goods and services to satisfy human wants are limited. Accordingly, the
subject matter of economics deals with problems associated with the production and distribution
of economic goods. Economists, therefore, have identified six basic economic problems that are
faced by all societies. Economists try to find out how decisions on such core problems are made
by various economic agents. The basic economic problems faced by societies are:

a) What to produce d) Full utilization of resources

b) How to produce e) Attainment of efficiency
c) For whom to produce f) Growth of the economy

a) What to produce

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The problem "what to produce" is the problem of choice between commodities. This problem
arises mainly for two reasons. Firstly, scarcity of resources does not permit production of all the
goods and services that people would like to consume. Secondly, all the goods and services are
not equally valued in terms of their utility by the consumers. Some commodities yield higher
utility than others. Since all the goods and services cannot be produced for lack of resources, and
all that is produced may not be bought by the consumers, the problems of choice between the
commodities arise.

Example: Consider a potential businessperson planning to start a business around Debre Markos
University. Given his initial capital, he may have a number of alternative business ideas in his
mind, like running a cafeteria, a photocopy shop, a barber, internet café, grocery etc. Because of
resource limitations, however, he can run only one or two types of businesses. Thus, he has to
decide which business to run. Thus, he has to identify the most attractive business sectors and
start producing commodities (goods or services).

b) How to produce

The problem "how to produce" refers to the methods or techniques of production to be adopted,
i.e. the choice of technology. Here, the problem is how to determine an optimum combination of
inputs; Labor and capital to be used in the production of goods and services. This problem
mainly arises mainly because of scarcity of resources. If labor and capital were available in
unlimited quantities, any amount of labor and capital could be combined to produce a
commodity. But, since resources are not available in unlimited quantity, it becomes imperative to
choose a technology which uses resources most economically. A basic distinction is between
capital-intensive production and labor-intensive production technology. Capital-intensive
technology uses large amounts of capital relative to labor in a production process. While labor-
intensive technology uses large amount of labor resource relative to capital to produce a
commodity.

Example: Assume two road construction projects in Bahir Dar city. Project A is construction of a
‘cobblestone’ road, while project B is construction of ‘asphalt’ road. In which one of the two
projects do you think the technology is labor-intensive? Why?

Based on the definitions, the cobblestone project is labor-intensive, as it absorbs many labor
input relative to capital. And Project B is capital intensive as it employs huge capital relative to
labor. Therefore, a society which decides to construct a road has to decide also how to construct
the road, in other words, which of the available technologies to use.

c) For whom to produce

For whom to produce is the problem related to the distribution of products, i.e. identifying the
market or the users of the commodity what you produce using a certain technical means. In other
words, this problem the problem of synchronizing the supply pattern with demand pattern so that

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those who have the ability and willingness to pay the price get the commodity and there is no
surplus production.

Identifying the users of a commodity to be produced would help whether to produce that
commodity or not, where to use a capital-intensive or labor-intensive technology, and what
amount of the commodity to produce.

Example: In the case of the road construction projects, if the users of the road are mainly
pedestrians and lightweight cars, the road can be constructed using cobblestone. Otherwise, it
should be constructed using asphalt. Similarly, if the community around the Main Campus has a
demand for photocopy and cafeteria services, the businessperson can start these businesses.
Otherwise, he should think of a better business idea.

d) The problem of resource utilization

Full utilization of resources is the most desirable way of optimization of production and
consumption in the economy. Production of goods and services is always constrained by the
scarcity of relevant resources. When resources are scarce, one would expect that they are utilized
fully but there are examples in different societies of under utilization of resources in spite of
demand for goods and services in whose production the resources can be used. What are the
reasons for such unemployment or underutilization of productive resources is a big question that
economists try to respond.

e) The problem of efficiency

Production is said to be inefficient if it would be possible to reallocate resources and to produce

more of at least one good without simultaneously producing less of any other good. The goods
(including services) that are produced are said to be inefficiently distributed if it would be
possible to redistribute them among the individuals in the society and make at least one person
better off without simultaneously making any one worse off. Inefficiencies in both, production
and consumption are to be reduced. That is the same thing as saying that production and
consumption in the society have to be efficient.

f) Problem of Growth of Economy

The problem of growth of economy is quite serious in most of the countries particularly under-
developed and developing ones. By "growth" we mean increase in productive capacity and actual
production of goods and services from year to year. More goods and services are required by a
country over time because of necessity to meet the demands of growing population. A part from
this, the standard of living of people improves over time due to the impact of education and
development of science & technology. Thus, they need varieties of goods and services which
meet their requirements. An economy has to make necessary arrangements for production of
greater amount as well as greater varieties of goods of services. It is, however, not very easy to

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achieve the objective of growth of the economy. There will be several constraints to this which
are to be removed. What is to be the rate of growth, what is the appropriate way to achieve
growth and development of the economy? These are vital questions for which a society must find
the answers. The six problems as discussed above are fundamental and common to all
economics.

The first three problems i.e. what to produce, how to produce and for whom to produce are
normally considered more fundamental than the other three but all of them are of equal
importance in the context of contemporary economic complexities The different economic
systems try to solve these problems in different ways. In a free market economy, these problems
are solved by a system of prices. In mixed economy, they are solved partly by a system of prices
of and partly by government. In centralized socialist economy, these problems are solved by a set
of public norms or directions by the government. In brief, we can say that the basic economic
problems of different societies are solved in different ways.

1.6 Alternative Economic Systems

Societies have developed the following different economic systems, or institutions or

mechanisms, in order to resolve the three fundamentals economic problems.

a) Pure Market Economy

In this system, the three basic economic questions are answered as follows. Firms address the
‘what to produce’ question by producing those goods and services that could give them the
maximum possible profit. The ‘how to produce’ question is answered by choosing the techniques
of production which are least costly. The ‘for whom to produce and distribute’ question is
addressed depending on peoples decision as to how to spend their income.

Economic activities are coordinated and directed through market mechanism (or demand and
supply). There is no government intervention in the economy. Rather the private sector, through
the forces of demand and supply, is expected to solve the problems.

You should be aware of the fact that no economy in the real world has a characteristic of pure
market economic system, even that of the economy of USA. This is because, although very
rarely, the government of USA intervenes in the economy. However, as compared to many
economies in the world, many of the characteristics of the economy of USA are much closer to
the pure market economic system.

b) Command Economy

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It is an economic system where the questions of what, how, and for whom to produce is resolved
by the government through a central planning board. The central planning board studies the
needs and preferences of the society and decides on what, how and for whom to produce.
Resources are owned by the public sector. Example: North Korea and Cuba.

c) Mixed Economy

It is a type of economic system in which decisions of what, how and for whom to produce is
provided by profit making firms via the market system(through the forces of demand and
supply) and the government. It is a midway system between pure market system and strict
planned economy. All real world economies, including that of our economy, are examples of this
economic system.

1.7 Decision Making Units and the Circular-flow of Economic Activities

i. Decision Making Units

Households, business organizations also called firms and government make important economic
decisions such as consumption, production, exchange and distribution. In short, they make
economic decisions to resolve the basic economic problems.

a) Households: - they are the owner of scarce resources, they are mostly considered as
consumers.

Households, as decision making units, decide on:

 The sale of their scarce resources (labor, land, capital and entrepreneur) to firms and the
government.
 What and how much of the goods and services to buy.
 Paying tax to the government.

b) Firms:- they are economic agents who transform scarce resources in to final goods and
services, mostly referred as producers. They make economic decision on:

 What, how and for whom to produce?

 The level of resources they will purchase from the households
 Paying tax to the government

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c) Government: - Government is an organization that has legal and political power to exert
control over individuals, firms and market. Sometimes, markets fail to work properly (as
required) and hence fail to allocate scarce resources efficiently. This calls for the intervention of
the government in the economy.

ii. The circular flow of economic activities

It shows the interaction of decision-making units.

 Resource market:- are markets where inputs that are used in the production of goods and
services are sold.
 Product market: - are markets where goods and services are traded.
 Real flow: - the flow of goods, services and resources.
 Financial or money flow: - the flow of money (income and expenditure).

Look at the following two-sector circular flow model and critically observe the diagram. The
diagram shows how the decision-making units (households and firms) interact each other in a
given economy.

Figure 1.1 Two sector circular flow of economic activities

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In the diagram above, firms and households are the two decisions making units. Households
supply resources in the resource market. In return, they receive money income and they spend all
the income to purchase goods and services from firms (i.e. they do not save). Firms buy
resources from households. Then, they combine these inputs and produce goods and services.
Finally, they sell these goods and services to households in the product market and generate
income (revenue).

1.8. The nature of the firm

A firm is a for-profit business, usually formed as a partnership that provides professional

services, such as legal or accounting services. It is an economic explanation of why individuals
choose to form partnerships, companies and other business entities rather than trading
bilaterally through contracts on a market.

1.8.1 Objectives of firm

The main objectives of firms are: Profit maximization, Sales maximization, increased market
share/market dominance, Social/environmental concerns, Profit satisficing and Co-
operatives.

 In neoclassical economics, the theory of the firm is a microeconomic concept that states
that a firm exists and makes decisions to maximize profits.

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  The theory of the firm influences decision-making in a variety of areas, including
resource allocation, production techniques, pricing adjustments, and the volume of
production.

 Modern takes on the theory of the firm sometimes distinguish between long-run
motivations, such as sustainability, and short-run motivations, such as profit
maximization.

1.8.2 Goal and constraints

Goals are clear objectives for what you want your end state to be, while constraints are given
conditions, or circumstances that your solution must satisfy. To make good decisions,
firstly, a manager must clearly identify goals and constraints. Since resources are limited every
manager faces constraints. For example, as a manager of a restaurant I may want to make my
restaurant the most popular in town and gain the greatest market share. Sound decision
making involves having well defined goals. – Leads to making the “right”
decisions. In striking to achieve a goal, we often face constraints. –
Constraints are an artifact of scarcity.

1.9. Theory of profit –an overview

The term profit means different things to different people. Business people, accountants, tax
collectors, employees, and economists have their individual meaning of profit. Before exposing
you to the theories of profit, it will be helpful for you to distinguish between two often
misunderstood profits concepts: the Accounting profit and the Economic profit.

In its general sense, profit is regarded as income accruing to equity holders, in the same sense as
wages accrue to the workers; rent accrues to owners of rentable assets; and, interest accrues to
the money lenders. To the accountant, ‘profit’ means the excess of revenue over all paid out
costs, such as manufacturing and overhead expenses. It is more like what is referred to a ‘net
profit’. For practical purposes profit or business income refers to profit in accounting sense.

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The Accounting Profit: Accounting profit may be defined as follows:

Accounting Profit =πa=TR – (w+ r+ I + m)

w h ere TR=Total Revenue ;

w=wages∧salaries ;
r =rent ;
i=interest ;∧¿
m=cost of materials .

You can observe that when calculating accounting profit, it is only the explicit or book costs that
are considered and subtracted from the total revenue (TR).

The Economic or Pure Profit: Unlike accounting profit, economic profit takes into account both
the explicit costs and implicit or imputed costs. Explicit cost is a payment made to others/ and or
out-of-pocket costs for a firm during the course of running a business that represents the
outflows of cash in clear and obvious terms. Explicit costs include things like wages, mortgage,
rent, utilities, advertisements, raw materials and other general, administrative and sales costs.
The implicit or opportunity cost can be defined as the payment that would be necessary to
draw forth the factors of production from their most remunerative alternative use or employment.
Implicit costs are the opportunity cost of resources already owned by the firm and used in
business—for example, expanding a factory onto land already owned. Opportunity cost is the
income foregone which the business could expect from the second best alternative use of
resources. The foregone incomes include interest, salary, and rent, often called transfer costs.

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Economic profit also makes provision for (a) insurable risks, (b) depreciation, (c) necessary
minimum payment, to shareholders to prevent them from withdrawing their capital investments.
Economic profit may therefore be defined as ‘residual left after all contractual costs, including
the transfer costs of management, insurable risks, depreciation, and payments to shareholders
have been met.
Thus,

Economic∨Pure Profit=πe=TR – EC – IC

w h e ℜ EC =Explicit Costs ;∧,

IC=Implicit Costs.

Note that economic profit as defined by the above equation may necessarily not be positive. It
may be negative since it may be difficult to decide beforehand the best way of using the business
resources. Pure profit is a short-term phenomenon. It does not exist in the long-run under
perfectly competitive conditions.

To say that products that can be produced profitably will be, and those that cannot be produced
profitably will not begs the question of what we mean by “profit. ”What is commonly thought of
as profit by the accountant may not match the meaning assigned to the term by an economist. An
economist’s notion of profit goes back to the basic fact that resources are scarce and have
alternative uses. To use a certain set of resources to produce a good or service means that certain
alternative production possibilities were forgone. Costs in economics have to do with forgoing
the opportunity to produce alternative goods and services. The economic, or opportunity, cost of
any resource in producing some good or service is its value or worth in its next best alternative
use.

Given the notion of opportunity costs, economic costs are the payments a firm must make, or
incomes it must provide, to resource suppliers to attract these resources away from alternative
lines of production. Economic costs (TC) include all relevant opportunity costs. These payments
or incomes may be either explicit, “out-of-pocket” (cash expenditures) or implicit costs which
represent the value of resources used in the production process for which no direct payment is
made. This value is generally taken to be the money earnings of resources in their next best
alternative employment. When a computer software programmer quits his or her job to open a
consulting firm, the forgone salary is an example of an implicit cost. When the owner of an
office building decides to open a hobby shop, the forgone rental income from that store is an
example of an implicit cost. When a housewife decides to redeem a certificate of deposit to
establish a day-care center for children, the forgone interest earnings represent an implicit cost.

In short, any sacrifice incurred when the decision is made to produce a good or service must be
taken into account if the full impact of that decision is to be correctly assessed.

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Economist’s concept of profit is the pure profit or ‘economic profit’. Economic profit is a return
over and above the opportunity cost, that is, the income expected from the second alternative
investment or use of business resources. In this unit, emphasis will be placed on the various
concepts of profit. These relationships may be summarized as follows:

Accounting profit : П A=TR−TC explicit

Economic profit : П e=TR−TC=TR−TC explicit – Tc implicit

Example 1.1 Abera operates a small shop specializing in party favors. He owns the building
and supplies all his own labor and money capital. Thus, Abera incurs no explicit rental or wage
costs. Before starting his own business Abera earned Birr 1,000 per month by renting out the
store and earned Birr 2,500 per month as a store manager for a large department store chain.
Because Abera uses his own money capital, he also sacrificed Birr 1,000 per month in interest
earned on bonds. Abera’s monthly revenues from operating his shop are Birr 10,000 and his total
monthly expenses for labor and supplies amounted to Birr 6,000. Calculate Abera’s monthly
accounting and economic profits.

Solution: Total accounting profit is calculated as follows:

Total revenue Birr 10,000

Total explicit costs (6,000)
Accounting profit = Birr 4,000

On the other hand: Economic profit :πe=TR−TC=TR−¿)

Accounting profit: π A=TR−TCexplicit

Abera’s accounting profit appears to be a healthy Birr 4,000 per month.

However, if we take into account Abera’s implicit costs, the story is quite different. Total
economic profit is calculated as follows:

Total revenue = Birr10, 000

Total explicit costs (6,000)
Forgone rent 1,000
Forgone salary 2,500
Forgone interest income 1,000
Total implicit costs (4,500)
Total economic costs 10,500
Economic profit (loss) = Birr (500)

Economic profits are equal to total revenue less total economic costs, which is the sum of
explicit and implicit costs. Accounting profits, on the other hand, are equal to total revenue less

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total explicit costs.

It is, of course, a simple matter to make accounting profit equivalent to economic profit by
making explicit all relevant implicit costs. Suppose, for example, that an individual quits a Birr
40,000 per year job as the manager of a family restaurant to open a new restaurant. Since this is a
sacrifice incurred by the budding restaurateur, the forgone salary is an implicit cost. On the other
hand, this implicit cost can easily be made explicit by putting the restaurant owner “on the
books” for a salary of Birr 40,000.The somewhat arbitrary distinction between explicit and
implicit costs is illustrated in the following problem.

Example 1.2 Neway is the owner of a small grocery store in Hossana town. Neway’s annual
revenue from operating the grocery is Birr200, 000 and his total explicit cost is Birr 180,000
per year. (Neway pays himself an annual salary of Birr 30,000). A supermarket chain wants
to hire him as the general manager for Birr 60,000 per year.
a. What is the opportunity cost to Neway of owning and managing the grocery store?
b. What is Neway’s accounting profit?
c. What is Neway’s economic profit?

Solution

a. Opportunity cost is the Birr 60,000 in forgone salary that Neway might have earned had

b. πA=TR−TCexplicit=Birr 200,000 – Birr 180,000=Birr 20,000

he decided to work as general manager for the supermarket chain.

c. πe=TR−TCexplicit−TCimplicit
¿ Birr 200,000−Birr 180,000−Birr 30,000
= -Birr 10,000

Another way of looking at this problem is to consider Neway’s forgone income following his
decision to continue to operate the grocery store. Neway’s forgone income may be summarized
as follows:

πe=grocery store salary−supermarket salary

¿ $ 20,000+ $ 30,000−$ 60,000=−$ 10,000

This is the same as the result in part b, since the grocery store salary less the supermarket salary
is just the opportunity cost as defined.

1.10 THEORIES OF PROFIT

The unsettled controversy on the sources of profit has led to the emergence of various theories of
profit in economics. The following discussions summarize the main theories.

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Walker’s Theory of Profit: Profit as Rent of Ability: One of the widely known theories of profit
was stated by F. A. Walker who theorized ‘profit’ as the rent of “exceptional abilities that an
entrepreneur may possess” over others. He believes that profit is the difference between the
earnings of the least and the most efficient entrepreneurs. Walker assumes a state of perfect
competition, in which all firms are presumed equal managerial ability. In Walker’s view, under
perfectly competitive conditions, there would be no pure or economic profit and all firms would
earn only marginal wages, which is popularly known in economics as ’normal profit’.

Clark’s Dynamic Theory: The J. B. Clark’s theory is of the opinion that profits arise in a
dynamic economy, not in a static economy. A static economy is defined as the one in which
there is absolute freedom of competition; population and capital are stationary; production
process remains unchanged over time; goods continue to remain homogeneous; there is freedom
of factor mobility; there is no uncertainty and no risk; and if risk exists, it is insurable. In a static
economy therefore, firms make only the ‘normal profit’ or the wages of management.

A dynamic economy on the other hand, is characterized by the following generic changes:

 Population increases;
 Increase in capital;
 Improvement in production technique;
 Changes in the forms of business organizations; and,
 Multiplication of consumer wants.

The major functions of entrepreneurs or managers in a dynamic environment are in taking

advantage of the generic changes and promoting their businesses, expanding sales, and reducing
costs. The entrepreneurs who successfully take advantage of changing conditions in a dynamic
economy make pure profit. From Clark’s point of view, pure profit exists only in the short-run.
In the long-run, competition forces other firms to imitate changes made by the leading firms,
leading to a rise in demand for factors of production. Consequently, production costs rise, thus
reducing profits, especially when revenue remains unchanged.

Hawley’s Risk Theory of Profit: The risk theory of profit was initiated by F. B. Hawley in 1893.
According to Hawley, risk in business may arise due to such reasons as obsolescence of a
product, sudden fall in the market prices, non-availability of crucial raw materials, introduction
of better substitutes by competitors, risk due to fire, war and the like. Risk taking is regarded as
an inevitable accompaniment of dynamic production, and those who take risk have a sound
claim of a separate reward, referred to as ‘profit’. Hawley simply refers to profit as the price
paid by society for assuming business risk. He suggests that businesspeople would not assume
risk without expecting adequate compensation in excess of actuarial value, that is, premium on
calculable risk.

Schumpeter’s Innovation Theory of Profit:The innovation theory of profit was developed by

Joseph A. Schumpeter. Schumpeter was of the opinion that factors such as emergence of interest
and profits, recurrence of trade cycles are only incidental to a distinct process of economic

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development; and certain principles which could explain the process of economic development
would also explain these economic variables or factors. Schumpeter’s theory of profit is thus
embedded in his theory of economic growth. In his explanation of the process of economic
growth, Schumpeter began with the state of stationary equilibrium, characterized by equilibrium
in all spheres. Under conditions of stationary equilibrium, total receipts from the business are
exactly equal to the total cost outlay, and there is no positive profit. According to the
Schumpeter’s theory, profit can be made only by introducing innovations in manufacturing
technique, as well as in the methods of supplying the goods. Sources of innovation include:

 Introduction of new commodity or a better quality good;

 Introduction of new method of production;
 Opening of a new market;
 Discovery of new sources of raw material; and,
 Organizing the industry in an innovative manner with the new techniques.

Profit Maximization Objective

Profit maximization objective helps in predicting the behavior of business firms in the real
world, as well as in predicting the behavior of price and output under different market
conditions. There are some theoretical profit-maximizing conditions that we must have in our
finger tips. These are presented below:

The Profit-Maximizing Conditions

We first define profit as:

π=TR – TC ……………… (Equation 1.1)

w h ere TR=Total Revenue=Unit price (P) x Quantity (Q)=PQ ,∧,

TC=Total cost=Variable Cost (VC)+¿ Cost (FC).

There are two major conditions that must be fulfilled for equation (1.1) to be a maximum profit:
(i) the first-order (or necessary) condition, and (ii) the second-order (or supplementary)
condition.

The first-order condition requires that at a maximum profit, marginal revenue (MR) must equal
marginal Cost (MC). Note that by the term ‘marginal revenue’, we mean the revenue obtained
from the production and sale of one additional unit of output, while ‘marginal cost’ is the cost
arising from the production of the one additional unit of output. The second-order condition
requires that the first-order condition must be satisfied under the condition of decreasing
marginal revenue (MR) and increasing marginal cost (MC).

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Fulfillment of these two conditions makes the second-order condition the sufficient condition for
profit maximizations. In technical terms, the profit-maximizing conditions can be formulated as
follows:

Given profit (π )=TR – TC to be maximized,

let: TR=f (Q)∧,

TC=f (Q)

where Q = quantity produced and sold.

Then π=F (Q)=f (Q)TR – f (Q)TC ………………. (Equation 1.2)

The first-order condition requires that the first derivative of equation (1.2) should be zero.

Now let’s find the derivative of π=f ( Q ) at any value Q and let d represent the change in Q from
Q to Q+d . The corresponding change in π=f (Q) is f ( Q+ d )−f (Q) . To maximize profits,
marginal profits must be zero.

dπ dTR dTC
i.e = − …………………………..(Equation 1.3)
dQ dQ dQ

dTR dTC
You can observe that this condition holds only when: = i.e when MR=MC
dQ dQ

To get the second-order condition, we take the second derivative of the profit function to get:
2 2 2
d π d TR d TC
2
= 2
− 2 …………………………..(Equation 1.4)
dQ dQ dQ

The second-order condition requires that equation (1.4) is negative, so that:

2 2 2 2
d TR d TC d TR d TC
2
− 2
<0 Or 2
< 2 ………….Equation (1.5)
dQ dQ dQ dQ

Equation (1.5) may also be written as: slope of MR < Slope of MC, since the left-hand side of
equation (1.5) represents the slope of MR and the right-hand side represents the slope of MC.
This implies that at the optimum point of profit maximization, marginal cost (MC) must intersect
the marginal revenue (MR) from below. We conclude that maximum profit occurs where the
first- and second-order conditions are satisfied.

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Example: Suppose that the unit price of a commodity is defined by:

P=100 – 2Q ………….Equation 1.6

Then, TR=PQ =(100 – 2Q)Q ………Equation 1.7

TR¿ 100 Q – 2 Q2

Suppose also that the total cost of producing this commodity is defined by the cost function:
2
TC=100+0.5 Q ……………………Equation 1.8

You are required to apply the first-order condition for profit maximization and determine the
profit-maximizing level of output.

According to the first-order condition, profit is maximized where: MR = MC,

Given equations (1.7) and (1.8), we get:

dTR
MR=
dQ

It follows that profit is maximized where: MR = MC

Or100 – 4 Q=Q ………….………………Equation 1.11

Solving for Q in equation (1.11), we get:

100=5Q

5 Q=100

Q=100 /5=20.

The output level of 20 units satisfies the first-order condition. Let us see if it satisfies the Second-
order condition.
2 2
d TR d TC
2
− 2
<0
dQ dQ

Therefore −4−1=−5 and this is less than zero. Thus the second-order condition is also satisfied
at the output level of 20 units. We therefore conclude that the profit-maximizing level of output

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in this problem is 20 units. To determine the maximum profit, you will substitute 20 for Q in the
original profit function. Thus, the maximum profit will be:
¿
π =TR – TC
2 2
¿ 100 Q – 2 Q – (100+0.5 Q )

¿ 2000 – 800 – 100−200

¿ 900 Birr

We conclude that the maximum profit is 900.

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