THE UNIVERSITY OF ZAMBIA

LECTURE NOTES FOR BS310

MANAGERIAL ECONOMICS

BY TOBIAS MICHELO(BA, UNZA; MScEC, UZ)

 MANAGERIAL ECONOMICS
DEFINITIONS
•Before embarking on the nitty-gritties of managerial
economics, it is essential to have a broad understanding of
the fundamentals of managerial roles. In particular, an
effective manager must be able to do the following:

a.Identify goals and constraints;

b.Recognize the nature and importance of profits;
c.Understand incentives;
d.Understand markets;
e.Recognize the time value of money; and
f.(6) Use marginal analysis.
 Identifying Goals & Constraints
• The first step in making sound decisions is to have well-
defined goals, and the constraints that comes with the
decision.
• Take an example of a student faced with two choices of
either maximizing their marks in a particular course or all
courses on average, study habits will differ accordingly.
• Or a food bank distributing food to needy people in rural
or/and to needy inner-city residents will entail different
strategies, and ultimately decision making.
• Notice that in both instances, the decision maker faces
constraints that affect the ability to achieve a goal.
• Available time affects your ability to earn an A in this course;
a budget affects the ability of the food bank to distribute
food to the needy. Constraints are an artifact of scarcity.
 Goals & Constraints
• Constraints include such things as technology and the prices
of inputs used in production and these make it difficult for
managers to achieve goals such as maximizing profits or
increasing market share.

• Thus the goal of maximizing profits requires the manager to

decide;
What product should be produced,
How much of it,
Which technology to use,
How much of each input to use in the production process,
What should be the optimal price to charge for a product,
How to react to decisions made by competitors, and so on.
 Goals & Constraints
• Different units within a firm may be given different goals.
• Those in a firm’s marketing department might be instructed
to use their resources to maximize sales or market share,
while those in the firm’s financial group might focus on
earnings growth or risk-reduction strategies.
 NATURE & IMPORTANCE OF PROFITS
• The overall goal of most firms is to maximize profits or the firm’s
value. It is therefore important that we examine & understand the
nature and importance of profits in a free-market economy.

• Accounting profit is the total amount of money taken in from sales

(total revenue, or price times quantity sold) minus the dollar cost of
producing goods or services.

• A more general way to define profits is in terms of what economists

refer to as economic profits.

• Economic profits are the difference between the total revenue and the
total opportunity cost of producing the firm’s goods or services.
 NATURE & IMPORTANCE OF PROFITS
• Firms and consumers both face choices between different activities, eg
producing or consuming different types of goods.

• The opportunity cost of an activity is the cost of the activity measured

in terms of the best alternative foregone.

• The opportunity cost of studying for the Bachelor of Business

Administration exams is the time that you could have spent doing
other things.
• In the business world, the opportunity cost of opening a restaurant is
the best alternative use of the resources used to establish the
restaurant—say, opening a hairstyling salon.

• The opportunity cost of using a resource includes both the explicit (or
accounting) cost of the resource and the implicit cost of giving up the
best alternative use of the resource.
• The opportunity cost of producing a good or service generally is higher
than accounting costs because it includes both the dollar value of costs
(explicit, or accounting, costs) and any implicit costs.
• Implicit costs are very hard to measure and therefore managers often
overlook them. Effective managers, however, continually seek out
data from other sources to identify and quantify implicit costs.
• Imagine running a business and at the end of the year, your
accountant informs you that your costs were $20,000 and that your
revenues were $100,000. Thus, your accounting profits are $80,000.
• First, the costs do not include the time you spent running the business.
Had you not run the business, you could have worked for someone
else, and this fact reflects an economic cost not accounted for in
accounting profits. Supposed you had worked for someone else, you
could have been paid 30,000 for example.
• Secondly, you could have decided to rent your building, and earn
$100,000. Thus your total cost for running this business becomes
$20,000.
 THE OPPORTUNITY COST
PRINCIPLE
• Thus, for the production of one com­modity, we have to forego or
sacrifice the production of another commodity.
• The concept of opportunity cost implies three things:
1. The calculation of opportunity cost involves the measurement of
sacrifices.
2. Sacrifices may be monetary or real.
3. The opportunity cost is termed as the cost of sacrificed alternatives.
In managerial decision making, the concept of opportunity cost
occupies an important place. The economic significance of opportunity
cost is as follows:
• 1. It helps in determining relative prices of different goods.
• 2. It helps in determining normal remuneration to a factor of
production.
• 3. It helps in proper allocation of factor resources.
 ROLE OF PROFITS
• Adam Smith’s classic line from The Wealth of Nations: “It is not out of the
benevolence of the butcher, the brewer, or the baker, that we expect our
dinner, but from their regard to their own interest.”
• This simply implies that businessmen do not venture into businesses to
satisfy our (customers appetite), but rather, their motivation is satisfying
their interests, profits signals where the scarce resources are highly valued by
society.
• A manager should therefore always understand all the necessary businesses
forces that influence business profits and sustainability.

• A key theme of this course is to bring out the many interrelated forces and
decisions that influence the level, growth, and sustainability of profits.
• Michael Porter designed a framework that organizes many complex
managerial economics issues into five categories or “forces” that impact the
sustainability of industry profits:
• (1) entry,
• (2) power of input suppliers,
• (3) power of buyers,
• (4) industry rivalry, and
• (5) substitutes and complements.
The Five Forces Framework and Industry Profitability
 THE FIVE FORCES FRAMEWORK
ENTRY
• Entry heightens competition and reduces the margins of existing firms
in a wide variety of industry settings.

• For this reason, the ability of existing firms to sustain profits depends
on how barriers to entry affect the ease with which other firms can
enter the industry.

• A number of economic factors affect the ability of entrants to erode

existing industry profits

• These may include economies of scale, Significant network effects,

existing firms with strong reputations, larger base of loyal consumers,
Governments patents and licenses, trade policies, and environmental
legislation.
 THE FIVE FORCES FRAMEWORK
Power of Input Suppliers.
• Industry profits tend to be lower when:

• Suppliers have the power to negotiate favorable terms for their inputs.
• Inputs are relatively standardized and relationship-specific
investments are minimal.
• Input markets are not highly concentrated
• Alternative inputs are available with similar marginal productivities per
dollar spent
• The government constrains the prices of inputs through price ceilings
and other controls extent limits the ability of suppliers to expropriate
profits from firms in the industry.
 THE FIVE FORCES
FRAMEWORK
 Power of Buyers: Similar to the case of suppliers, industry profits tend to be
lower when:
• Customers or buyers have the power to negotiate favorable terms for
the products or services produced in the industry.
• Buyer concentration and hence customer power tend to be higher in
industries that serve relatively few “high-volume” customers.
• Buyer power tends to be lower in industries where the cost to
customers of switching to other products is high—as is often the case
when there are relationship-specific investments and hold-up
problems.
• Imperfect information that leads to costly consumer search.
• A few close substitutes for the product
• Government regulations such as price floors or price ceilings can also
impact the ability of buyers to obtain more favorable terms.
 THE FIVE FORCES FRAMEWORK
 Industry Rivalry: The sustainability of industry profits also depends
on the nature and intensity of rivalry among firms competing in the
industry.

• Rivalry tends to be less intense (and hence the likelihood of sustaining

profits is higher) in concentrated industries—that is, those with
relatively few firms.

• The level of product differentiation and the nature of the game being
played— whether firms’ strategies involve prices, quantities, capacity,
or quality/service attributes.
 THE FIVE FORCES FRAMEWORK

Substitutes & Compliments: The level and sustainability of industry

profits also depend on the price and value of interrelated products and
services.

•The presence of close substitutes erodes industry profitability.

•As a manager it is important to understand how to quantify the degree

to which surrogate products are close substitutes by using elasticity
analysis and models of consumer behavior.

•Government policies (such as restrictions limiting the importation of

prescription drugs from one country to the other) can directly impact
the availability of substitutes and thus industry profits.
 Understand Incentives
• To succeed as a manager, you must have a clear grasp of the role of
incentives within an organization such as a firm and how to construct
incentives to induce maximal effort from those you manage.

• Many professionals and owners of small establishments have

difficulties because they do not fully comprehend the importance of
the role incentives play in guiding the decisions of others.

• Simply increasing one’s salary is not enough incentives to ensure

employees work towards bringing in profits in the Organization.

• Business owners provide employees with “incentive plans” in the form

of bonuses. These bonuses are in direct proportion to the firm’s
profitability.
 Understand Incentives
• If the firm does well, the CEO receives a large bonus. If the firm does
poorly, the CEO receives no bonus and risks being fired by the
stockholders.
• These types of incentives are also present at lower levels within firms.
Some individuals earn commissions based on the revenue they
generate for the firm’s owner.
• If they put forth little effort, they receive little pay; if they put forth
much effort and hence generate many sales, they receive a generous
commission.
• The thrust of managerial economics is to provide you with a broad
array of skills that enable you to make sound economic decisions and
to structure appropriate incentives within your organization.

• We will begin under the assumption that everyone with whom you
come into contact is greedy, that is, interested only in his or her own
self-interest. In such a case, understanding incentives is a must.
 Understand Markets
• From an economics point of view, and managerial economics in
particular, there are two sides that we need to understand to
complete the market. For every buyer of a good there is a
corresponding seller.
• The final outcome of the market process then, depends on the relative
power of buyers and sellers in the marketplace.
• The power, or bargaining position, of consumers and producers in the
market is limited by three sources of rivalry that exist in economic
transactions:
Consumer–producer rivalry,
Consumer–consumer rivalry, and
Producer–producer rivalry.
• Each form of rivalry serves as a disciplining device to guide the market
process, and each affects different markets to a different extent.
• Thus, your ability as a manager to meet performance objectives will
depend on the extent to which your product is affected by these
sources of rivalry.
 Understanding Markets
Consumer–Producer Rivalry
• Occurs because of the competing interests of consumers and
producers. Consumers attempt to negotiate or locate low prices, while
producers attempt to negotiate high prices.

• Of course, there are limits to the ability of these parties to achieve

their goals. If a consumer offers a price that is too low, the producer
will refuse to sell the product to the consumer.

• Similarly, if the producer asks a price that exceeds the consumer’s

valuation of a good, the consumer will refuse to purchase the good.

• These two forces provide a natural check and balance on the market
process even in markets in which the product is offered by a single
firm (a monopolist).
 Understanding Markets
Consumer–Consumer Rivalry
• This is a second source of rivalry that guides the market process, and
occurs among consumers.

• This source of rivalry reduces the negotiating power of consumers in

the marketplace.
• Consumer-consumer rivalry arises because of the economic doctrine
of scarcity. This is because when quantities of goods available are
limited, consumers will compete with one another for the right to
purchase the available goods.

• Consumers who are willing to pay the highest prices for the scarce
goods will outbid other consumers for the right to consume the goods.

• This source of rivalry is present even in markets in which a single firm

is selling a product.
 Understanding Markets
Producer–Producer Rivalry
• Unlike the other forms of rivalry, this disciplining device functions only
when multiple sellers of a product compete in the marketplace.

• Given that customers are scarce, producers compete with one another
for the right to service the customers available.

• Those firms that offer the best-quality product at the lowest price earn
the right to serve the customers.
 Understanding Markets
Government and the Market
• In modern economies, government also plays a role in disciplining the
market process.
• When agents on either side of the market find themselves
disadvantaged in the market process, they frequently attempt to
induce government to intervene on their behalf.

• For example, the market for electricity in most towns is characterized

by a sole local supplier of electricity, and thus there is no producer–
producer rivalry.
• Consumer groups may initiate action by a public utility commission to
limit the power of utilities in setting prices.

• Similarly, producers may lobby for government assistance to place

them in a better bargaining position relative to consumers and foreign
producers.
 Recognize the Time Value of Money
• The timing of many decisions involves a gap between the time when
the costs of a project are borne and the time when the benefits of the
project are received.

• It is important to recognize that $1 today is worth more than $1

received in the future. This is because the opportunity cost of
receiving the $1 in the future is the forgone interest that could be
earned were $1 received today.

• This opportunity cost reflects the time value of money. For this reason,
managers must understand present value analysis in order to properly
account for the timing of receipts and expenditures.

• The present value (PV) of an amount received in the future is the

amount that would have to be invested today at the prevailing interest
rate to generate the given future value.
Present Value Analysis
Present Value Analysis
 Present Value Analysis
• The present value of a future payment reflects the difference between
the future value (FV) and the opportunity cost of waiting (OCW):
PV = FV - OCW.
• Intuitively, the higher the interest rate, the higher the opportunity cost
of waiting to receive a future amount and thus the lower the present
value of the future amount.
• The basic idea of the present value of a future amount can be
extended to a series of future payments.
• For example, if you are promised FV1 one year in the future, FV2 two
years in the future, and so on for n years, the present value of this sum
of future payments is
 Net Present Value
• Given the present value of the income stream that arises from a
project, one can easily compute the net present value of the project.
The net present value (NPV) of a project is simply the present value
(PV) of the income stream generated by the project minus the
current cost (C0) of the project: NPV PV C0.
• If the net present value of a project is positive, then the project is
profitable because the present value of the earnings from the project
exceeds the current cost of the project.

• On the other hand, a manager should reject a project that has a

negative net present value, since the cost of such a project exceeds
the present value of the income stream that project generates.
• Suppose that by sinking C0 dollars into a project today, a firm will
generate income of FV1 one year in the future, FV2 two years in the
future, and so on for n years. At the interest rate is i, the net present
value of the project is
 Exercise
• The manager of Toyota Zambia is contemplating the purchase of a new vehicles
that will cost $3000,000 and has a useful life of five years. The machine will yield
(year-end) cost reductions to Automated Products of $600,000 in year 1,
$500,000 in year 2, $800,000 in year 3, and $900,000 in years 4 and 5. What is
the present value of the cost savings of the machine if the interest rate is 10%?
Should the manager purchase the machine?
• Answer:
• By spending $300,000 today on a new machine, the firm will reduce
costs by $365,000 over five years. However, the present value of the
cost savings is only
• Consequently, the net present value of the new machine is
• Since the net present value of the machine is negative, the manager
should not purchase the machine.
• In other words, the manager could earn more by investing the
$300,000 at 8 percent than by spending the money on the cost-
saving technology.