Managerial Economics

Introduction, Basic Principles and Methodology

The central themes of Managerial Economics:

1. Identify problems and opportunities2. Analyzing alternatives from which choices

can be made3. Making choices that are best from the

standpoint of the firm or organization

• Not true that all managers must be managerial economists

• But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.

Some Economic Principles of Managers

1.Role of manager is to make decisions. Firms come in all sizes but no firm has unlimited resources so managers must decide how resources are employed

2. Decisions are always among alternatives.3. Decision alternatives always have costs

and benefitsOpportunity cost = next best alternative foregone.Marginal or incremental approach

4. Anticipated objective of management is to increase the firm’s value

• Maximize shareholder’s wealth• Negative impact = principal-agent problem

5. Firm’s value is measured by its expected profitsTime value of money, discount rates

6. The firm must minimize cost for each level of production

7. The firm’s growth depends on rational investment decisionsCapital budgeting decisions

8. Successful firms deal rationally and ethically with laws and regulations

Macroeconomics & Microeconomics

• Economists generally divide their discipline into two main branches:

• Macroeconomics is the study of the aggregate economy.– National Income Analysis (GDP)– Unemployment– Inflation– Fiscal and Monetary policy– Trade and Financial relationships among nations

• Microeconomics is the study of individual consumers and producers in specific markets.– Supply and demand– Pricing of output– Production processes– Cost structure– Distribution of income and output

Microeconomics is the basis of managerial economics

• Methodology, data and applicationMethodology- is a branch of philosophy that

deals with how knowledge is obtained.How can you know that you are managing

efficiently and effectively?You need some theory to do some analysis.Without theory, there can be no good

analysis

Microeconomics (probably more than other disciplines) provides the methodology for managerial economics

Managerial Economics is about both methodology and data

You need data to plug into some model to do some analysis.

This gives you the information to manageManagerial Economics lends empirical content to

the study of effective management

Review of Economic Terms

• Resources are factors of production or inputs.– Examples:• Land• Labor• Capital• Entrepreneurship

• Managerial Economics– The study of how to direct scarce resources in

the way that most efficiently achieves a managerial goal.

• Managerial economics is the use of economic analysis to make business decisions involving the best use (allocation) of an organization’s scarce resources.

• Relationship to other business disciplines

– Marketing: Demand, Price Elasticity– Finance: Capital Budgeting, Break-Even Analysis,

Opportunity Cost, Economic Value Added– Management Science: Linear Programming,

Regression Analysis, Forecasting– Strategy: Types of Competition, Structure-Conduct-

Performance Analysis– Managerial Accounting: Relevant Cost, Break-Even

Analysis, Incremental Cost Analysis, Opportunity Cost

• Questions that managers must answer:

– What are the economic conditions in a particular market?• Market Structure?• Supply and Demand Conditions?• Technology?• Government Regulations?• International Dimensions?• Future Conditions?• Macroeconomic Factors?

• Questions that managers must answer:

– Should our firm be in this business?– If so, what price and output levels achieve our

goals?

• Questions that managers must answer:

– How can we maintain a competitive advantage over our competitors?• Cost-leader?• Product Differentiation?• Market Niche?• Outsourcing, alliances, mergers, • acquisitions?• International Dimensions?

• Questions that managers must answer:

– What are the risks involved?• Risk is the chance or possibility that actual

future outcomes will differ from those expected today.

• Types of risk

– Changes in demand and supply conditions– Technological changes and the effect of

competition– Changes in interest rates and inflation rates– Exchange rates for companies engaged in

international trade– Political risk for companies with foreign

operations

• Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices:– What and how many goods and services should be

produced?– How should these goods and services be produced?– For whom should these goods and services be

produced?

• Economic Decisions for the Firm– What: The product decision – begin or stop

providing goods and/or services.– How: The hiring, staffing, procurement, and

capital budgeting decisions.– For whom: The market segmentation decision

– targeting the customers most likely to purchase.

• Three processes to answer what, how, and for whom– Market Process: use of supply, demand, and

material incentives– Command Process: use of government or

central authority, usually indirect– Traditional Process: use of customs and

traditions

• Profits are a signal to resource holders where resources are most valued by society

• So what factors impact sustainability of industry profitability?

• Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability

1. Entry

2. Power of input sellers

3. Power of buyers

4. Industry rivalry

5. Substitutes and Complements

Entry:Heightens competitionReduces margin of existing firmsAbility to sustain profits depends on the

barriers to entry: cost, regulations, networking, etc.

Profits are higher where entry is low

Power of input suppliers:Do input suppliers have power to negotiate

favorable input prices?Less power if a. inputs are standardized, b. not highly concentratedc. alternative inputs available

Profits are high when suppliers power is low

Power of buyers:High buyer power ifa. buyers can negotiate favorable terms for

the good/serviceb. Buyer concentration is highc. Cost of switching to other products is lowd. perfect information leading to less costly

buyer search

Industry rivalry:Rivalry tends to be less intensea. in concentrated industriesb. high product differentiationc. high consumer switching cost

Profits are low where industry rivalry is intense

Substitutes and complements:Profitability is eroded when there are close

substitutesGovernment policies (restrictions e.g. import

restriction on drugs from Canada to US) can affect the availability of substitutes.

Sustainable Industry

Profits

Power of Input Suppliers

·Supplier Concentration·Price/Productivity of Alternative Inputs·Relationship-Specific Investments·Supplier Switching Costs·Government Restraints

Power ofBuyers

·Buyer Concentration·Price/Value of Substitute Products or Services·Relationship-Specific Investments·Customer Switching Costs·Government Restraints

Entry·Entry Costs·Speed of Adjustment·Sunk Costs·Economies of Scale

·Network Effects·Reputation·Switching Costs·Government Restraints

Substitutes & Complements·Price/Value of Surrogate Products or Services·Price/Value of Complementary Products or Services

·Network Effects·Government Restraints

Industry Rivalry·Switching Costs·Timing of Decisions·Information·Government Restraints

·Concentration·Price, Quantity, Quality, or Service Competition·Degree of Differentiation

The Five Forces Framework

Market Interactions• Consumer-Producer Rivalry– Consumers attempt to locate low prices, while

producers attempt to charge high prices.

• Consumer-Consumer Rivalry– Scarcity of goods reduces the negotiating

power of consumers as they compete for the right to those goods.

• Producer-Producer Rivalry– Scarcity of consumers causes producers to

compete with one another for the right to service customers.

• The Role of Government– Disciplines the market process.

Overview of Lectures

Lecture 1: DemandLecture 2: SupplyLecture 4: Quantitative Demand AnalysisLecture 5: The Theory of Individual BehaviorLecture 6:Demand Estimation & ForecastingLecture 7: ProductionLecture 8: Cost of Production

Lecture 9: Organizing ProductionLecture 10: Perfect CompetitionLecture 11:The Firm’s Decisions in Perfect

CompetitionLecture 12:MonopolyLecture 13:Price DiscriminationLecture 14:Monopolistic CompetitionLecture 15: OligopolyLecture 16: Oligopoly Games

Lecture 17: Labor and Capital MarketLecture 18: Capital MarketLecture 19: Economic Equations and Their

SolutionsLecture 20: Economics Applications of

DerivativesLecture 21: ECONOMIC APPLICATION OF

DERIVATIVES – ALecture 22: ECONOMIC APPLICATION OF

DERIVATIVES - A

Lecture 23: ECONOMIC APPLICATION OF MAXIMA AND MINIMA-A

Lecture24: MAXIMIZATION OR MINIMIZATION (OTIMIZATION) OF MULTI-VARIABLE FUNCTIONS OR TWO OR MORE VARIABLE

Lecture 25: CONSTRAINED OPTIMIZATIONLecture 26: CONSTRAINT OPTIMIZATION –

ALecture 27: Correlation & Regression

Lecture 28: Measuring a Nation’s IncomeLecture 29: MoneyLecture 30: Monetary PolicyLecture 31: Fiscal Policy and NI Determination