Chapter 1 The Nature and Scope of Managerial Economics

Managerial Economics Defined Salvatore - “The application of economic theory and the tools of decision science to examine how an organization can achieve its aims or objectives most efficiently.” Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision- making.”

Economic Theory and Tools of Decision Sciences Microeconomics Macroeconomics Tools of Decision Sciences Mathematical Economics to express economic theory in equation form Econometrics applies statistical tools to estimate the models, and forecasting

Managerial Decision Problems Economic theory Microeconomics Macroeconomics Decision Sciences Mathematical Economics Econometrics MANAGERIAL ECONOMICS Application of economic theory and decision science tools to solve managerial decision problems OPTIMAL SOLUTIONS TO MANAGERIAL DECISION PROBLEMS

The Process of Decision Making Five basic process a. Define Problem b. Determine the objective c. Possible solution d. Select the best possible solution e. Implement the decision

Product Markets Households Firms Factor Markets Rs Rs Goods and Services Goods and Services Firms Households Economic Resources Economic Resources Income Rs Factor Markets Factor Payment Rs

Theory of the Firm Firm Combines and organizes resources for the purpose of producing goods and/or services for sale. Transaction and organization of productive factors are generally accomplished by the central control of managers. Firms do not continue to grow larger and larger indefinitely Primary goal is to maximize the wealth or value of the firm.

The present value of all expected future profits Value of the Firm The present value of all expected future profits

Constraints on the Operation The primary goal of the firm is to maximize the value or wealth of the firm subject to the constraint that it faces.

Limitations of the Theory of the Firms Maximization of sales Managers seek to maximize sales after adequate profit is earned to satisfy stockholders Maximization of management utility The agent may be more interested in maximizing his utility than maximizing the principle’s Satisficing behavior Managers strive for some satisfactory goal e.g sales, profit, market share, etc.

Definitions of Profit Business Profit: Total revenue minus the explicit or accounting costs of production. Economic Profit: Total revenue minus the explicit and implicit costs of production. Opportunity Cost: Implicit value of a resource in its best alternative use.

Theories of Profit Risk-Bearing Theories of Profit Above average returns are required by the firms to remain in sectors in which there is above average risk. Frictional Theory of Profit Profit arises as a result of friction or disturbances from long run equilibrium. Monopoly Theory of Profit Firms with monopoly power restrict the output and charge higher prices

Contd…. Innovation Theory of Profit A reward for the introduction of successful innovation Managerial Efficiency Theory of Profit Firms that are more efficient than the average will earn above normal profits.

Function of Profit Profit is a signal that guides the allocation of society’s resources. High profits in an industry are a signal that buyers want more of what the industry produces. Low (or negative) profits in an industry are a signal that buyers want less of what the industry produces.

Contd… From society’s welfare point of view the profit system may not be perfect.