Managerial Economics Introduction Managerial Economics: Describes the economic forces that shape the internal and external environments of a business firm. Prescribes rules for managerial decision-making that furthers the objective of the firm. Traditional economic theory “explains” economic phenomena and makes “what if” or conditional predictions Managerial economics “describes” the economic forces what shape the internal and external economic environments and It “prescribes rules for managerial decision-making that further the goal of the firm What’s the goal of the firm?

A Decision-Making Model Objectives Define the problem Alternative Solutions Social constraints Evaluation Organizational and input constraints Implement and monitor the decision

Objective of the Firm Not market share Not growth Not revenue Not empire building Not name recognition Not state-of-the-art technology These are the right answer to the wrong question. If the question was: What are the means effective in achieving the objective of the firm, then these are the correct answers. But the question is not about the means but rather about the fundamental objective of the firm. Do not make Type III error – asking the wrong question. Type I error – wrongly convict an innocent person; Type II error – failure to convict a guilty person

What’s the objective of the firm? The objective of the firm is to maximize the value of the firm. Value of the firm is the true measure of business success (of course, from a for-profit perspective.) Two questions: 1. How is the “value of the firm” defined and measured? 2. How do managers go about adding value to the firm?

Managerial Economics Q1- What’s the value of the firm? “The present value of the firm’s future net earnings.” 1 2 n V = [--------] + [ --------] + . . . + [ -------- ] (1+r)1 (1+r)2 (1+r)n t =  [ ------- ] , t = 1, 2, ... , N (1+r)t

Managerial Economics Q2 - How should a manager go about adding value? A good map or a travel guide to the “curious land of the Econ” should help.

Profit = Total Rev - Total Cost Managerial Economics A Useful Map Profit = Total Rev - Total Cost  = P . Qd - AC . Qs

(Why are profits necessary?) Theories of Profits (Why are profits necessary?) Risk-Bearing Theory of Profit - Profits (normal profits) are necessary to compensate for the risk that entrepreneurs take with their capital and efforts Dynamic Equilibrium (Frictional) Theory - Profits, especially extraordinary profits, are the result of our economic system’s inability to adjust instantaneously to unanticipated changes in market conditions.

Theories of Profits Monopoly Theory - Profits are the result of some firm’s ability to dominate the market Innovation Theory - Extraordinary profits are the rewards for successful innovations Managerial Efficiency Theory - Extraordinary profits can result from exceptionally managerial skills of well-managed firms.

Managerial Actions Controllable factors (internal environment): Productions Technology Marketing Mix Employment Policies Investment Strategies Capital structure

Non-Controllable factors(external environment): Managerial Actions Non-Controllable factors(external environment): Level of Economic activities Economic Regulations Unions Global Business conditions BOP and Exchange rate changes

Terminology Issues The Marginality analysis Economic Profits Accounting Profits Cash flows

The Principle of Marginality $ $1,000 MC MB Hospital Days 1 2 3 4

The Principle of Opportunity Cost Costs are opportunities sacrificed. To be precise, the opportunity cost of a choice or decision is measured by the highest valued alternative that will be given up. Cost is not always the monetary expense Cost is often implicit rather than explicit

Significance of the Opportunity Cost Concept Accounting profits = Net revenue – Accounting costs (dollar costs of goods and services) Reported on the firms income statement Economic profits = Net revenue – Opportunities Costs Economic profits and opportunity costs are critical to decision making

More examples of useful concepts The principal-agent or the agency problems: Moral hazard

What’s Managerial Economics? Managerial economics is not a separate management discipline Rather, it is a logical and useful tool for framing and solving management problems.

Outline for this Course Microeconomics Way of Thinking Sellers, Production, Costs Consumers, Value and Demand Markets and Pricing

What will we learn? useful economic principles for sound economic decision-making in a management context. the basics of the demand side of the market and which factors influence the buyers’ behavior. the fundamentals of the market’s supply side -laws of production and how these laws impact a firm’s costs. how firms’ costs and buyers’ demand together determine the firm’s price and net profit.