Nature and Scope of Managerial

Economics
• Definition of Managerial Economics

• Relationship to other fields of Study

– Relationship to the Economic Theory

– Relationship to the Decision Sciences
– Relationship to the Functional Areas of Business
Administration Studies
 Definition of Managerial Economics
• Salvatore defines as;
“Managerial economics refers to the application of
economic theory and the tools of analysis of decision
science to examine how an organization can achieve
its objectives most efficiently.”

• Douglas defines as;

“Managerial economics is the application of
economic principles and methodologies to the
decision-making process within the firm or
organization.”
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• It can be seen as a means to an end by managers,
in terms of finding the most efficient way of
allocating their scarce resources and reaching
their objectives.

• As an approach to decision-making, managerial

economics is related to economic theory,
decision sciences and business functions.
• This definition can be well explained with the help of
following diagram;
 Management Decision Problems
Examples:
•A hospital may seek to treat as many patients as possible at an
adequate medical standard with its limited physical resources (i.e.
physicians, technicians, nurses, equipment, beds etc.) and budget.

•The goal of a state university may provide an adequate education

to as student as possible subject to the physical and financial
constraints it faces.
 Relationship to Economic Theory
• Economic theory seeks to predict and explain
economic behaviour. It begins with a model, which is
the abstract of many details surrounding an event
and seeks to identify a few of the most important
determinants of the event.

• For example, economic theory assumes that firm

seeks to maximize profits, thus it predicts how much
of particular commodity the firm should produce
under different form of market structure.
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• Economic theory is mainly divided into microeconomics and
macroeconomics.

• Microeconomics is the study of the economic behaviour of

individual decision-making units –individual consumers,
resource owners, and business firms in an economy.

• Macroeconomics is the study of the total or aggregate level

of output, income, employment, consumption, investment,
and prices for the economy viewed as a whole.
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• The main branch of economic theory with which
managerial economics is related is microeconomics. In
particular, the following aspects of microeconomic
theory are relevant:

• theory of the firm

• theory of consumer behaviour (demand)
• production and cost theory (supply)
• price theory
• market structure and competition theory
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• There is one main difference between the emphasis
of microeconomics and that of managerial
economics:

• the former tends to be descriptive, explaining how

markets work and what firms do in practice
(managerial economics)

• while the latter is often prescriptive, stating what

firms should do, in order to reach certain objectives
(microeconomics)
 Relationship to Decision Sciences
• The decision sciences provide the tools and techniques of
analysis used in managerial economics.

• Decision Sciences comprise of mathematical economics

and econometrics.

• Mathematical Economics expresses and analyzes

economic models using the tools of mathematics.

• Econometrics employs statistical methods to estimate

and test economic models using empirical data.
 Relationship to Functional Areas of
Business Administration
• Functional areas of business administration
studies include accounting and finance,
marketing, human resource management and
production.

• These disciplines study the business

environment in which the firm operates and
therefore the background for managerial
decision making.
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• For example
• A production department may want to plan and schedule
the level of output for the next quarter,

• the marketing department may want to know what price

to charge and how much to spend on advertising,

• the finance department may want to determine whether

to build a new factory to expand capacity, and
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• the human resources department may want to
know how many people to hire in the coming
period and what it should be offering to pay
them.

• All of these functional areas can apply the

theories and method in the context of the
particular situation and tasks that they have to
perform.
 Conclusion
• Managerial economics can be regarded as an
overview course that integrates economic theory,
decision sciences, and the functional areas of
business administration studies and examines how
they interact with one another as the firm attempts
to achieve its goal most efficiently.
 Basic process of decision making
• It is important to note that the goals and constraints
may differ from case to case, however the basic
decision-making process is the same as it can be
divided into five basic steps;

1. Define the problem.

2. Determine the objective
3. Identify possible solutions
4. Select the best possible solution
5. Implement the decision
 Nature of Managerial Economics;
A further note
• Managerial Economics is micro-economic in character.

• Managerial Economics largely uses that body of

economic concepts and principles, which is known as
'Theory of the firm' or 'Economics of the firm'.

• Managerial Economics is pragmatic. It avoids difficult

abstract issues of economic theory but involves
complications ignored in economic theory to face the
overall situation in which decisions are made.
 Scope of Managerial Economics
• The scope of economics can further be understood
with following;

• Demand and Supply analysis: It deals with various

aspects of demand and supply of a commodity.
Certain important aspects of demand and supply
analysis are demand and supply schedules, curves
and functions, law of demand and supply and their
limitations, elasticity of demand and supply and
factors influencing demand and supply.
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• Production analysis: microeconomic techniques are
used to analyse production efficiency, optimum factor
allocation, costs, economies of scale and to estimate the
firm's cost function.

• Pricing analysis: Pricing is a very important area of

Managerial Economics. In fact, the success of a business
firm largely depends on the correctness of the prices
decisions taken by it. The important aspects dealt with
under this area are :- Price Determination in various
Market Forms, Pricing methods, Differential Pricing,
Product-line Pricing and Price Forecasting.
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• Capital budgeting: Investment theory is used to examine
a firm's capital purchasing decisions

• Risk analysis: various uncertainty models, decision rules,

and risk quantification techniques are used to assess the
riskiness of a decision.
 Importance of managerial economics
• Managerial economics has been receiving more
attention in business as managers become more aware
of its potential as an aid to decision-making, and this
potential is increasing all the time. This is happening for
several reasons:

• It is becoming more important for managers to make

good decisions and to justify them, as their
accountability either to senior management or to
shareholders increases.
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• As the number and size of multinationals
increases, the costs and benefits at stake in the
decision-making process are also increasing.

• In the age of plentiful data it is more imperative

to use quantitative and rationally based
methods, rather than ‘intuition’.
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• The pace of technological development is increasing with
the impact of the ‘new economy’. There is no doubt that
there is an increased need for economic analysis because
of the greater uncertainty and the need to evaluate it.

• Improved technology has also made it possible to

develop more sophisticated methods of data analysis
involving statistical techniques.
 1-23

Profits as a Signal
• Profits signal to resource holders where
resources are most highly valued by society.
– Resources will flow into industries that are most
highly valued by society.
 The Five Forces Framework 1-24

Entry Costs Entry Network Effects

Speed of Adjustment Reputation
Sunk Costs Switching Costs
Economies of Scale Government Restraints

Sustainable Industry
Power of Profits Power of
Input Suppliers Buyers
Supplier Concentration Buyer Concentration
Price/Productivity of Price/Value of Substitute
Alternative Inputs Products or Services
Relationship-Specific Relationship-Specific
Investments Investments
Supplier Switching Costs Customer Switching Costs
Government Restraints Government Restraints

Industry Rivalry Substitutes & Complements

Concentration Switching Costs Price/Value of Surrogate Network Effects
Price, Quantity, Quality, or Timing of Decisions Products or Services Government
Service Competition Information Price/Value of Complementary Restraints
Degree of Differentiation Government Restraints Products or Services
 1-25

Understanding Firms’ Incentives

• Incentives play an important role within the firm.
• Incentives determine:
– How resources are utilized.
– How hard individuals work.
• Managers must understand the role incentives play
in the organization.
• Constructing proper incentives will enhance
productivity and profitability.
 1-26

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.
 1-27

The Time Value of Money

• Present value (PV) of a future value (FV) lump-

sum amount to be received at the end of “n”
periods in the future when the per-period interest
rate is “i”:
FV
PV 
1  i  n

• Examples:

Lotto winner choosing between a single lump-sum payout of
$104 million or $198 million over 25 years.

Determining damages in a patent infringement case.
 1-28

Present Value vs. Future Value

• The present value (PV) reflects the difference
between the future value and the opportunity
cost of waiting (OCW).
• Succinctly,
PV = FV – OCW
• If i = 0, note PV = FV.
• As i increases, the higher is the OCW and the
lower the PV.
 1-29

Present Value of a Series

• Present value of a stream of future amounts (FVt)

received at the end of each period for “n” periods:
F V1 FV2 FVn
PV    ...
1  i  1
1  i  2
1  i  n

• Equivalently,
n
FVt
PV 
t 1 1  i 
t
 1-30

Net Present Value

• Suppose a manager can purchase a stream of

future receipts (FVt ) by spending “C0” dollars today.
The NPV of such a decision is
F V1 FV2 FVn
NPV    ...  C0
1  i  1
1  i  2
1  i  n

Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept project
 1-31

Marginal (Incremental) Analysis

• Control Variable Examples:
– Output
– Price
– Product Quality
– Advertising
– R&D
• Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
 1-32

Net Benefits
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue - Costs
 1-33

Marginal Benefit (MB)

• Change in total benefits arising from a change

in the control variable, Q:
B
MB 
Q
• Slope (calculus derivative) of the total benefit
curve.
 1-34

Marginal Cost (MC)

• Change in total costs arising from a change in

the control variable, Q:
C
MC 
Q
• Slope (calculus derivative) of the total cost
curve
 1-35

Marginal Principle
• To maximize net benefits, the managerial
control variable should be increased up to
the point where MB = MC.
• MB > MC means the last unit of the control
variable increased benefits more than it
increased costs.
• MB < MC means the last unit of the control
variable increased costs more than it
increased benefits.
 The Geometry of Optimization: Total
1-36

Benefit and Cost

Total Benefits Costs
& Total Costs
Benefits
Slope =MB

B
Slope = MC
C

Q* Q
 The Geometry of Optimization: Net
1-37

Benefits
Net Benefits

Maximum net benefits

Slope = MNB

Q* Q
 1-38

Conclusion
• Make sure you include all costs and
benefits when making decisions
(opportunity cost).
• When decisions span time, make sure you
are comparing apples to apples (PV
analysis).
• Optimal economic decisions are made at
the margin (marginal analysis).
• Present value analysis is also useful in
determining the value of a firm, since the value of
a firm is the present value of the stream of profits
(cash flows) generated by the firm’s physical,
human, and intangible assets. In particular, if p0 is
the firm’s current level of profits, then p1 is next
year’s profit, and so on. Therefore, the value of
the firm is:
• In other words, the value of the firm today is the present
value of its current and future profits. To the extent that
the firm is a “going concern” that lives on forever even
after its founder dies, firm ownership represents a claim to
assets with an indefinite profit stream. Notice that the
value of a firm takes into account the long-term impact of
managerial decisions on profits. When economists say that
the goal of the firm is to maximize profits, it should be
understood to mean that the firm’s goal is to maximize its
value, which is the present value of current and future
profits