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Collection Highlights

Managerial Economics & Business Strategy 9th Edition Jeff

Prince

Managerial Economics & Business Strategy, 10e ISE Michael

R. Baye

Managerial Economics Hirschey

Introducing Translation Studies Theories and Applications

5th Edition Jeremy Munday
The Pilgrim s Progress John Bunyan

How Dreams Speak An Interactive Journey into Your

Subconscious 150 Symbols Illustrated and Fully Explained
Nicole Chilton

What She Didn't See 1st Edition Angela C Nurse

The Making of Migration The Biopolitics of Mobility at

Europe s Borders 1st Edition Tazzioli Martina

Quantitative Equity Portfolio Management: An Active

Approach to Portfolio Construction and Management, 2nd
Edition Ludwig B. Chincarini
How AI Works From Sorcery to Science 1st Edition Ronald T
Kneusel
1
Chapter 1
Introduction
An Economist’s Theory of Reincarnation: If you’re good, you come back

on a higher level. Cats come back as dogs, dogs come back as horses, and
people—if they’ve been very good like George Washington—come back as
money.

If all the food, clothing, entertainment, and other goods and services

we wanted were freely available, no one would study economics, and

we would not need managers. However, most of the good things in life
are scarce. We cannot have everything we want. Consumers cannot

consume everything but must make choices about what to purchase.

Similarly, managers of firms cannot produce everything and must

make careful choices about what to produce, how much to produce,

and how to produce it. Studying such choices is the main subject
matter of economics. Economics  is the study of decision making in
the presence of scarcity.1

Managerial economics  is the application of economic analysis to

managerial decision making. It focuses on how managers make

economic decisions by allocating the scarce resources at their disposal.

To make good decisions, a manager must understand the behavior of

other decision makers, such as consumers, workers, other managers,

and governments. In this book, we examine decision making by such
participants in the economy, and we show how managers can use this

understanding to be successful.

 Learning Objectives

1. Describe the major business decisions managers face. 

2. Explain how economic models are useful in managerial

decision making. 

3. Illustrate how a knowledge of economics can help your

career. 
 1.1 Managerial Decision
Making
A firm’s managers allocate the limited resources available to them to
achieve the firm’s objectives. The objectives vary for different
managers within a firm but each managerial task is constrained by
resource scarcity. At any moment in time, a production manager has to

use the existing factory and a marketing manager has a limited

2
marketing budget. Such resource limitations can change over time, but

managers always face constraints.

Profit
The main objective of most private-sector firms is to maximize profit,
which is the difference between revenue and cost. Senior managers of

a firm might have other concerns as well, including social

responsibility and personal career objectives. However, the primary

responsibility of senior managers to the owners of the firm is to focus

on the bottom line: maximizing profit.

Managers have a variety of roles in the profit maximization process.

The production manager seeks to minimize the cost of producing a

particular good or service. The market research manager determines

how many units of any particular product can be sold at a given price,
which helps to determine how much output to produce and what price

to charge. The research and development (R&D) manager supervises

the development of new products that will be attractive to consumers.

The most senior manager, usually called the chief executive officer
(CEO), coordinates the firm’s managerial functions and sets its overall

strategy.
Trade-Offs
People and firms face trade-offs because they can’t have everything.

Managers must focus on the trade-offs that directly or indirectly affect

profits. Evaluating trade-offs often involves marginal reasoning:
considering the effect of a small change. Key trade-offs include:

How to produce: To produce a given level of output, a firm trades

off inputs, deciding whether to use more of one and less of

another. Car manufacturers choose between metal and plastic for

many parts, which affects the car’s weight, cost, and safety.

What prices to charge: Some firms, such as farms, have little or no

control over the prices at which their goods are sold and must sell

at the price determined in the market. However, many other firms

set their prices. When a manager of such a firm sets the price of a

product, the manager must consider whether raising the price by a

dollar increases the profit margin on each unit sold by enough to

offset the loss from selling fewer units. Consumers, given their

limited budgets, buy fewer units of a product when its price rises.

Thus, ultimately, the manager’s pricing decision is constrained by

the scarcity under which consumers make decisions.

Whether to innovate: One of the major trade-offs facing managers

is whether to maximize profit in the short run or in the long run.

For example, a forward-looking firm may invest substantially in

innovation—designing new products and better production
methods—which lowers profit in the short run, but may raise profit

in the long run.

 Other Decision Makers
It is important for managers of a firm to understand how the decisions

3
made by consumers, workers, managers of other firms, and
governments constrain their firm. Consumers purchase products
subject to their limited budgets. Workers decide on which jobs to take

and how much to work given their scarce time and limits on their

abilities. Rivals may introduce new, superior products or cut the prices
of existing products. Governments around the world may tax,

subsidize, or regulate products.

Interactions between economic decision makers take place primarily in

markets. A market  is an exchange mechanism that allows buyers to

trade with sellers. A market may be a town square where people go to

trade food and clothing, or it may be an international

telecommunications network over which people buy and sell financial

securities. When we talk about a single market, we refer to trade in a

single good or group of goods that are closely related, such as soft

drinks, movies, novels, or automobiles. The primary participants in a

market are firms that supply the product and consumers who buy it,

but government policies such as taxes also play an important role in

the operation of markets.

Strategy
When competing with a small number of rival firms, senior managers

consider how their firm’s products are positioned relative to those of

its rivals. The firm uses a strategy—a battle plan that specifies the
actions or moves that the firm will make to maximize profit. A strategy

might involve choosing the level of output, the price, or the type of

advertising now and possibly in the future. For example, in setting its
production levels and prices, Pepsi’s managers must consider what

choices Coca-Cola’s managers will make. One tool that is helpful in

understanding and developing such strategies is game theory, which we

use in several chapters.

1.2 Economic Models
Economists use economic models to explain how managers and
other decision makers make decisions and to interpret the result-
ing market outcomes. A model  is a description of the relation-

ship between two or more variables. Models are used in many

fields. For example, astronomers use models to describe and pre-
dict the movement of comets and meteors, medical researchers

use models to describe and predict the effect of medications on

diseases, and meteorologists use models to predict weather.

Business economists construct models dealing with economic

variables and use such models to describe and predict how a

change in one variable will affect another variable. Such models

are useful to managers in predicting the effects of their decisions

and in understanding the decisions of others. Models allow man-

agers to consider hypothetical situations—to use a what-if analysis

—such as “What would happen if we raised our prices by 10%?” or

“Would profit rise if we phased out one of our product lines?”

Models help managers predict answers to what-if questions and

to use those answers to make good decisions.

Mini-Case

Using an Income Threshold Model in China

According to the income threshold model, people whose

incomes are below a threshold do not buy a particular

consumer durable, while many people whose income ex-

ceeds that threshold buy it.

If this theory is correct, we predict that, as most people’s

incomes rise above the threshold in lower-income coun-

tries, consumer durable purchases will increase from near

zero to large numbers virtually overnight. This prediction

is consistent with evidence from Malaysia, where the in-

come threshold for buying a car is about $4,000.

In China, incomes have risen rapidly and now exceed the

threshold levels for many types of durable goods. In re-

sponse to higher incomes, Chinese car purchases have

taken off.

For example, Li Rifu, a 46-year-old Chinese farmer and

watch repairman, thought that buying a car would im-

prove the odds that his 22- and 24-year-old sons would

find girlfriends, marry, and produce grandchildren. Soon

after Mr. Li purchased his Geely King Kong for the equiva-
lent of $9,000, both sons met girlfriends, and his older son

got married.

Given the rapid increase in Chinese incomes in the past

couple of decades, four-fifths of all new cars sold in China
are bought by first-time customers. An influx of first-time

buyers was responsible for Chinese car sales increasing

by a factor of nearly 18 between 2000 and 2017. In 2005,

China produced fewer than half as many cars as the Unit-

ed States. In 2017, China was by far the largest producer
 of cars in the world. It produced nearly three times as
many cars as the United States—the second largest pro-
ducer—as well as 39% more than the entire European

Union. One out of every three cars in the world is pro-

duced in China.2

Simplifying Assumptions

Everything should be made as simple as possible, but not simpler.

—Albert Einstein

A model is a simplification of reality. The objective in building a

model is to include the essential issues, while leaving aside the

many complications that might distract us or disguise those essen-

tial elements. For example, the income threshold model focuses
on only the relationship between income and purchases of

durable goods. Prices, multiple car purchases by a single con-

sumer, and other factors that might affect durable goods purchas-

es are left out of the model. Despite these simplifications, the

model—if correct—gives managers a good general idea of how the
automobile market is likely to evolve in countries such as China.

We have described the income threshold model in words, but we

could have presented it using graphs or mathematics. Represent-
ing economic models using mathematical formulas in spread-

sheets has become very important in managerial decision making.

Regardless of how the model is described, an economic model is a
simplification of reality that contains only its most important fea-
tures. Without simplifications, it is difficult to make predictions
because the real world is too complex to analyze fully.

Economists make many assumptions to simplify their models.

When using the income threshold model to explain car purchas-
ing behavior in China, we assume that factors other than income,
such as the color of cars, do not have an important effect on the

decision to buy cars. Therefore, we ignore the color of cars that

are sold in China in describing the relationship between income
and the number of cars consumers want. If this assumption is cor-
rect, by ignoring color, we make our analysis of the auto market

simpler without losing important details. If we’re wrong and these

ignored issues are important, our predictions may be inaccurate.
Part of the skill in using economic models lies in selecting a mod-
el that is appropriate for the task at hand.
Testing Theories
Blore’s Razor: When given a choice between two theories, take the one

that is funnier.

Economic theory refers to the development and use of a model to

formulate hypotheses, which are proposed explanations for some

phenomenon. A useful theory or hypothesis is one that leads to clear,

testable predictions. A theory that says “If the price of a product rises,

the quantity demanded of that product falls” provides a clear

prediction. A theory that says “Human behavior depends on tastes, and

tastes change randomly at random intervals” is not very useful because

it does not lead to testable predictions.

Economists test theories by checking whether the theory’s predictions
are correct. If a prediction does not come true, they might reject the

theory—or at least reduce their confidence in the theory. Economists

use a model until it is refuted by evidence or until a better model is

developed for a particular use.

A good model makes sharp, clear predictions that are consistent with

reality. Some very simple models make sharp or precise predictions

that are incorrect. Some more realistic and therefore more complex

models make ambiguous predictions, allowing for any possible

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