The Fundamentals of Managerial Economics
What is Managerial Economics?
• Managerial economics is a valuable tool for analysing business situations. It is a tool to help managers make better decision.
• Why is managerial economics so valuable to a diverse group of decision makers?
• In order to understand about
managerial economics and why it is so valuable, we need to know the meaning of
the term Manager and Economics.
“Manager” in Managerial Economics Who is “the Manager”?
• A person who directs resources (whether its people, money, machine, etc) to achieve a stated goal (growth, revenue, profit etc)
• Directs the efforts of others (followers, common people, employees etc)
• Purchases inputs used in the production of output.
• Directs the product price or quality decisions.
“Economics” in Managerial Economics What is Economics?
• The science of making decisions in the presence of scarce (limited) resources.
• Resources are used to produce a good or service.
• Economic Decisions are important because there are trade-offs between scarcity and competition.
So, what is Managerial Economics
• It is the study to understand how to direct scarce resources (such as capital, assets, people etc) in the way that most efficiently achieves a managerial goal.
• That goal could be lower cost, higher revenue, and higher profit.
What is Managerial Economics
• Managerial Economics help firms make difficult business decision such as:
• Whether it should purchase components from other manufacturers or produce them within the firm?
• Whether it should specialize in making one type of computer or produce several different types?
• How many computers should it produces, and at what price should it sells them?
MANAGERIAL ECONOMICS AS A TOOL FOR DECISION MAKING
Using economics to manage organization effectively
Managerial Economics a Valuable Tool
• Dear students, now you know what is "Manager", "Economics" and "Managerial Economics".
• Now we need to understand how managerial economics is a valuable tool for analyzing business situations
Economics of Effective Management
What is the use of economics for effective business management?
Since this course is designed for you as managers of firms or businesses, we focus on studying the usage of economics for effective managerial decisions as they relate to maximising profits or the value of the firm.
Economics of Effective Management
• What are the basic Economic Principles for Effective Management?
• We will go through each principle to understand
what can influence the economic decisions.
• It begins with identify goals
and constraints
• Sound decisions must have well-defined goals.
• The decision maker often faces constraints that affect the ability to achieve a goal.
• For example, if your goal is to maximise your grade in this course rather than maximise your overall grade point average, your study habits will differ accordingly.
The Goal of Maximizing Profits
• The goal of maximising profits requires a decision about the optimal price for a product.
• Total Sales (Revenue) = Price x Unit of Product/Services Sold
• Profit = Sales – Cost
• The managers should decide how much to produce, use of technology, input use, and how to react to the decision made by competitors.
Accounting Profit vs. Economic Profit
Accounting Profit
• The total amount of money taken in from sales (total revenue) minus the dollar cost of producing goods and services.
• Accounting Profit = Sales – Cost of Producing Goods and Services Economic Profit
• The difference between the total revenue (sales) and the total opportunity cost of producing the firm's goods or services.
• Economic Profit = Total Revenue – Total Opportunity Cost of Producing Goods and Services.
Opportunity Cost
• The opportunity cost of using a resource includes both explicit (or accounting cost) and implicit cost of giving up the best alternative use of the resource.
• Implicit costs are very hard to measure and therefore managers often overlook them.
Explicit Cost vs. Implicit Cost
• For example, an employee could take a vacation and travel.
• The explicit costs would include travel expenses, the cost of a hotel room, and costs related to entertainment.
• The implicit costs relate to the tradeoff, namely the wages that the employee could have earned if the vacation was not taken.
Opportunity Cost
• Profits signal to resource holders where resources are most highly valued by society.
• To know more on this, you may refer to the textbook on the role of profits.
FRAMEWORK FOR SUSTAINABLE INDUSTRY PROFITS 5 Porter Forces
Framework for Sustainable Industry Profits
• Michael Porter’s “five forces” framework organises many complex managerial economics issues into five categories or “forces” that impact the sustainability of industry profits:
• Entry
• Power of Input suppliers
• Power of buyers
• Industry rivalry
• Substitutes and Complements
Five Forces and Industry Profitability
Power of Input Suppliers
·Supplier Concentration
·Price/Productivity of Alternative Inputs
·Relationship-Specific Investments
·Supplier Switching Costs
·Government Restraints Power of Buyers
·Buyer Concentration
·Price/Value of Substitute Products or Services
·Relationship-Specific Investments
·Customer Switching Costs
·Government Restraints Entry Industry Rivalry
·Concentration
·Price, Quantity, Quality, or Service Competition
·Degree of Differentiation Level, Growth, and Sustainability of Industry Profits
·Entry Costs
·Speed of Adjustment
·Sunk Costs
·Economies of Scale
·Network Effects
·Reputation
·Switching Costs
·Government Restraints Substitutes & Complements
·Price/Value of Surrogate Products
·Network Effects or Services
·Government
·Price/Value of Complementary Restraints Products or Services
·Switching Costs
·Timing of Decisions
·Information
·Government Restraints
Five Forces and Industry Profitability Based on Michael Porter's Five Forces Framework, you may refer to the descriptions below for each of the elements:
Entry
• More competition and reduces the margins of existing firms in the wide variety of industry settings.
• Sustainable profits of existing firms depend on barriers to entry.
Five Forces and Industry Profitability Power of Input Suppliers
• Industry profits tend to be lower when suppliers have the power to negotiate favorable terms for their inputs.
Power of Buyers
• Industry profits tend to be lower when customers have the power to negotiate favorable terms for the products or services produced in the industry.
Five Forces and Industry Profitability Industry Rivalry
• Sustainability of industry profits depends on the nature and intensity of rivalry among firms. The rivalry is less in the concentrated industries. Substitutes and complements
• Industry profits also depend on the price and value of interrelated products and services.
ECONOMIC INCENTIVES
Understanding Incentives
• Changes in profits (growth in profit) provide an incentive to how resource holders use their resources.
• Economic incentives are what motivates you to behave in a certain way, while preferences are your needs, wants and desires. Economic incentives provide you the motivation to pursue your preferences. • People respond to Incentives
Understanding Incentives
• Within a firm, incentives impact how resources are used and how hard workers work.
• One role of a manager is to construct incentives to induce maximal effort from employees.
• Salary
• Commission
• Bonus
• Many professionals and owners of small establishments have difficulties because they do not fully comprehend the importance of the role incentives play in guiding the decisions of others
What is a Market?
• Market transaction has two sides:
• Buyer.
• Seller.
• Bargaining position of consumers and producers is limited by three rivalries in economic transactions: • Consumer-producer rivalry.
• Consumer-consumer rivalry.
• Producer-producer rivalry.
Role of Government in a Market
• What is the role of the government to regulate the market?
• When agents on either side of the market find themselves disadvantaged in the market process, they attempt to induce the government to intervene on their behalf.
• Can the Government run the Economy?
TIME VALUE OF MONEY
The Time Value of Money
• Dear students, we now discuss how managers can use present value analysis to properly account for the timing of many decisions involves a gap between the time when the costs of a project are borne and the time when the benefits of the project are received.
• Managers can use present value analysis to properly account for the timing of receipts and expenditures.
• Time value of money – concept of present value
Present Value Analysis
• The amount that would have to be invested today at the prevailing interest rate to generate the given future value.
• Present value of a future value
• The amount that would have to be invested today at the prevailing interest rate to generate the given future value: 𝑃𝑉= 𝐹𝑉/(1+𝑖)↑ 𝑛
• Present value reflects the difference between the future value and the opportunity cost of waiting: 𝑃𝑉= 𝐹𝑉− 𝑂𝐶𝑊
The Time Value of Money
• Consider a project that returns the following income stream:
• Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.
• At an annual interest rate of 3 percent, what is the present value of this income stream? 𝑃𝑉=$10,000/(1+0.03)↑1 +$50,000/(1+0.03)↑2 +$100,000/ (1+0.03)↑3 =$148,352.70
Present Value Analysis
• The higher the interest rate, the higher the opportunity cost of waiting to receive a future amount and thus the lower the present value of the future amount.
Net Present Value
• The present value of the income stream generated by a project minus the current cost of the project:
• Given the present value of the income stream that arises from a project, one can easily compute the net present value of the project. Profit maximization principle
• Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits.
MARGINALANALYSIS
Understanding Marginal Analysis
• Dear Students, Marginal analysis is the important concept in economics.
• What is marginal analysis?
• The marginal analysis states that optimal managerial decisions involve comparing the marginal (or incremental) benefits of a decision with the marginal (or incremental) costs.
• Given a control variable, , denote the
• total benefit as , total benefits derived from Q units.
• total cost as , representing the total costs of corresponding level of Q.
Understanding Marginal Analysis
• Marginal benefit refers to what people are willing to give up in order to obtain one more unit of a good, while;
• marginal cost refers to the value of what is given up in order to produce that additional unit.
• Additional units of a good should be produced as long as marginal benefit exceeds marginal cost.
• Manager’s objective is to maximize net benefits (produce goods at maximum profit)
• Marginal Analysis Video
Marginal Analysis
• How can the manager maximize net benefits?
• Use marginal analysis
• Marginal benefit: 𝑀𝐵( 𝑄)
• The change in total benefits arising from a change in the managerial control variable, 𝑄.
• Marginal cost: 𝑀𝐶( 𝑄)
• The change in the total costs arising from a change in the managerial control variable, 𝑄.
• Marginal net benefits: 𝑀𝑁𝐵( 𝑄) 𝑀𝑁𝐵( 𝑄)= 𝑀𝐵( 𝑄)− 𝑀𝐶( 𝑄)
Marginal Analysis Principle
• Marginal principle
• To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs.
• At this level (MB = MC) marginal net benefits are zero; nothing more can be gained by further changes in that variable.
Figure below depicts the marginal benefits, marginal costs, and marginal net benefits. Quantity (Control Variable) Total benefits Total costs 0 𝐵( 𝑄) 𝐶( 𝑄) Maximum total benefits Maximum net benefits
Determining the Optimal Level of a Control Variable II 1-44 Quantity (Control Variable) Net benefits 0 Maximum net benefits Slope = 𝑀𝑁𝐵( 𝑄) 𝑁( 𝑄)= 𝐵( 𝑄)− 𝐶( 𝑄)=0
Determining the Optimal Level ofa Control Variable III Quantity (Control Variable) Marginal benefits, costs and net benefits 0 𝑀𝐶( 𝑄) 𝑀𝐵( 𝑄)𝑀𝑁𝐵( 𝑄) Maximum net benefits
Maximum Total Benefits
• At the level Q where the marginal benefit curve intersects the marginal cost curve, marginal net benefits are zero. That level Q maximizes net benefits.
Key Terms and Concepts
Review the following key concepts and terms
Economics
• Trade offs
• Opportunity costs
• Implicit costs and explicit costs
• Economic profits and accounting profits
• Marginal benefits and marginal costs
• Present value and net present value
• Time value of money
• Porter’s five forces