Maryland International

College

Managerial Economics

Chapter One
Introduction to Managerial Economics
Course Description
• This course is designed to develop students‘ capacity
• to analyse the economic environments in which business entities
operate and
• To understand how managerial decisions can vary under different
constraints that each economic environment places on a manager‘s
pursuit of his/her goals.
• The course, having the set of mathematical techniques and
economic theories and principles,
• will give students a deeply grounded insight on such matters as to
what combination of those theories and techniques should they
employ in what situations in making attempts to address managerial
problems.
Course Objectives
At the end of this course, students should be able to:

- illustrate the application of economic theory and methodology as an alternative in

managerial decisions.

- provide students with a basic foundation of economic concepts and tools that
have direct managerial applications.

- sharpen analytical skills of students through integrating knowledge of economic

theory with decision making techniques.

- help students become more skilful at designing and developing business strategy
at firm level.

- gain a rigorous understanding of competitive markets as well alternative market

structures.
Course Content
I. Introduction to Managerial Economics

II. Demand Analysis and Optimal Pricing

I. Fundamental Economic Concepts and Optimization Techniques

III. Decision Making Under Risk and Uncertainty

IV. Production and Cost Analysis

V. Market Structures: Price and Output Determination

 Chapter One
Introduction to Managerial Economics
Content
• Definition, Managerial Issues,
• Theory of the Firm
• Decision Making
 Definition
Many definitions have been given about managerial economics.

Most of them consider it as the application of economic theory and methods to

business decision-making.
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.

Managerial Economics is economics applied in decision-making.

It is a special branch of economics bridging the gap between the economic theory and
managerial practice.
Its stress is on the use of the tools of economic analysis in clarifying problems in
organizing and evaluating information and in comparing alternative courses of action
 Theory of the FIRM
A. Theory of the Firm
• It is the microeconomic concept founded in neoclassical economics that states that a
firm exists and make decisions to maximize profits.
• The theory holds that the overall nature of companies is to maximize profits
meaning to create as much of a gap between revenue and costs.
• The firm's goal is to determine resource allocation, production, pricing
and demand within the market and allocate resources to maximize net
profits.
• the theory has been debated and expanded to consider whether a company's goal is
to maximize profits in the short-term or long-term.
– If a company's goal is to maximize short-term profits it might find ways to boost
revenue and reduce costs.
– However, companies need to make capital investments to ensure profitable in the
long-term.
– cash investment in assets would hurt short-term profits but help with the long-term
viability
– If competition is strong, long-term profits could only be maximized if there's a
balance between short-term profits and investing in the future.
Theory of the FIRM – basic business model
B. Role and Function of a FIRM
In Economics, Producers – often referred to as firms or companies play a role in using
Inputs (different factors of production) and Producing Goods and Services (Output).

Role/ Function of Firms:

1. deciding what to produce and how to produce.
2. production or acquiring inputs that the firm intends to sell
3. market and sell its output or the products that it has obtained
4. Finance the firm's activities of acquiring and selling or the controlling the
financial
5. Investing in capital and new technology to provide new goods and services for
the consumer in given country
…theory of the FIRM
 Firms
 are major economic institutions in market economies.
 have the following common characteristics:
 Owners, Managers, Objectives, pool of resources (labor, physical capital, financial capital
and learned skills and competences)
 Administrative or organizational structures through which production is organized.
 Performance assessment by owners, managers and other stakeholders.
 Whatever its size, a firm is owned by someone or some group of individuals or
organizations.
 shareholders and they are able to determine the objectives and activities
 appoint managers who will make day-to-day decisions.
 owners bear the risks associated with operating the firm and have the right to receive the
residual income
 The divorce between ownership and control and its implication for the operation and performance
of the firm is at the centre of many of the managerial economics decision making - Principal Agent
problem
…theory of the FIRM
Decision making units in economic activities
(Consumers, Producers and Government)
…theory of the FIRM
C. What is Profit?
•Profit - is the surplus revenue after a firm has paid all its costs.
•Profit - can be seen as the monetary reward to shareholders and owners of a
business.
•A firm may seek short-run profit maximization and under-invest in the long-
term.
– In a capitalist economy, profit plays an important role in creating
incentives for business and entrepreneurs.
– For any big firm, the reward of higher profit will encourage them to try and
cut costs and develop new products.
• If an industry is profitable, it will encourage new firms to enter.
• If a firm becomes unprofitable, it will either have to adapt and change or
close down.
…theory of the FIRM
– This profit motive can help increase efficiency, provide greater
choice for consumers and allocate resources according to consumer
preferences.
The Role of profits
…theory of the FIRM
•Michael Porter’s “Five Competitive Forces”:

•factors that influence the sustainability of firm profits

 Market entry conditions for new firms
 Market power of input suppliers
 Market power of product buyers
 Market rivalry amongst current firms
 Price and availability of related products including both ‘substitutes’ and
‘complements’
…theory of the FIRM
Types of Profits
1. Frictional profit theory - Abnormal profits observed following unanticipated
changes in demand or cost conditions
2. monopoly profit theory - Above-normal profits caused by barriers to entry that
limit competition
- Due to economies of scale, high capital requirements, patents, or import protection
3. innovation profit theory - Above-normal profits that follow successful invention or
modernization –
- for example, Microsoft Corporation has earned superior rates of return
because it successfully developed, introduced, and marketed the Graphical User
Interface
4. Compensatory profit theory - above-normal rates of return that reward firms for
extraordinary success in meeting customer needs, maintaining efficient operations
- If firms that operate at the industry’s average level of efficiency receive normal
rates of return, it is reasonable to expect firms operating at above-average levels of
efficiency to earn above-normal rates of return.
 …theory of the FIRM
D. Profit Maximization
• An assumption in classical
economics is that firms
seek to maximize profits.
– Profit = Total Revenue
(TR) – Total Costs (TC).
• Therefore, profit
maximization occurs at
the biggest gap between
total revenue and total
costs.
• A firm can maximize
profits if it produces at an
output ; whereby:-
– Marginal Revenue (MR) =
Marginal Cost (MC)
…theory of the FIRM
•Profits Maximization Basics

• Profit maximization is not entirely without merit.

– If a company is not turning out high enough a profit, it risks falling
behind in its growth and losing market share to competitors.
– Most investors do care a great deal about the profit statements of any
company and will try and invest their money accordingly.
– To attract additional investment, a company must demonstrate not
only a long-term business plan, but immediate short-term success.
…theory of the FIRM
•Sales Revenue Maximization
•The model was developed by Baumol (1959) who argued that
managers have discretion in setting goals and that sales revenue
maximization was a more likely short-run objective than profit
maximization firms.
•The reasons are as follows:
Sales revenue is a more useful short-term goal for the firm than profit.
Sales are measurable and can be used as a specific target to motivate staffs,
Specific sales targets are thought to be clearly understood by all within the firm.
Rewards for senior managers are often tied to sales revenue rather than profit,
It is assumed that an increase in revenue will more than offset any associated
increases in costs, so that additional sales will increase profit
…theory of the FIRM
Risks of focusing on Profit maximization
• Solely focusing on profit maximization comes with a level of risk in regards to public
perception and a loss of goodwill between the company, consumers, investors, and
the public.
– maximizing profits is not the only driving goal of a company particularly with
publicly held companies
– firms that have issued equity or sold stock have diluted ownership - CEOs
having multiple goals including profit maximization, sales maximization, public
relations, and market share.
– Further risks exist when a firm focuses on a single strategy within the
marketplace to maximize profits. If a company relies on the sale of one
particular good and the product eventually fails within the marketplace, the
company can fall into financial hardship.
– Competition and the lack of investment in its long-term success such as
updating and expanding product offerings can eventually drive a company into
bankruptcy.
…theory of the FIRM
•Limitations of Profit Maximization
 It is not so easy to know exactly your marginal revenue and the marginal cost of last
goods sold.
 For example, it is difficult for firms to know the price elasticity of demand for their good
– which determines the MR.
 It also depends on how other firms react.
 If they increase the price, and other firms follow, demand may be inelastic. But, if they
are the only firm to increase the price, demand will be elastic
 Many firms may have to seek profit maximization through trial and error.
 e.g. if they see increasing price leads to a smaller % fall in demand they will try increase
price as much as they can before demand becomes elastic
 It is difficult to isolate the effect of changing the price on demand.
 Demand may change due to many other factors apart from price.
 Firms may also have other objectives and considerations.
 For example, increasing price to maximize profits in the short run could encourage more
firms to enter the market; therefore firms may decide to make less than maximum
profits and pursue a higher market share.
 Firms may also have other social objectives such as running the firm like a cooperative
 – to maximize the welfare of stakeholders (consumers, workers, suppliers) and not just
profit of owners.
 Profit satisfice . Not optimize
 This occurs when there is separation of ownership and control and where managers do
enough to keep owners happy but then maximize other objectives such as enjoying work
…theory of the FIRM
E. Value Maximization Vs Profit maximization
1) Profit Maximization - is a short-term objective that assure the growth of the
capital , but it neglects risk and uncertainty the company can pass -through in the
future – traditional/classical theory of the firm
• the firm is thought to have profit maximization as its primary goal.
• The firm’s owner-manager is assumed to be working to maximize the firm’s short-
run profits.
2) Value Maximization - is a long- term objective that undertakes safe actions in
order to increase the market value of its common stock over time - more
complete model of a firm
• the value maximization model also offers insight into a firm’s voluntary
“socially responsible” behavior.
• the traditional theory of the firm emphasizes profits and value maximization
while ignoring the issue of social responsibility
…theory of the FIRM
Social Responsibility of Business
• What does all this mean with respect to the value maximization theory of the
firm?
• Is the model adequate for examining issues of social responsibility and for
developing rules that reflect the role of business in society?
• firms are primarily economic entities and can be expected to analyze social
responsibility from within the context of the economic model of the firm.
• close relation between the firm and society indicates the importance of business
participation in the development and achievement of social objectives
…theory of the FIRM
Types of Firms
• Individual entrepreneurs – self-employed individuals
• Private companies – often small/mid-sized companies who are owned by a small
number of individuals.
• Public limited companies – generally large companies who are listed on the stock
market. The public can buy shares in the company and share in their profits.
• Co-operatives/social ventures. Firms which are not targeting profit maximization
but exist to further particular social and economic goals.
• Government-owned companies – In some industries, the largest firms are State-
owned companies.
Chapter Review Questions (Discussion Forum)
1. Are firms primarily an economic entities? Discuss?
2. How would the objectives of
a) a large firm differ from a small owner-managed firm? (give examples/cases)
b) For profit business enterprise and social enterprise differ? (give examples/cases)
c) A public enterprise and private enterprise differ? (give examples/cases)
3. Is it reasonable to expect firms to take actions that are in the
public interest but are detrimental to stockholders? Is
regulation always necessary and appropriate to induce firms
to act in the public interest? Substantiate with real world
examples