MANAGERIAL

ECONOMICS
THE FUNDAMENTALS
INTRODUCTION

• What is economics?

Economics is a social science that deals with the activities of man

which are directly related to the efficient allocation of scarce
resources in order to maximize production for the satisfaction of
human wants.
Economic means scarce.
Economics – is the study about scarcity.
INTRODUCTION

• Give two key words that relate to economics

Wants-
 are the individual’s preferences in satisfying needs.
 are the insatiable desires of human being.
• Why are wants unlimited?
INTRODUCTION

• Give two key words that relate to economics

Scarcity -
 scarce means limited or economic.
 something is scarce when payment or sacrifice is involved
in obtaining it.
 scarcity exists when the demand exceeds what that is available.
 scarcity forces us to make a choice.
INTRODUCTION

• What is decision making?

Decision making means to make a choice

 The study of economics makes a decision maker to act
rationally.
 A rational decision maker chooses an option with the smallest
possible opportunity cost.
INTRODUCTION

• What is opportunity cost?

Opportunity cost is the value of forgone alternatives.

 opportunity cost is closely associated to the word regret.

 regret = payoff of the best option – payoff of a choice.
INTRODUCTION

• What is production possibilities frontier?

PPF shows the maximum combinations of two commodities that the
economy can produce at full employment of its available resources.
 PPF shows the consequence of scarcity to the economy.
 It is impossible to produce more of two commodities at a time, given the
limited resources.
 the points along the PPF curve are the efficient and the attainable combinations.
 A point below the PPF curve is attainable but inefficient combination.
 A point above (outside) the PPF curve are unattainable combinations.
INTRODUCTION

• What are the simplifying assumptions about the economy in examining the PPF?
Simplifying assumptions in examining PPF.
 all available resources are used fully.
 all available resources are used efficiently.
 the quantity and quality of available resources are not changing during our
period of analysis.
 technology is not changing during our period of analysis.
 we can produce only two goods with our available resources and technology.
INTRODUCTION

Table 1.1 Production Possiblities Table

alternatives Bread (tons) Roses (tons)
A 150 0
B 120 20
C 90 40
D 60 60
E 30 80
F 0 100
 INTRODUCTION
Table 1.1
Production
Possiblities Production Possibilities Frontier
160
Table 140

altern Bread Roses 120

atives (tons) (tons) 100

80
A 150 0
60
B 120 20
40
C 90 40 20
D 60 60 0
0 20 40 60 80 100
E 30 80
F 0 100
INTRODUCTION

Production Possibilities Frontier

160
140
120
100 Economic growth
80
60
40
20
0
0 20 40 60 80 100
INTRODUCTION

• How can economic growth be attained?

Given the economy’s scarce resources, economic growth can

be attained through the application of technology.
 Technology can move the economy produce commodities outside its PPF.
 A rightward shift of the PPF indicates economic growth.
 Technology makes the economy to produce more by using few resources.
 Technology refers to the modern technique in producing goods and services.
INTRODUCTION

• What is managerial economics?

Managerial economics is the study of how to direct scarce

resources in the way that most efficiently achieves a managerial goal.
Manager is a person who:

 direct the efforts of others.

 purchase inputs to be used in the production of goods and services.
 are in charge of making other decisions, such as product price or quality.
ECONOMICS OF EFFECTIVE MANAGEMENT

An effective manager must:

• Identify Goals and Constraints
• Recognize the Nature and Importance of Profits
• Understand incentives,
• Understand markets,
• Recognize the time value of money, and
• Use marginal analysis
ECONOMICS OF EFFECTIVE MANAGEMENT

Identify Goals and Constraints

• Setting of well-defined goals – Maximize Profits
 Minimize cost
 Maximize Revenue
ECONOMICS OF EFFECTIVE MANAGEMENT

Identify Goals and Constraints

Example: Resource allocation problem using the graphical linear programming.
Goal or objective: Max Z = 3X + 5Y
Constraints
labor hours: 2X + 3Y < = 200 hrs.
Raw Mat 1 3X + 4Y < = 500 hrs.
ECONOMICS OF EFFECTIVE MANAGEMENT

Identify Goals and Constraints

Example: Resource allocation problem using the graphical linear programming.
Goal or objective: Max Z = 3X + 5Y
Constraints (converting inequality to equality to solve the intercepts)
labor hours: 2X + 1Y = 200 ; (0 , 200) and (100 , 0)
Raw Mat 1 2X + 2Y = 400 ; (0 , 200) and (200 ,0)
ECONOMICS OF EFFECTIVE MANAGEMENT

Identify Goals and Constraints

Example: Resource allocation problem using the graphical linear programming.
Y
Y S1 (0, 200)
200

S2 (100, 0) X
100 200
ECONOMICS OF EFFECTIVE MANAGEMENT

Identify Goals and Constraints

Example: Resource allocation problem using the graphical linear programming.
Goal or objective: Max Z = 3X + 5Y
Soln.
S1 = 3( 0 ) + 5 ( 200 ) = 1000 Optimal solution
S2 = 3( 100 ) + 5 ( 0 ) = 300
ECONOMICS OF EFFECTIVE MANAGEMENT

• Recognize the Nature and Importance of Profits

 Economic versus Accounting Profits
 The Role of Profits
 ECONOMICS OF EFFECTIVE MANAGEMENT

• Recognize the Nature and Importance of Profits

 Economic versus Accounting Profits

Economic profit = total revenue - economic total cost.

Economic total cost = total revenue – (explicit cost + implicit cost)
Accounting profit = total revenue – explicit cost
Accounting cost = explicit cost = (total fixed cost + total variable cost)
 ECONOMICS OF EFFECTIVE MANAGEMENT

The Role of Profits

 The profits signals the owners of resources where the resources
are most highly valued by society.
Invisible hand (Adam Smith) – describes the unintended social
benefits of the individual’s self interested action.

“It is not out of the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own interest.” ADAM SMITH
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
Adam Smith, 1723-1790

“Man has almost constant occasion for the help of his

brethren, and it is vain for him to expect it from their
benevolence only. He will be more likely to prevail if he can
interest their self-love in his favor, and show them that it is
for their own advantage to do for him what he requires of
them...

Adam Smith and the Invisible Hand

Passages from The Wealth of Nations, 1776
“It is not from the benevolence of the butcher”
the brewer, or the baker that we expect our dinner, but from
their regard to their own interest....
ECONOMICS OF EFFECTIVE MANAGEMENT

• Five Forces Framework and Industry Profitability

 Entry
 Power of Inputs Suppliers
 Power of Buyers
 Industry Rivalry
 Substitutes and Complements
ECONOMICS OF EFFECTIVE MANAGEMENT

Entry
 Entry heightens competition and reduces margins of existing firms in a wide
variety of industry setting.
 The ability of existing firms to sustain profits depends on how barriers to entry
effect the ease with which other firms can enter the industry.
 Entry can come from a number of directions, including the formation of new
companies.
 A number of economic factors affect the ability of entrants to erode existing
industry profits.
ECONOMICS OF EFFECTIVE MANAGEMENT

 Power of Input Suppliers

 Industry profits tend to be lower when suppliers have the power to negotiate favorable
terms for their inputs.
 Supplier power tends to be low when inputs are relatively standardized and relationship-
specific investment are minimal.
 Input markets are highly concentrated, or alternative inputs are available with similar
marginal productivities per dollar spent.
 In some occasions, the government constrains the prices of inputs through price ceilings
and other controls, which limits to some extent the ability of suppliers to expropriate
profits from firms in the industry.
ECONOMICS OF EFFECTIVE MANAGEMENT

 Power of Buyers
 Industry profits tend to be lower when customers or buyers have the power to negotiate
favorable terms for the products or services produced in the industry.
 In most consumer markets, buyers are fragmented and thus buyer concentration is low.
 Buyer concentration and hence customer power tend to be higher in industries that serve
relatively few “high-volume” customers.
 Buyer power tends to be lower in industries where the cost to customers of switching to other
products is high, imperfect information that leads to costly consumer search, or few close
substitutes for the product.
 Government regulations, such as price floors or price ceilings can also impact the ability of
buyers to obtain more favorable terms.
ECONOMICS OF EFFECTIVE MANAGEMENT

 Industry Rivalry
 The sustainability of industry profits also depends on the nature and intensity of rivalry
among firms competing in the industry.
 Rivals tend to be less intense in concentrated industries—that is, those with relatively few
firms.
 The level of product differentiation and the nature of the game being played—whether
firm’s strategies involve prices, quantities, capacity, or quality/service attributes.
 Rivalry tends to be more intense in industry settings where there is little product
differentiation and firms compete in price, and where consumer switching costs are low.
 Imperfect information and the timing of decisions affect rivalry among firms.
ECONOMICS OF EFFECTIVE MANAGEMENT

 Substitutes and Complements

 The level and sustainability of industry profits depends on the price and value of
interrelated products and services.
 Porter’s original five forces framework emphasized that the presence of close substitutes
erodes industry profitability.
 Elasticity analysis and models of consumer behavior quantify the degree to which products
are close substitutes or close complements.
 The presence of complementary products also affects industry profitability.
 The change in price of complementary products enable the firm in one market to enter
other market through a differentiation strategy.
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Incentives
 Within a firm, incentives affect how resources are used and how hard workers work.
 The manager must construct incentives to induce maximal effort from the people being
managed.
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Markets
 For every buyer of a good, there is a corresponding seller.
 The final outcome of the market process, then, depends on the relative power of
buyers and sellers in the marketplace.
 The power, or bargaining position, of consumers and producers in the market is limited
by three sources of rivalry that exist in economic transactions:
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Markets
 The power, or bargaining position, of consumers and producers in the market is limited
by three sources of rivalry that exist in economic transactions:
 consumer-producer rivalry
 Consumer-consumer rivalry
 Producer - producer rivalry
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Markets
consumer-producer rivalry
 Occurs because of the competing interests of consumers and producers.
 Consumers attempt to negotiate or locate low prices, while producers attempt to
negotiate high prices.
 If consumer offers a price that is too low, the producer will refuse to sell the good.
Similarly If the producer asks a price that exceeds the consumer’s valuation of a good, the
consumer will refuse to purchase the good.
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Markets
consumer-consumer rivalry
 A second source of rivalry that guides the market process occurs among consumers.
 Consumer-consumer rivalry reduces the negotiating power of consumers in the
marketplace.
 C to C rivalry arises because of the economic doctrine of scarcity. Consumers who are
willing to pay the highest prices for the scarce goods will outbid other consumers for the
right to consume goods.
ECONOMICS OF EFFECTIVE MANAGEMENT

Understand Markets
 Each form of rivalry serves as a disciplining device to guide the market process, and each
effects different markets to a different extent.
 Your ability as manager to meet performance objectives will depend on the
extent to which your product is affected by these sources of rivalry.
ECONOMICS OF EFFECTIVE MANAGEMENT

Recognize the Time Value of Money

 Present Value Analysis
 Present Value and Indefinitely Lived Assets
ECONOMICS OF EFFECTIVE MANAGEMENT

Use Managerial Analysis

 Discrete Decisions
 Continuous Decisions
 A Calculus Alternative
ECONOMICS OF EFFECTIVE MANAGEMENT

Calculus