Managerial Economics Economy The word economy comes from

Managerial Economics

Economy. . . The word economy comes from a Greek word Oikonomos which means “one who manages a household. ” Economics is the study of how society manages its scarce resources.

Microeconomics and Macroeconomics • Microeconomics focuses on the individual parts of the economy. – How households and firms make decisions and how they interact in specific markets • Macroeconomics looks at the economy as a whole. – Economy-wide phenomena, including inflation, unemployment, and economic growth

The Diverse Fields of Economics Examples of microeconomic and macroeconomic concerns Production Prices Income Employment Microeconomics Production/Output in Individual Industries and Businesses How much steel How many offices How many cars Price of Individual Goods and Services Price of medical care Price of gasoline Food prices Apartment rents Distribution of Income and Wealth Wages in the auto industry Minimum wages Executive salaries Poverty Employment by Individual Businesses & Industries Jobs in the steel industry Number of employees in a firm Macroeconomics National Production/Output Total Industrial Output Gross Domestic Product Growth of Output Aggregate Price Level Consumer prices Producer Prices Rate of Inflation National Income Total wages and salaries Employment and Unemployment in the Economy Total number of jobs Unemployment rate Total corporate profits

POSITIVE VERSUSare NORMATIVE ANALYSIS • Positive statements that attempt to describe the world as it is. Positive economics studies economic behavior without making judgments. It describes what exists and how it works. – Called descriptive analysis • Normative statements are statements about how the world should be. Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. – Called prescriptive analysis

POSITIVE VERSUS NORMATIVE ANALYSIS • Positive or Normative Statements? ? ? – An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE – Higher federal budget deficits will cause interest rates to increase. POSITIVE ?

Fundamental Economic Problem • There are three fundamental economic problems for every human society. It is immaterial whether it is centrally planned, mixed or advanced industrial society. • They are what commodities are produced, how these goods are made and for whom they are produced. • What: Whether produce one good more and other less. • How: how goods are produced; choice of technologies; division of labor who will do what. • For whom: for whom are goods produced? Distribution of products among household; what pattern it takes; where the income goes.

Economic System • Market, Command Mixed System – We have indicated three fundamental problems in the previous section. One can solve those problems in different way. It is a question of organization that what, how and for whom can be dealt with. The three available systems try to address those problems under their respective market system. – A market economy is one in which individuals private firms market the major decisions about production and consumption. A system of prices, market, of profits and losses, of incentives and rewards determines what, how and for whom. In extreme case the economy is seen practicing laissez-faire which means non-interference from the government side in economic decision making.

Economic System • In a command economy the extreme opposite happens where the government takes all decision about the economy. • Mixed economy consists of the elements of command market. Most prevalent one. • Society can not have everything. In must decide through Input-Output relationship. It must choose the technology. Inputs: land, labor, capital, and entrepreneurship. Out is the commodity produced by these inputs.

Lionel Robbins Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

What is Economics? • Let us have some idea of some economists and the main idea of economics.

INTRODUCTION OF MANAGERIAL ECONOMICS Concept of Managerial Economics (contd. ) Managerial economics is by nature goal oriented and prescriptive which may be viewed as economics applied in decision making at the level of firm. Like an individual most of the problems of the firm emerge in allocation of scarce resources. We can trace different ideas given by scholars in this subject. “Managerial economics is the price theory in service of business executive. ” -D. J. Watson “Managerial economics can be viewed as an application of that part of microeconomics that focuses on such topics as risk, demand, production, cost, pricing, and market structure. ” -Petersen and Lewis “Managerial economics is concerned with the ways in which managers should make decisions in order to maximize the effectiveness or performance of the organizations they manage. ” - Edwin Mansfield 12

What is Managerial Economics Douglas - “Managerial economics is. . the application of economic principles and methodologies to the decisionmaking process within the firm or organization. ” Pappas & Hirschey - “Managerial economics applies economic theory and methods to business and administrative decision-making. ” Salvatore - “Managerial economics refers to the application of economic theory and the tools of analysis of decision science to examine how an organisation can achieve its objectives most effectively. ”

INTRODUCTION OF MANAGERIAL ECONOMICS Concept of Managerial Economics (contd. ) Following diagram shows how does the managerial economics provide the link between traditional economics and decision sciences Management Problems Economic Theory Decision Sciences Managerial Economics Economic Methodology: Descriptive Model Prescriptive Model Study of Functional Areas: Accounting, Finance, and Marketing Optimal Decision 14

Managerial Decision Problems Economic theory Microeconomics Macroeconomics Decision Sciences Mathematical Economics Econometrics MANAGERIAL ECONOMICS Application of economic theory and decision science tools to solve managerial decision problems OPTIMAL SOLUTIONS TO MANAGERIAL DECISION PROBLEMS

What is Managerial Economics (contd. ) • Howard Davies and Pun-Lee Lam • “It is the application of economic analysis to business problems; it has its origin in theoretical microeconomics. ” From these ideas it can be concluded managerial economics is the discipline, which deals with the application of economic theory to business management. Thus it lies on the borderline between economics and business management and serves as a bridge between these two disciplines.

INTRODUCTION OF MANAGERIAL ECONOMICS Distinction between Managerial Economics and Traditional Economics There are some differences between managerial economics and traditional economic theory because managerial economics seeks the help of other disciplines such as statistics, mathematics, accounting, management to get optimal solution to the managerial decision-making problems. Differences between managerial economics and traditional economics which are outlined below: i. Managerial economics concerns with the application of economic principles to the problems of the firm but the traditional economics deals with the body of principles itself. ii. Managerial economics is highly microeconomics in character. It studies the problems of a firm but does not study the macroeconomic phenomenon. But traditional economics consist of both micro and macro economics. 17

INTRODUCTION OF MANAGERIAL ECONOMICS Distinction between Managerial Economics and Traditional Economics (contd. ) iii. Traditional economics is a study of both firm and an individual, whereas managerial economics is a study of the problem of a firm only. iv. Managerial economics focuses its attention in the study of profits because it has great influence primarily on entrepreneurial decision and value theory of the firm. In traditional economics, the microeconomics is a branch under which all theories of factor pricing such as rent, wages, interest and profit are studied. v. Traditional economics studies human behavior on the basis of certain assumptions, but these assumptions may not be true in managerial economics because managerial economics is concerned with practical problems. 18

What is Managerial Economics (contd. ) It is an application of that part of microeconomics that focuses on Risk Demand Production Cost Pricing, and Market Structure. It helps rational decision making through MODEL BUILDING

INTRODUCTION OF MANAGERIAL ECONOMICS Scope of Managerial Economics (contd. ) Microeconomics Applied to Operational Issues: Operational issues of firms are of internal nature. Internal issues include all those problems which arise within the business organization and fall within the control of the management. Some of the basic internal issues are: a) Choice of business and the nature of products, that is, what to produce, b) Choice of size of the firm, that is, how much to produce, c) Choice of technology, that is, choosing the factor-combination (technique of production) d) Choice of price, that is, how to price the commodity, e) How to promote sales, f) How to face competition, g) How to decide on new investments, h) How to manage profit and capital, i) How to manage an inventory, that is, stock of both finished goods and raw materials. 20

INTRODUCTION OF MANAGERIAL ECONOMICS Scope of Managerial Economics (contd. ) Microeconomics Applied to Operational Issues: Microeconomics deals with such questions confronted by managers. The following microeconomic theories deal with most of these questions. a) Demand Analysis and Forecasting: - An understanding of the forces behind demand is a powerful tool for managers. Such knowledge provides the background needed to make pricing decisions, forecast sales and formulate marketing strategies. A forecast of future sales is essential before employing resources. b) Theory of Production and Production Decisions: - Production theory explains the relationship between inputs and output. It also explains under what conditions costs increase or decrease; how total output behaves when use of inputs is changed; and how can output be maximized from a given quantity of resources. Thus, it helps the managers in determining the size of the firm, and the amount of capital and labour to be employed keeping in view the objectives of the firm. 21

INTRODUCTION OF MANAGERIAL ECONOMICS Scope of Managerial Economics (contd. ) Microeconomics Applied to Operational Issues: c) Market Structure and Pricing Theory: - Price theory explains how prices of outputs and inputs are determined under different market conditions; when price discrimination is desirable, feasible and profitable; and to what extent advertising can be helpful in expanding sales in a competitive market. Hence, price theory can be helpful in determining the price policy of the firm. d) Analysis of Cost: - Estimates of cost are essential for planning purposes. The factors determining costs are not always known or controllable which gives rise to cost uncertainty. Factors of production are scarce and they have alternative uses. Factors of production may be allocated in a particular way to get maximum output. Thus the analysis of costs and their links to output are also importance in managerial economics. 22

INTRODUCTION OF MANAGERIAL ECONOMICS Scope of Managerial Economics (contd. ) Microeconomics Applied to Operational Issues: e) Profit and Capital Management (Investment Decisions): - Profit provides the index of success of a business firm. Profit analysis is difficult, because the uncertainty of expectations makes realization of profit planning and measurement difficult and these areas are covered in the study of managerial economics. Capital management means planning and control of capital expenditures. Hence, it is very important for a firm to manage required capital through proper investment planning. The main topics covered are: cost of capital, types of investment decisions, and evaluation and selections of investment projects. 23

INTRODUCTION OF MANAGERIAL ECONOMICS Scope of Managerial Economics (contd. ) Microeconomics Applied to Operational Issues: f) Inventory Management: - Inventory refers to a stock of raw materials or finished goods which a firm keeps. Management of inventory is very important for a firm to keep intact of its current production and supply capacity and to meet the challenges arising from change in market and other conditions. In this regard, a major question that arises is: how much of the inventory is the ideal stock? If it is high, capital is unproductively tied up, and that might be useful for other productive purposes if the stock of inventory is reduced. On the other hand, if the level of inventory is low, production will be hampered. Hence, managerial economics uses different methods which are helpful in minimizing the inventory cost. 24

Stories of Four Great Economists Adam Smith (1723 – 1790) was a Scottish Economist. He is said FATHER OF ECONOMICS He is also FATHER OF CAPITALISM His Book: WEALTH OF NATIONS We want to talk about POVERTY not wealth. His main theory is “There is an invisible hand that determine everything – Don’t disturb it” What is the invisible hand?

• P Invisible hands – demand supply – determines quantity and price S D Q

Economics is very easy • Teach a Parrot to say Demand Supply – then the parrot becomes an economist. • Ask her any questions – she will say ‘demand supply’ – then she is a great economist.

David Ricardo • David Ricardo 1772 -1823 • His theory said, increase in agricultural production would ultimately decline.

Thomas Malthus • Thomas Robert Malthus, (1766 -1834), English economist and demographer.

Malthus • He was a Church Priest. • Once he noted he had never seen a dead bird. (except bats and crows). • He searched the reasons. • Bird die on a flowing stream and the body is taken away by the water. • Birds commit suicide when food is not available. – A tragic case – God cannot do this. • He investigated further and studied economics – especially Ricardo

Population Theory His theory: population growth will always tend to outrun the food supply, * There will be hunger, famine, war, disasters, * Population Control is needed. * This is called Malthusianism

Karl Marx Karl Heinrich Marx (1818 – 1883) was a German philosopher, economist, sociologist, historian, journalist and revolutionary socialist. His ideas played a significant role in establishing communism. He published various books. Das Kapital (1867– 1894); His thinking, Factors of Production Congealed Labor theory Exploitation Dialectic Materialism

John m Keynes 1883 – 21 April 1946 – A British Economist. Studied Mathematics Very young professor, most learned young man, Wanted to marry an illiterate women, Then what happened? ? -- Wrote a book “General Theory” Could not sell.

Lord Keynes (continued) • • Went to stock market, Dominated stock market, Became rich, Became Lord, Married, Divided economics into Macro and Micro, An interview of his wife. He successfully introduced mathematics in economics

The Process of Model-building • The economics ‘method’ • The steps: the hypothetical-deductive approach – make assumptions about behaviour – work out the consequences of those assumptions – make predictions – test the predictions against the evidence – PREDICTIONS SUPPORTED? The model is accepted as a good explanation (for the moment) – PREDICTIONS REFUTED? Go back and re-work the whole process

Definitions & assumptions Theoretical analysis If predictions not supported by data, model is amended or discarded Predictions tested against data If predictions borne out by data, the model is valid, for the moment 36

Economic Laws Idea • Check the Idea • Prove it. If proved then Hypothesis • Prove the Hypothesis • If Proved then Theory Law • Prove theory • If proved then • Law is valid every where,

Economic Policy Criteria for judging economic outcomes: • Efficiency, or allocative efficiency. An efficient economy is one that produces what people want at the least possible cost. • Equity, or fairness of economic outcomes. • Growth, or an increase in the total output of an economy. • Stability, or the condition in which output is steady or growing, with low inflation and full employment of resources.

Figure 1 The Circular Flow MARKETS FOR GOODS AND SERVICES • Firms sell Goods • Households buy and services sold Spending Revenue FIRMS • Produce and sell goods and services • Hire and use factors of production Factors of production Wages, rent, and profit Goods and services bought HOUSEHOLDS • Buy and consume goods and services • Own and sell factors of production MARKETS FOR FACTORS OF PRODUCTION • Households sell • Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of Taka Copyright © 2004 South-Western

Revenue (=GDP) Good and services sold Spending (=GDP) MARKETS FOR GOODS AND SERVICES Good and services bought HOUSEHOLDS FIRMS Inputs for Production Wages, rent, interest and profit (=GDP) MARKETS FOR FACTORS OF PRODUCTION Land, labor and capital Income (=GDP) Flow of goods & services Flow of money: Taka THE CIRCULAR FLOW DIAGRAM

Assumptions Assumption: The economy composed of households and firms only Households: own factors of production, consume goods and service Firms: hire factors of production to produce goods and services

The Circular Flow of Economic Activity The diagram above represents the transactions between firms and households in a simple economy. In the upper loop, the arrow emanating from firms to households represents the sale by firms of goods and services to households. On the other hand, the arrow from households to firms represents the payments. In the lower loop, the arrow originating from the households to the firms shows that firms hire labor and capital from households in order to produce goods and services. The arrow emanating from the firms indicates their payments for the use of the factors of production.

The Circular Flow of Economic Activity Prices of outputs and inputs are determined in these markets and guide the decisions of all market participants, The firm, an entity, organizes factors of production to produce goods and services, The prices of product and factor of production guide interaction between individual and firms.

The Production Possibilities Frontier. Model: The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Figure 2 The Production Possibilities Frontier Quantity of Garments Produced 3, 000 D C 2, 200 2, 000 A Production possibilities frontier B 1, 000 0 300 600 700 1, 000 Quantity of Rice Produced

Figure 3 The Production Possibilities Frontier Quantity of Garments Produced 3, 000 D C 2, 200 2, 000 A Production possibilities frontier B 1, 000 0 300 600 700 1, 000 Quantity of Rice Produced

Theory of the Firm • Expected Value Maximization – Owner-managers maximize short-run profits. – Primary goal is long-term expected value maximization. • Constraints and the Theory of the Firm – Resource constraints. – Social constraints • Limitations of the Theory of the Firm – Alternative theory adds perspective. – Competition forces efficiency. – Hostile takeovers threaten inefficient managers.

Value of the Firm The present value of all expected future profits

Profit Measurement • Business Versus Economic Profit – Business (accounting) profit reflects explicit costs and revenues. – Economic profit. • Profit above a risk-adjusted normal return. • Considers cash and noncash items. • Variability of Business Profits – Business profits vary widely.

Why Do Profits Vary Among Firms? • Disequilibrium Profit Theories –Rapid growth in revenues. –Rapid decline in costs. • Compensatory Profit Theories –Better, faster, or cheaper than the competition is profitable.

Role of Business in Society • Why Firms Exist – Business is useful in satisfying consumer wants. – Business contributes to social welfare • Social Responsibility of Business – Serve customers. – Provide employment opportunities. – Obey laws and regulations.

How to Read and Understand Graphs • Each point on the Cartesian plane is a combination of (X, Y) values. • The relationship between X and Y is causal. For a given value of X, there is a corresponding value of Y, or X causes Y.

Reading Between the Lines • A line is a continuous string of points, or sets of (X, Y) values on the Cartesian plane. • The relationship between X and Y on this graph is negative. An increase in the value of X leads to a decrease in the value of Y, and vice versa.

Positive and Negative Relationships An upward-sloping line describes a positive relationship between X and Y. A downward-sloping line describes a negative relationship between X and Y.

Different Slope Values

Different Slope Values