PAN African e-Network Project

Diploma in Business Management

Managerial Economics
Session - 1

Ms. Tavishi
1

What is Managerial Economics?

Douglas - Managerial economics is ..
the application of economic principles
and methodologies to the decisionmaking process within the firm or
organization.

Meaning
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.

BUSINESS ADMINISTRATION
DECISION PROBLEMS
TRADITIONAL ECONOMICS :
THEORY AND METHODOLOGY

DECISION SCIENCES :
TOOLS AND TECHNICS

MANAGERIAL ECONOMICS :
INTEGRATION OF ECONOMIC
THEORY AND
METHODOLOGY WITH
TOOLS AND TECHNICS
BORROWED FROM OTHER
DECIPLINES
OPTIMAL SOLUTIONS TO
BUSINESS PROBLEMS

Definitions
&
assumptions
Theoretical
analysis

If predictions
not supported by
data, model is
amended or
discarded

Predictions

Predictions
tested
against data

If predictions
borne out by
data, the model
is valid, for
the moment

Should Assumptions
Assumptions be
be Realistic?
Realistic?
Should
The assumption of profit-maximising may be
unrealistic or inaccurate
However, what matters is the explanatory or
predictive power of a theory (or model), not the
descriptive realism of its assumptions.
A model built on unrealistic assumptions may
give good predictions.
Assumptions are a necessary simplifying device

What Is A Good Model?

It allows us to make predictions and set
hypotheses
The predictions can be tested against the
empirical evidence
The predictions are supported by the empirical
evidence

 For the academic economist: to

understand, to make predictions about
firms behavior
The positive approach to theory: What
is?

 For the businessperson: to assist decisionmaking, to provide decision-rules which can be

applied
The normative approach to theory: What
should be?
These purposes are different, they can lead to
misunderstanding, and economists are not
always honest about the limitations of their
approach for practical purposes.

Drive Rental Car or Co. Car?

Sue has been asked by her boss to attend
a business meeting 125 miles away. She
has two alternatives for getting to the
meeting and back: 1) rent a car for $50
plus fuel costs or 2) drive a companyowned car. Her boss has asked her to
choose
the
cheapest
form
of
transportation for the company. What
should Sue do?

Buy New Book or Used Book?

Joe has signed up to take an Econ class which
is about to begin. His instructor expects him to
read material from the textbook and to
access/use on-line supplements.

 Joe has two alternatives: 1) buy a new

book for $120 which gives him the
supplements at no additional charge or 2)
buy a used book for $70 which does not
include the supplements so they would
have to be purchased separately for $35.
What should Joe do?

Fuel Once or Twice?

Suppose an airline company has a round trip
flight from Houston to Cancun to Houston.
Soaring oil prices have airlines scrambling to
save money on fuel. The company has noticed
fuel prices are 17 cents per gallon less in
Houston vs Cancun. Rather than refueling in
Cancun, the airline is thinking about buying
enough fuel for the whole trip in Houston before
departure. What are the marginal analysis
considerations in this case?

How Much to Spend on TV and Radio

Advertising?
Total
Spent

New Beer Sales

Generated (in barrels
per year)
TV

Radio

$100,000

4,750

950

$200,000

9,000

1,800

$300,000

12,750

2,550

$400,000

16,000

3,200

$500,000

18,750

3,750

$600,000

21,000

4,200

$700,000

22,750

4,550

$800,000

24,000

4,800

$900,000

24,750

4,950

$1,000,000

25,000

5,000

$0

Max B(T,R)
Subject to: T + R = 1,000,000

What Is the Additional Revenue?

Suppose a statistician in your firms research
department has given you his/her
mathematical estimate of your companys
sales (total revenue = TR and Q = quantity of
output) as follows:
TR = 7Q - .01Q2
What will be the added revenue of selling
another unit of output? If the added cost of
producing another unit of output is constant at
$2.00, at what level of output is the additional
revenue generated from that output just equal
to the added cost?

Putting Saturn in Orbit

Microeconomic analysis was particularly
important to GM when it started selling its line of
Saturn cars in 1991. In producing and selling
Saturns, GM tried drastically new approaches.
GM spent an estimated $5 billion to get Saturn
going. What were the major changes
implemented by GM and were they well founded
based on economic considerations?

Deal or No Deal
Reports have it that the native Americans
who originally owned Manhattan Island
sold it in 1626 for $24. Meanwhile, in
1984 it was estimated that the value of
that property was $23 billion. Was selling
the land for $24 in 1626 a mistake?

 Its easy to identify successful

strategies (and the reasons for their
success) or failed strategies (and the
reasons for their failures) in retrospect.
Its much more difficult to identify
successful or failed strategies before
they succeed or fail.
Luke Frueb and Brian
McCann
Managerial Economics
(2008)

 While there is no doubt that luck, both good

and bad, plays a role in determining the
success of firms, we believe that success is
often no accident. We believe that we can
better understand why firms succeed or fail
when we analyze decision making in terms of
consistent principles of market economics
and strategic action.
Besanko, et. Al
Economics of Strategy (2nd)

Common Causes of Failed

Strategies
1. Relevant information
a. Not enough
b. Enough BUT either ignored or
used/analyzed incorrectly

2. Irrelevant information used

Microeconomics is the study of how individual

firms or consumers do and/or should make
economic decisions taking into account such
things as:
1.
2.
3.
4.
5.

Their goals, incentives, objectives.

Their choices, alternatives, problems.
Constraints such as inputs, resources, money, time,
technology, competition.
All (cash & noncash) incremental or marginal
benefits and costs.
The time value of money.

Managerial Economics
Managerial Economics is microeconomics
applied to decisions made by business
managers.

Goals, Incentives, Objectives

A fundamental economic truth is that
individual firms or decision makers
respond to economic incentives. What
these incentives are (i.e. money, profits,
utility, etc.) and how they influence
economic decision making are key topics
for study and analysis in business (or
managerial) economics.

Managerial Goals (examples)

$ sales, total revenue, gross income,
market share
Q sales, Q of output, output per unit of
input (production efficiency)
$ costs, total costs, cost per unit of output
(cost efficiency)
$ profits, total profits, profit per unit of
output

Managerial Choices
(examples)

Output quantity
Output quality
Output mix
Output price
Marketing and
advertising

Production
processes (input
mix)
Input quantity
Production location
Production
incentives
Input procurement

Michael Porters Five Competitive

Forces
= Decision-making constraints
= Factors that influence the sustainability of firm
profits
1. Market entry conditions for new firms
2. Market power of input suppliers
3. Market power of product buyers
4. Market rivalry amongst current firms
5. Price and availability of related products
including both substitutes and complements

Marginal Analysis
Analysis of marginal costs and marginal
benefits due to a change
Marginal = additional or incremental
Costs and benefits that are constant (i.e.
fixed, dont change) are excluded from the
analysis
Changes occurring at the margin are all that
matter
Two important dimensions of change:
direction, magnitude

Good Economic Decisions

Marginal benefits > marginal costs
Examples of marginal benefits:
profit
revenue
cost
safety
risk
Marginal costs = opposite of above examples

Marginal Analysis
(Examples)
Y

Incremental Y/
Incremental X
MR

TR

X
Units of output

TC

Units of output

MC

TP

Units of input

MP

TRP

Units of input

MRP

TC

Units of input

MFC

TU

Units of good

MU

Profit

Units of output

MP

Assume you are a member of your companys

Marketing Dept. You believe, and correctly so,
1) the market demand for your firms product is linear,
2) if your company charges $5.00 for its product,
quantity sold would be 200 units and
3) if your company set price = $3.00, the number of
units sold would be 400.
Develop alternative ways of explaining to upper-level
management more fully the relationship between the
companys price and the resulting number of units of
product sold.

Variable Relationships
Example of Alternative Ways of Depicting

Tabular

$7

100

200

300

400

500

600

700

Variable Relationships
Example of Alternative Ways of Depicting

Graphical

Variable Relationships
Example of Alternative Ways of Depicting

Mathematical
Q = 700 100P
P = 7 0.01Q

Common Math Terms Used in

Economic Analysis
Term

Definition

Variable

Something whose value or magnitude (often

Q or $ in Econ) may change (or vary); usually
denoted by letter labels such as Y, X, TR, TC

Parameter or
Constant

Something whose value does NOT change

General
equation or
function

A mathematical expression that suggests the

value of one variable relates to or depends on
the value of another variable (or set of
variables) without showing the precise nature
of that relationship [e.g. y = f(x)].

Common Math Terms Used in

Economic Analysis
Term

Definition

Specific
equation or
function

A mathematical expression that shows

precisely how the value of one variable is
related to the value of another variable (or
set of variables) [e.g. y = 10 + 2x].

Inverse
equation or
function

A mathematical expression rewritten so that

the variable previously on the right-hand side
of the equal sign now becomes the variable
solved for on the left-hand side of the equal
sign [e.g. y = 2x and x = 1/2 y are each an
inverse equation of the other].

Common Math Functions Used in

Economics
Name of
Function Form
Y = a0
Y = a0 + a1 x

Function
Constant
Linear

(or y = mx + b)

Graph of Function
Horizontal straight line with
slope = 0
Straight line with slope = a1
(or = m)

Y=a0+a1x+a2x2

Quadratic

Parabola (u-shaped curve)

with either minimum or
maximum value

Y=a0+a1x+a2x2+a3x3

Cubic

Curved line (e.g. slope

changes from getting flatter
to steeper

Y=a0x-n

Hyperbola

Curved line (u-shaped)

bowed towards origin

Ceteris Paribus
Y = a + b1X1 + bnXn=> the value of Y
depends on the values of n different
other variables; a ceteris paribus
assumption => we assume that all X
variable values except one are held
constant so we can look at how the
value of Y depends on the value of the
one X variable that is allowed to change

Straight Line Equation

Given 2 pts on a straight line, how to solve for the
specific equation of that line?
Recall, in general, the equation of a straight line is Y =
a + bX, where b = the slope, and a = the vertical axis
intercept. The specific equation has the values of a
and b specified.
Solution procedure:
1. Solve for b = Y/X = (Y2-Y1)/(X2-X1)
2. Given values at one pt for Y, X, and b, solve for a
(e.g. a = Y1 bX1)

Graphical Concepts (Variable Relationships)

Y axis:a vertical line in a graph along which the
units of measurement represent different
values of, normally, the Y or dependent
variable.
Y axis intercept:
the value of Y when the value of X = 0, or
the value of Y where a line or curve
intersects the Y axis; = a in Y = a + bX

Graphical Concepts (Variable Relationships)

X axis:a horizontal line in a graph along which
the units of measurement represent
different values of, normally, the X or
independent variable
X axis intercept:
the value of X when the value of Y = 0, or
the value of X where a line or curve
intersects the X axis

Graphical Concepts (Variable Relationships)

Slope:
= the steepness of a line or curve; a +(-) slope =>
the line or curve slopes upward (downward) to the
right
= the change in the value of Y divided by the
change in the value of X (between 2 pts on a line or
a curve)
= Y/X = 1st derivative (in calculus)
= Y/ X using algebraic notation
= the marginal effect, or the change in Y brought
about by a 1 unit change in X
= b if Y = a + bX

Slope Graphically

y r is e
y2 y1

x
ru n
x2 x1

Slope Calculation Rules

(slope = Y/ X = dy / dx)

Rule

Example

1. Slope of a constant = 0

If y=6, slope = 0

2. power rule => slope of a

function y = axn is (n)(a)xn-1

If y=3x2, slope = (2)(3)x21

=6x
If y=x, slope = (1)x1-1=1

3. Sum of functions rule =

slope of the sum of two
functions is the sum of the
two functions slopes

If y = x + 3x2, slope = 1 + 6x

Mathematics of Optimization
Optimization a decision maker wishes to
either MAXimize or MINimize a goal (i.e.
objective function)
For a function to have a maximum or
minimum value, the corresponding graph
will reveal a nonlinear curve that has
either a peak or a valley

Mathematics of Optimization
The mathematical equation of the function to be optimized will
have THE VERTICAL AXIS VARIABLE ON THE LEFT-HAND
SIDE OF THE EQUATION (e.g. Y = f(x) Y is the vertical axis
variable)
the slope of a curve at either a peak or a valley will = 0; in math
terms, the slope is the first derivative (I.e. dY/dX = 0)
Constrained optimization do the best job of maximizing (or
minimizing) a function given constraints; the Lagrangian
Multiplier Method is a mathematical procedure for solving these
kinds of problems

Typical Time Value of Money

Problems in Business
How to compare or evaluate two
different dollar amounts at two different
time periods?

$X

$Y

t1

t2

t3

Assume x = $900, y = $1000, r = 6%, t1 = 3,

t2 = 5

Time Value of Money

(Basic Concept)
A dollar is worth more (or less) the sooner (later) it is
received or paid due to the ability of money to earn
interest.
present value
+ interest earned
= future value
Or
future value
- interest lost
= present value

Time Value of Money

(Applications/Uses)
1. To evaluate business decisions where at
least some of the cash flows occur in the
future
2. To project future dollar amounts such as
cash flows, incomes, prices
3. To estimate equivalent current-period
values based on projected future values

Time Value of Money Concepts

PV = present value
= the number of $ you will be able to
borrow [or have to save] presently in
order to
payback [or collect] a given
number of $ in
the future
FV = future value
= the number of $ you will have to pay back
[or be able to collect] in the future as a
result of having borrowed [or saved] a
given
number of $ presently

Time Value Equation

FV1
FV2

FVn

=
=
=
=
=
=

PV + PV(r)
PV(1+r)
FV1+FV1(r)
FV1(1+r)
PV(1+r)(1+r)
PV(1+r)2

= PV(1+r)n

Time Value Problems

Given
PV,r,n
FVn,r,n

FVn = PV(1+r)n
Solve For
FVn = PV(1+r)n = compounding
PV=FVn[1/(1+r)n]

= discounting

FVn,PV,n r (1+r)n=FVn/PV ( find in n row)

FVn,PV,r n (1+r)n=FVn/PV ( find in r column)

Net Present Value (NPV)

= an investment analysis concept
= PV of future net cash flows initial
cost

= PV of MRs PV of MCs
= invest if NPV > 0
= invest if PV of MRs > PV of MCs

Internal Rate of Return

= an investment analysis
alternative

= value of r that results

in a NPV = 0

Payback Period
= an investment analysis alternative
= period of time required for the sum
of net cash flows to equal the initial
cost
= value of n such that
n

i1

N C Fi C

Firm Valuation
The value of a firm equals the present value of all its
future profits

P V t / (1 i )

If profits grow at a constant rate, g<I, then:

P V 0 (1 i ) / (i g ). 0
current profit level.

Maximizing Short-Term
Profits
If the growth rate in profits < interest rate and
both remain constant, maximizing the present
value of all future profits is the same as
maximizing current profits.

Time Value of Money

(Applied to Inflation)
Can be used to estimate or forecast future
prices, revenues, costs, etc.
FVn = PV (1+r)n where
PV = present value of price, cost, etc.
r = estimated annual rate of increase
n = number of years
FV = future value of price, cost, etc.

:
Meaning of demand : No. of units of a commodity that
customers
are willing to buy at a given
price under a set
of conditions.

Demand Analysis

Demand function : Qd = f (P, Y, Pr W)

Demand Schedule : A list of prices and quantitives
and the list is so
arranged that at each price the
corresponding
amount is the quantity
purchased at that price

The Law of Demand

The law of demand holds that other things
equal, as the price of a good or service
rises, its quantity demanded falls.
The reverse is also true: as the price of a
good or service falls, its quantity demanded
increases.

Demand Schedule
Price per Widget ($)

Quantity Demanded of Widget per

day

$5

$4

$3

$2

$1

10

Demand Schedule
A demand schedule is a table that lists
the various quantities of a product or
service that someone is willing to buy over
a range of possible prices

Demand Schedule
A demand schedule can be shown as points on
a graph.
The graph lists prices on the vertical axis and
quantities demanded on the horizontal axis.
Each point on the graph shows how many units of
the product or service an individual will buy at a
particular price.
The demand curve is the line that connects
these points.

Demand curve
Demand Curve for Widgets
$6

$5

$4

Price per Widget

Demand Curve for Widgets

$3

$2

$1

$0

Quantity Demanded of Widgets

10

11

Introduction to Demand
The demand curve has a negative
slope, consistent with the law of
demand.
This shows that people are normally willing
to buy less of a product at a high price and
more at a low price.
According to the law of demand, quantity
demanded and price move in opposite
directions.

Change in the quantity

demanded
An increase in the Price of
Widgets from $3 to $4 will
lead to a decrease in the
Quantity Demanded of
Widgets from 6 to 4. $6

Demand Curve for Widgets

At $3 per Widget, the

Quantity demanded of
widgets is 6.

$5

$4

Price per Widget

Demand Curve for Widgets

$3

$2

$1

$0

Quantity Demanded of Widgets

10

11

Changes in Demand
Demand Curves can also shift in response to
the following factors:
Buyers (# of): changes in the number of
consumers
Income: changes in consumers income
Tastes: changes in preference or popularity of
product/ service
Expectations: changes in what consumers expect
to happen in the future
Related goods: compliments and substitutes

BITER: factors that shift the demand curve

 Prices of related goods affect on demand

Substitute goods a substitute is a product

that can be used in the place of another.

The price of the substitute good and demand for the

other good are directly related

For example, Coke Price Pepsi Demand
Complementary goods a compliment is a

good that goes well with another good.

When goods are complements, there is an inverse

relationship between the price of one and the

demand for the other
For example, Peanut Butter
Jam Demand

Increase
Increase in Demand
$6

$5

$4

Price per Widget

Orginal Demand Curve

$3

New Demand Curve

$2

$1

$0

10

Quantity Demanded of Widets

12

14

Decrease
Decrease in Demand

$6

$5

$4

Original Demand Curve

$3 Widget
Price per

New Demand Curve

$2

$1

$0

Quantity Demanded of Widgets

10

12

Changes in demand
Changes in any of the factors other
than price causes the demand
curve to shift either:
Decrease in Demand shifts to the
Left (Less demanded at each price)
OR
Increase in Demand shifts to the
Right (More demanded at each price)

From Individual Demand to Market

Demand
The market demand curve shows the
relationship between the price of the
good and the quantity demanded by
all consumers, ceteris paribus.

An example of hot chocolate:

There is a coffee cart in the building that primarily
serves the individuals who work in the building.
The market is defined to some

extent by the

geography of the building. Individuals who buy the

hot chocolate rarely come from other buildings to
purchase a cup.

An example of hot
chocolate:

During the time period [UT]under consideration [8:00-9:00am on

a week day ] the incomes and preferences of buyers are unlikely
to
change. The prices of coffee, lattes, etc. can be controlled by the
vendor and the price of soft drinks from the machines remains
constant. The number of workers in the building remain at a
constant level.

 Under

these

circumstances,

we

observe the number of cups of hot

chocolate [H] sold each morning as
the price [P] is changed. From these
observations

the

relationship is estimated.

demand

Complementary goods
Two goods may be complimentary,
i.e. the two goods are used
together. [tennis rackets and tennis
balls or CDs and CD Players]
An increase in the price of CDs will
tend to reduce the demand [shift the
demand function to the left] for CD
Players

.
The income of the Pago-Pagans declines after
a typhoon hits the island
Pago-Pagan is named on of the most beautiful
islands in the world and tourism to the island
doubles.
The price of Frisbees decreases. (Frisbees are a
substitute good for boomerangs)

Example
Many Pago-pagans begin to believe that they
may lose their jobs in the near future. (Think
expectations!)
The Boomerang Manufactures decide to add a
money back guarantee on their product, which
increases the popularity for them

Introduction to Supply

Supply refers to the various quantities of

a good or service that producers are
willing to sell at all possible market
prices.

Supply can refer to the output of one

producer or to the total output of all
producers in the market (market
supply).

Supply Curve for Widgets

$6

$5

$4

Price per Widget

Supply Curve

$3

$2

$1

$0

Quantity Supplied of Widgets

10

11

Changes in Supply
Supply Curves can also shift in
response to the following factors:
Subsidies and taxes: government
subsides encourage production, while
taxes discourage production
Technology: improvements in production
increase ability of firms to supply

 Other goods: businesses consider the

price of goods they could be producing
Number of sellers: how many firms are in
the market
Expectations: businesses consider future
prices and economic conditions
Resource costs: cost to purchase factors
of production will influence business
decisions

STONER: factors that shift the supply

curve

Changes in Supply
Supply
Increase
Curveinfor
Supply
Widgets
$6

$5

$4

Price per Widget

Original Supply Curve

Supply Curve
New Supply Curve

$3

$2

$1

$0

1
0

2 2

4 4

65

68

10

Quantities
Quantity
Supplied
Supplied
of of
Widgets
Widgets

129

10
14

11

Changes in Supply
Decrease
in Supply
Supply
Curve
for Widgets
$6

$5

$4

Price per Widget

Original Supply Curve

Supply Curve
New Supply Curve

$3

$2

$1

$0

1
0

44

78

Quantity
Quantity
Supplied
Supplied
of Widgets
of Widgets

10 9

10
12

11

Changes in Supply
Changes in any of the factors other
than price causes the supply curve
to shift either:
Decrease in Supply shifts to the Left
(Less supplied at each price)
OR
Increase in Supply shifts to the Right
(More supplied at each price)

Cost to Produce

Cost of Resources Falls

Cost of Resources
Rises
Productivity Decreases

Productivity Increases

New Technology

Higher Taxes

Lower Taxes

Government Pays
Subsidy

Amount of Supply

Supply Curve Shifts

Normal good
A good for which an increase in
income increases demand.

inferior good
A good for which an increase in
income decreases demand.

Supply and Demand at Work

Markets bring buyers and sellers
together.
The forces of supply and demand
work together in markets to establish
prices.
In our economy, prices form the basis
of economic decisions.

Supply and Demand at Work

Supply and Demand Schedule can be
combined into one chart.
Price per
Widget ($)

Quantity
Demanded of
Widget per day

Quantity
Supplied of
Widget per day

$5

10

$4

$3

$2

$1

10

Supply and Demand at Work

Supply and Demand for Widgets

$6

$5

$4

Price per Widget

Demand Curve

$3

Supply Curve

$2

$1

$0

Quantity of Widgets

10

11

Supply and Demand at Work

A surplus is the amount by which the

quantity supplied is higher than the
quantity demanded.
A surplus signals that the price is too high.
At that price, consumers will not buy all of
the product that suppliers are willing to
supply.
In a competitive market, a surplus will not
last. Sellers will lower their price to sell
their goods.

Supply and Demand at Work

Supply and Demand for Widgets

Surplus

$6

$5

$4

Price per Widget

Demand Curve

$3

Supply Curve

$2

$1

$0

Quantity of Widgets

10

11

Supply and Demand at Work

A shortage is the amount by which the
quantity demanded is higher than the
quantity supplied
A shortage signals that the price is too low.
At that price, suppliers will not supply all of
the product that consumers are willing to
buy.
In a competitive market, a shortage will not
last. Sellers will raise their price.

Supply and Demand at Work

Supply and Demand for Widgets
$6

$5

$4

Price per Widget

Demand Curve

$3

Supply Curve

$2

$1

$0

Shortage
1

Quantity of Widgets

10

11

Supply and Demand at Work

When operating without restriction, our

market economy eliminates shortages and
surpluses.

Over time, a surplus forces the price down and a

shortage forces the price up until supply and demand
are balanced.
The point where they achieve balance is the
equilibrium price. At this price, neither a surplus nor
a shortage exists.

Once the market price reaches equilibrium, it tends

to stay there until either supply or demand changes.

When that happens, a temporary surplus or shortage

occurs until the price adjusts to reach a new
equilibrium price.

Supply and Demand at Work

Supply and Demand for Widgets
$6

$5

$4

Price per Widget

Demand Curve

$3

Supply Curve

$2

$1

$0

Quantity of Widgets

10

11

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