Managerial  

Economics
MBAFT 6103
 Today:  Introduction

1.  Introduce ourselves

2.  Go through the syllabus and the grading. Ask me

questions.

3. Laying down the basic rules.

4. Very short overview

 Structure  of  the  Course  

Lectures

—  Microeconomic Theory & concepts

—  Real world applications
—  Solving problems analytically and graphically
 Course  Assessment

Participation 5%
Midterm Exam 25%
Assignments (2) 20%
Final Examination 50%
 Laying  down  the  Rules  

•  Please be on time. If you are late, please be seated
quickly and quietly with minimum distraction to
others.
•  Please turn off your cell-phones.
•  You are welcome to discuss the materials I am
teaching in class. However, no talking during the
class, please.
•  Midterm Exam --- no re-takes. So if you miss it, then
you loose those points.
•  Assignments --- In-class. Will be discussed later.
•  Final --- Comprehensive.
 What  is  Managerial  
Economics?
•  Study of how to manage scarce resources to
achieve a managerial goal. Very broad in its scope
--- we will study both the behavior of the economic
agents on their own and the way their behaviors
interact to form larger units, such as markets.

•  Managerial Economics is Applied Microeconomics

--- that’s why we need to know the basic
Microeconomics tools.
What  is  Microeconomics?  
“..... is the study of how men and society choose, with
or without the use of money, to employ scarce source
productive resources, which could have alternative
uses, to produce various commodities over time and
distribute them for consumption, now and in the
future, among various people and groups in
society.” (Paul A. Samuelson)
What  is  Microeconomics?  

•  micro – individual economic behavior
•  macro – aggregate economic behavior

o  Example: increase in oil price

§  micro effects – vehicle users, electric power

generators
§  macro effects – inflation, unemployment
 Economics  of  Effective  
Management
•  Understand your consumers (Consumer Theory)

•  Identify your goals and constraints (Production Function and

cost function)

•  Understand the difference between accounting profit and

economic profit (Opportunity Cost)

•  Use marginal analysis (Marginal versus Average)

•  Understand the market where you will buy your inputs from
(Working of the input market, Input Demand Function)

•  Understand the market where you will be selling your goods

(Different kinds of Market Structures)
 Economics  of  Effective  Management:  

Some  Common  Mistakes  
•  Not understanding the consumer base

•  Maximize total revenue (which may not maximize profit)

•  Maximize profit margin (=price per unit – average cost

of production) (may not maximize profit)

•  Increase output to reduce average cost

•  Not understanding the market you are operating in

(complicated further by the globalization of markets)
 Main  Learning  Points

§  Economic Modeling --- some important tools

§  Individual Behavior --- consumers and producers
§  Market and market power

Ø  Timing
 1.  Microeconomic  Modeling  

Choice  vs.  Alternatives
•  In Microeconomics we construct and analyze
models.

•  Models are like maps – using visual/analytical

methods, they simply the process and facilitate
understanding of complex concepts.
Microeconomic models need to:

ü  Resemble Reality

ü  Be Understandable
ü  Be an Appropriate Scale
Microeconomic  Modeling  
An  Example  –  Market  for  Coffee  Beans

Price
per Supply
unit

Example: World-wide market

for unprocessed coffee beans,
December, 1997

Quantity
 Microeconomic  Modeling  
Example  –  Market  for  Coffee  Beans

P
Supply

Example: World-wide market

for unprocessed coffee beans,
December, 1997

Q
 Four  important  tools  to  
learn

•  Constrained Optimization.
Given the goals and the constraints which goods and
services will be produced/consumed and in what
quantities
•  Marginal Impacts.
To understand incremental impact over total impact
•  Equilibrium Analysis.
To understand how markets work
•  Comparative Statics.
What happens when the market conditions change
 Constrained  Maximization:  
The  Objective  Function  (or  the  Goal)

The Objective Function specifies what the agent
cares about.

Example

Does a manager care more about increasing

profits or increasing “power”?
 Constrained  Maximization:    
The  Constraints

•  Constraints are whatever limits is placed on the
resources available to the agent.

Examples

Ø  Time
Ø  Budget
Ø  Other Resources
Ø  Technical Capabilities
Ø  The Marketplace
Ø  Rules, Regulations, and Laws
 Constrained  Optimization

Example: Sonu’s purchasing decision

Food (F), Clothing (C), Income (I)

Price of food (pf), price of clothing (pc)
o 
Satisfaction from purchases: S = S(F,C)=(FC)1/2

Max S(F,C)
subject to: pfF + pcC < I

•  Note: we are modeling Sonu’s behavior

  A  Very  Important  Side-­‐‑Note

Exogenous  &  Endogenous  Variables

Variables whose values are given in an analysis are
exogenous variables. Variables whose values are
determined as a result of the model’s workings are
endogenous variables.
Example:
“How would a manager hire the most possible no. of workers on a budget of $100?”
vs.
“How would a manager minimize the cost of hiring three workers?”

OR

“How much food and clothing should the consumer purchase in order to maximize satisfaction
on a given budget ?”
vs.
“What is the minimum budget that the consumer must have in order to reach a given level of
satisfaction?”
 An  Important  Concept:  
Marginal  Impact

The Marginal Impact of a change in the exogenous
variable is the incremental impact of the last unit of
the exogenous variable on the endogenous variable.
 Marginal  Impact  

Advertising  Example  –  Beer  company’s  decision  problem

•  Budget = $1M to allocate between TV ads and

radio ads

•  Managerial Goal : Maximizing sale of beer

•  Constraint : The given budget

What should the manager do?

What should the manager do? Spend the entire amount on TV ads?
Incorrect. 22
 2.  Individual  Behavior  
Consumers  and  producers

•  Infinite rationality --- Benchmark for Managerial
Economics. Individuals with perfect cognitive ability
and self-control.
o  Individual consumers (maximize well-being given
budget constraint).
o  Individual producers (minimize cost given
production constraints)

•  Bounded rationality: individuals with limited

cognitive abilities and self-control.
 3.  Markets

Definition: Buyers and sellers communicate with one
another for voluntary exchange

•  Market need not be physical

•  Industry – businesses engaged in the production or

delivery of the same or similar items
 Competitive  Market

•  Benchmark for managerial economics
o  Perfectly competitive market
•  many buyers and many sellers
•  free entry and exit
•  no room for managerial strategizing

o  Achieves economic efficiency

 Competitive  Market

•  The Competitive Market Framework/Model:
o  demand
o  supply
o  market equilibrium
o  comparative statics
 Equilibrium

Definition: Equilibrium is defined as the point where
demand just equals supply in this market. In a
perfectly competitive market it is the point where the
demand and supply curves cross each other.

Equilibrium analysis is an analysis of a system in a state

that will continue to remain unchanged indefinitely as
long as the exogenous factors remain unchanged.
 4.  Comparative  Static  
Analysis

A Comparative Statics Analysis compares the

equilibrium state of a system before a change in the
exogenous variables to the equilibrium state after the
change.
 Equilibrium  
Market  for  Coffee-­‐‑Beans

 Market  Power

•  Ability of a buyer or seller to influence market
conditions
•  Seller with market power must manage
o  costs
o  pricing
o  R&D expenditure
o  strategy toward competitors
 Market  Power  
Example:  Prozac

•  August 2001: US Court of Appeals limited Prozac
patent
o  Lilly market value dropped $36 billion
o  Barr market value rose $1.1 billion

Huge discrepancy in impact – why?

 Timing:  A  Side  Note

Discounted future value
•  If discount rate = 10%,
o  Re.1 next year worth 1/1.10 = 91 p. now
o  Re.1 two years worth about 83 p. now
Example
o  Year 1: gain of Rs.3 million
o  Year 2 and 3: loss of Rs.2 million
o  Discount Rate = 10%
o  Net present value: 3− 2 − 2 = −0.94 million
2
[1.01] [1.01]
Microeconomic  Analysis:  

A  Side  Note
•  Positive Analysis:
•  Can explain what has happened due to an
economic policy or it can predict what might
happen due to an economic policy.

•  Normative Analysis:
•  An analysis of what should be done

o  We will mostly focus on positive analysis.

 Plan  for  the  course

•  Average versus Marginal; Optimization
•  Brief introduction to the Perfectly Competitive
Market framework
•  Consumer Theory
•  Producer Theory
•  Market Forces: Demand and Supply
•  Analysis of Competitive Market
•  Market Power and Monopoly
•  Price discrimination
•  Oligopoly Models
•  Game Theory
 Next

A short discussion of the Perfectly Competitive

framework, followed by Consumer Theory
 Reference  

§  Any book on Managerial Economics

§  Salvatore, “Managerial Economics

§  Pindyck and Rubinfeld, “Microeconomics” (really

good book!)