Unit 1: Nature of Managerial Economics and the Theory of the Firm

The following article is a story of success of the business tycoon Warren Buffet of
Berkshire Hathaway, Inc. It will tell how learning and knowledge in managerial
economics lead him to where he is now in the global business.

Success Story of Warren Buffet

Warren Buffet is famous for his razor-sharp focus on the competitive advantages of
Berkshire’s wide assortment of operating companies, including Benjamin Moore
(paints), Borsheim’s (jewellery), Clayton Homes, Dairy Queen, Fruit of the Loom,
GEICO (insurance), General Re Corporation (reinsurance), MidAmerican Energy, the
Nebraska Furniture Mart, See’s Candies, and Shaw’s Industries (carpet and floor
coverings). Berkshire Subsidiaries commonly earn
more than 30 percent per year on invested capital, compared with the 10 percent to 12
percent rate of return earned by other well-managed companies. Additional contributors
to Berkshire’s outstanding performance are substantial common stock holdings in
American Express, Coca-Cola, Procter & Gamble, and Wells Fargo, among others. As both
a skilled manager and an insightful investor, Buffet likes wonderful businesses with high
rates of return on investment, lofty profit margins, and consistent earnings growth.
Complicated businesses that face fierce competition and require large capital investment
are shunned.
Buffet’s success is powerful testimony to the practical usefulness of managerial
economics. Managerial economics answers fundamental questions. When is the market
for a product so attractive that entry or expansion becomes appealing? When is exit
preferable to continued operation? Why do some professions pay well, while others offer
only meagre pay? Successful managers make good decisions, and one of their most useful
tools is the methodology of managerial economics.

1.1 Nature and Definition of Managerial Economics

Managerial economics is defined as:

 the application of the economic concepts, theories, tools, and methodologies to

solve practical problems in a business.
 it is the application of microeconomic theories to business problems for purposes
of coming up with a sound and rational decisions.
 It bridges the gap between purely analytical problems dealt with in economic
theory and decision problems faced in real business.
  it helps out making rational choices to yield maximum return out of minimum
efforts and resources, and make the best selection among alternative course of
action.
Rational means logical or with reason. Rational choice simply means having arrived at a
decision or choice after the person has considered the logic and reasons in coming up with
the decision or choice.
Example of rational choices:
 An investor choosing one stock over another because he believes it offers a higher
return.
 A student chooses to enrol in SPSPS over other schools in Cebu City because of greater
convenience relative to quality education.
Therefore, managerial economics is a function of microeconomic theories and principles,
decision science, and business principles, situations/conditions.

Managerial Economics = Economics + Decision Science + Business Management

1.2 Scope of Managerial Economics

The following scopes of managerial economics are discussed in detail so that you will
understand the contribution of this discipline to manager’s decision-making process.
1. Demand Analysis and Forecasting. It helps in analysing the various types of demand
which enables the manager to arrive at reasonable estimates of demand for product
of his company. Managers not only assess the current demand but he has to take into
account also the future demand.
2. Production and Supply Analysis. Production analysis is narrower in scope than cost
analysis. Production analysis frequently proceeds in physical terms while cost
analysis proceeds in monetary terms. Production analysis mainly deals with different
production functions and their managerial uses. Supply analysis deals with various
aspects of supply of commodity.
3. Cost Analysis. It is helpful in understanding the cost of a particular product. It takes
into account all the costs incurred while producing a particular product. Under cost
analysis, we will take into account the determinants of cost, method of estimating
costs, the relationship between cost and output, the forecast of the cost, and profit.
4. Pricing Decisions, Policies and Practices. Pricing is a very important area in Managerial
Economics. Price is the genesis of revenue of a firm and as such the success of the
business firm largely depends on the correctness of the pricing decisions.
 5. Profit Management. Business firms are generally organized for the purpose of making
profits and, in the long run profits provide the chief measure of success. An important
point worth considering is the element of uncertainty existing about profits because
of variations in costs and revenues, which in turn, are caused by factors both internal
and external to the firm. If knowledge about the future were perfect, profit analysis
would have been a very easy task.
6. Capital Management. Of the various types and classes of business problems, the most
complex and troublesome for the business manager are likely to be those relating to
the firm’s capital investments. Relatively large sums are involved, and the problems
are so complex that their disposal not only requires considerable time and labor but
is a matter for top-level decision. Briefly, capital management implies planning and
control of capital expenditures.
1.3. Decision-Making as a Function in Managerial Economics
Managers are constantly called upon to make decisions in order to solve problems. Decision
making and problem-solving are on-going processes of evaluating situations or problems,
considering alternatives, making choices, and following them up with the necessary actions.
The entire decision-making process is dependent upon the right information being available
to the right people at the right time.

1.3.1 Decision-Making Process

Define the Identify Develop potential Analyze the Select the best Implement Establish a control and
Problem limiting factors alternatives alternatives alternative the decision evaluation system

Decision-making is a scientific process. Therefore, in order for the manager to

arrive at a rational decision, he has to follow the process in making decisions, which is
presented below:
 Define the problem. The decision-making process begins when a manager
identifies the real problem. One way that a manager can determine the true
problem in a situation is to identify the problem separate from its symptoms.
Example of a problem in business: Decreasing sales

 Identify limiting factors. In order to make the best decision, managers need
to have the ideal resources information, time, personnel, equipment, and
supplies and identify any limiting factors.
 Example: The decreasing sales may be attributable to the presence of a
new brand in the market, or poor marketing channels, or external factors
such as the threat of the COVID 19, etc. The manager has to identify
organization’s available resources, such as the right skills of the
personnel the availability of the system, or mechanism, the technology
and equipment, and time to address the problem and to identify what
resources do they need to acquire because they are not available in the
organization.
 Develop potential alternatives. One of the best known methods for
developing alternatives is through brainstorming. Managers usually discuss
possible potential alternatives to a given problem or situation with his/her
team or staff. This is done to get best ideas from others that can serve as
potential alternative solutions.
Example: Once the manager has identified the core cause of the problem
and the identified limiting factor/s, he/she needs to convene the key people in
the organization to discuss potential solutions to the problem. The manager has
to consider the suggested solutions of each staff or personnel.

 Analyze the alternative. From the gathered and collated ideas, the managers
need to identify the advantages and disadvantages of each alternative before
making the final decision.
Example: The manager has to weigh every alternatives/suggested
solutions given by the staff or personnel as to its advantages and disadvantages
to the organization and operation. This is done to get the most rational and
optimum (least-cost) solution to the identified problem.

 Select the Best alternative. The manager has to choose the best alternative
among other alternatives identified. The manager must decide which
alternative is the most feasible and effective, coupled with which carries the
lowest costs to the organization.
 Implement the decision. Positive results must follow decisions. To make
certain that employees understand their roles, managers must thoughtfully
devise programs, procedures, rules, or policies to help in the problem-solving
process.
Example: Once the manager has come up with the best alternative solution to
the problem, it has to be made available to all the employees in the form of
memoranda and meetings. To further simplify the decision, there is a need to
devise a program, set the guidelines, mechanisms, polices and rules which will
guide all employees towards solving the problem.
  Establish a control and evaluation system. Ongoing actions need to be monitored.
An evaluation system should provide feedback on how well the decision is being
implemented, what the results are, and what adjustments are necessary to get the
expected results.
Example: The manager has to evaluate the performance and activities of the
concerned units or division of the organization based on its unit’s objectives,
targets and deliverables. This is done to ensure that the problem will not recur or
will not create another problem.

1.4 The Role of Managerial Economics to the Accounting Profession

Managerial Economics is closely related to accounting through the efficient allocation of
resources of an organization. Economics determines the efficiency in using and allocating
limited resources of the organization and accounting set the standards and control systems
on how these scarce allocated resources are to be used by the organization. Managerial
economics is also closely related to accounting because it deals with the financial operation
of a business firm. A business is started with the main aim of earning profit. Capital is
invested / employed for purchasing properties such as building, furniture, etc. and for
meeting the current expenses of the business.
Goods are bought and sold for cash as well as credit. Cash is paid to credit sellers. It
is received from credit buyers. Expenses are met and incomes derived. This goes on the daily
routine work of the business. The buying of goods, sale of goods, payment of cash, receipt of
cash and similar dealings are called business transactions.
The business transactions are varied and multifarious. This has given rise to the
necessity of recording business transaction in books. They are written in a set of books in a
systematic manner so as to facilitate proper study of their results.
Management accounting provides the accounting data for taking business decisions.
The accounting techniques are very essential for the success of the firm because profit
maximisation, which is a concern in economics, is the major objective of the firm.
1.5 . The Nature and Function of Profit in Business
Generally, profit is defined as excess amount from deducting total cost from total
revenue. Economics and Accounting have a different view on profit.
Economists determine economic profit by deducting the explicit costs and implicit
costs from the sales revenue of the business. Implicit costs refer to the opportunity costs of
the resources provided by the firm’s owners themselves including capital and
entrepreneurial ability. Thus, economists take into account the normal rate of return on
capital used by the owner of the firm in its own business and the transfer earnings of the
owner-entrepreneur as costs of doing business. The economic profit represents the sales
revenue of the firm in excess of both explicit and implicit costs.
 Economic profits = Sales revenue – Explicit costs – implicit costs
Accountants on the other hand considers business profits as an accounting concept
and represent the residual sales revenue to the owners of the firm after making payments to
all other factors or resources the firm uses. It is the concept of business profits that is
generally used by the business community and accountants.
Business profits = Total sales revenue – Explicit costs
While explaining maximization of short-run profits or present value of the stream of
expected profits in the future, economists assume that it is economic profits that owner-
entrepreneur or managers of corporations seek to maximize. The concept of economic
profits brings into sharp focus the question why such profits which is over and above the
normal rate of return on equity capital and reward for entrepreneurial ability in case of
owner-entrepreneur, exists and what is its role in a free enterprise system.
Profits play an important role in a free market economy. Profits perform two
important primary roles in such an economy.
First, profits serve as a signal to change the rate of output or for the firms to enter or
leave the industry.
Second, profits play a critical role in providing incentive to introduce innovations and
increase productive efficiency and take risks.

Notes: Lord Keynes remarked that “Profit is the engine that drives the business enterprise. Every business
should earn sufficient profit to survive and grow over a long period of time.”

1.6 THEORY OF THE FIRM

The theory of the firm is the microeconomic concepts founded in neoclassical economics
that states that a firm exists and make decisions to maximize profits. The firm's goal is to
determine pricing and demand within the market and allocate resources to maximize net
profits. This is also called as the model of profit maximization.
The firm is formed, run and managed by an owner, employer or an entrepreneur which
has the following characteristics: he has the legal permission to run the enterprise, can enter
into contract with any productive resources supplier, takes his own decisions to maximize
his economic gains, entitled to enjoy residual income, can transfer rights and obligations to
others on contracts, can direct and dictate suppliers, can change the nature of the
management, and, can take final decisions.
Today, the emphasis on profits has been broadened to encompass uncertainty and the
time value of money. In this more complete model, the primary goal of the firm is long-term
expected value maximization or value optimization. In this premise, profit is not the end of
the firm. Rather, it is the means for the firm to achieve its end – and that is value
maximization or value optimization.
The value of the firm is the present value of the firm’s expected future net cash flows.
If cash flows are equated to profits for simplicity, the value of the firm today, or its present
value, is the value of expected profits, discounted back to the present as an appropriate
interest rate.
Satisficing Behavior /Behavioral Approach by Richard Cyert and James G. March,
explains how decisions are taken within the firm. People possess limited cognitive or mental
ability and so can exercise only bounded rationality when making decisions in complex and
uncertain situations. (Thus individuals and groups tend to satisfice –i.e. to attempt to attain
realistic goals, rather than maximize a utility or profit function. Cyert and March argued that
a firm cannot be regarded as a monolith (or a rigid and homogenous organization) because
different individuals and groups within it have their own aspirations and conflicting
interests, and the firm’s behavior is the weighted outcome of these conflicts.
Satisficing is a decision-making strategy that aims for a satisfactory or adequate
result, rather than the optimal solution. Instead of putting maximum exertion toward
attaining the ideal outcome, satisficing focuses on pragmatic or practical effort when
confronted with tasks. This is because aiming for the optimal solution may necessitate a
needless expenditure of time, energy, and resources. For example, customers often select a
product which is good enough, rather than perfect. A firm’s satisficing behavior is an
alternative business objective to maximising profits. It means a business is making
enough profit to keep shareholders happy or it is sufficient for investors to maintain confidence
in the management they appoint.

Notes: Bounded rationality is the idea that in decision-making, rationality of individuals is limited by the
information they have, the cognitive limitations of their minds, and the finite amount of time they have to make
a decision. Rationality is the quality of being based on or in accordance with reason or logic.).

1.6.1 Stakeholder Theory versus Shareholder Theory

A stakeholder can either be an individual, a group or an organization impacted by
the outcome of a decision or activity of the firm. They have an interest on the success of the
project. They tend to have long-term relationship with the organization. These stakeholders
are the suppliers, customers, competitors, the community, pressure groups, organization
employees, government, creditors, they can affect and are affected by the firm’s decisions
and activities.
 A shareholder, on the other hand, is a person or an institution that owns shares or
stock in a public or private operation. They are often referred to as members of a
corporation, and they have a financial interest in the profitability of the organization or
project. A shareholder is always a stakeholder in a corporation, but a stakeholder is not
always a shareholder. The distinction lies in their relationship to the corporation and their
priorities.
To further understand the essence of these two theories and its importance to
managers’ decision in terms of setting priorities, we will explain them separately.

Edward Freeman introduced the Stakeholder Theory in 1984. This theory of

organizational management and business ethics addresses morals and values
in managing an organization. It emphasizes the idea of responsible capitalism,
where businesses are driven not just by profits, but by purpose, values, and
ethics. Freeman argues that a firm should create value for all stakeholders, not
just shareholders/stockholders.

On the other hand, the Shareholder Theory of Milton Friedman (1960)

claims that the only duty of a corporation is to maximize the profits accruing to
its shareholders. This is the traditional view of the purpose of a corporation, since
many people buy shares in a company strictly in order to earn the maximum
possible return on their funds. If a company were to do anything not associated
with earning a profit, the shareholder would either attempt to remove the board
of directors or would sell his shares and use the funds to buy shares in some other
company that is more committed to earning a profit.
Under shareholder theory, the only reason management is working on behalf of
shareholders is to deliver maximum returns to them, either in the form of dividends or an
increased share price. Thus, managers have an ethical duty to the owners to generate
significant value.To take this concept one step further, a corporation should not engage in
any type of philanthropy, since that is not its purpose. Instead, the corporation can deliver
dividends to its shareholders, who then have the option to donate the money for
philanthropic purposes, if they choose to do so. The only case in which a corporation should
donate money is when the amount of the donation creates a benefit that is approximately
equivalent to or greater than the amount of the donation. When a corporation is owned by
just a few shareholders, any attempts by management to engage in significant amounts of
philanthropy can cause turmoil among the owners, if they are not all supportive of this
alternative use of company earnings.
A comparison and contrast matrix is presented in the next page to set the distinction
and similarities of the Stakeholder Theory and the Shareholder Theory,
 Stakeholder Theory
Comparison  Firm should create value
to all those who are
affected by firm’s
decision, and those who
can also affect the firm
 It is the business
managers ethical duty to
both corporate
shareholders and the
community at large that
the activities which
benefit the company do
not harm the community.
 more concerned with
longevity of their
relationship with the
organization and a better
quality of service.
 don’t take part in the
day-to-day operations of
the company or project.
Contrast  Shareholders or capital owners are also among those who
are affected by the firm’s decisions and at the same time
can affect the firm. Therefore, they are also firm’s
stakeholders
Shareholder Theory
 The only duty of a
corporation is to
maximize the profits or
returns of its
shareholders or capital
owners
 more concerned with
stock prices, dividends
and results. They have a
financial interest in the
success of the
organization,
 advocate for growth,
expansion, acquisitions,
mergers and other acts
that will increase the
company’s profitability.
 have some rights as
owners of the company,
which are detailed in the
company’s charter, such
as the right to inspect
financial records—
especially if they’re
concerned about how
the company is being
run by its top-tier
executive suite.
Summary
Managerial Economics is the application of the economic concepts, theories, tools, and
methodologies to solve practical problems in a business. It helps out making rational choices
to yield maximum return out of minimum efforts and resources, and make the best selection
among alternative course of action. Thus, managerial economics is a function of
microeconomic principles, decision science, and business principles and cases. Managerial
economics involves demand analysis and forecasting, production and supply analysis, cost
analysis, pricing decisions, profit management, and capital management. Managers are
expected to solve business problems and arrive at a rational decision. This can be done by
religiously following the decision-making process – from defining the problem down to the
establishment of a control and evaluation system.
Profits play an important role in a free market economy. Economists determine economic
profit by deducting the explicit costs and implicit costs from the sales revenue of the
business. Accountants on the other hand considers business profits as an accounting concept
and represent the residual sales revenue to the owners of the firm after making payments to
all other factors or resources the firm uses. it is economic profits that owner- entrepreneur
or managers of corporations seek to maximize. The theory of the firm is the microeconomic
concepts that states that a firm exists and make decisions to maximize profits. Thus, the
primary goal of the firm is long-term expected value maximization or value optimization.
The firm may also use initiate satisficing to maximize profit. A firm’s satisficing behaviour is
an alternative business objective to maximizing profits. The Stakeholder Theory of E.
Freeman argues that a firm should create value for all stakeholders, not just
shareholders/stockholders. On the other hand, the Shareholder Theory of Friedman
contends that the only duty of a corporation is to maximize the profits accruing to its
shareholders so that they will continuously place their money in the corporation. Managers
are guided by these two theories in setting their priorities.