1.

3 Explain - Managerial Economics

Explained
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Seven important things to know AND UNDERSTAND about Managerial
Economics
 

1. Managerial Economics can be defined as the blending of economic theory with

business practices so as to ease decision-making and future planning by
management.
2. Managerial Economics assists the managers of a firm in a rational solution of
obstacles faced in the firm’s activities. It makes use of economic theory and
concepts. It helps in formulating logical managerial decisions.
3. The key of Managerial Economics is the micro-economic theory of the firm. It
lessens the gap between economics in theory and economics in practice.
Managerial Economics is a science dealing with effective use of scarce resources. It
guides the managers in taking decisions relating to the firm’s customers,
competitors, suppliers as well as relating to the internal functioning of a firm.
4. Managerial economics uses both Economic theory as well
as Econometrics for rational managerial decision making. Econometrics is defined
as use of statistical tools for assessing economic theories by empirically measuring
relationship between economic variables. It uses factual data for solution of
economic problems
5. The study of Managerial Economics helps in enhancement of analytical skills,
assists in rational configuration as well as solution of problems. While
microeconomics is the study of decisions made regarding the allocation of resources
and prices of goods and services, macroeconomics is the field of economics that
studies the behavior of the economy as a whole (i.e. entire industries and
economies). Managerial Economics applies micro-economic tools to make business
decisions. It deals with a firm.
6. The use of Managerial Economics is not limited to profit-making firms and
organizations. But it can also be used to help in decision-making process of non-
profit organizations (hospitals, educational institutions, etc). It enables optimum
utilization of scarce resources in such organizations as well as helps in achieving the
goals in most efficient manner. Managerial Economics is of great help in price
analysis, production analysis, capital budgeting, risk analysis and determination of
demand.
7. Managerial Economics is associated with the economic theory which constitutes
“Theory of Firm”. Theory of firm states that the primary aim of the firm is to maximize
wealth. Decision making in managerial economics generally involves establishment
of firm’s objectives, identification of problems involved in achievement of those
 objectives, development of various alternative solutions, selection of best alternative
and finally implementation of the decision.

 
The role of managerial economist can be summarized as follows:

1. He studies the economic patterns at macro-level and analysis its significance to

the specific firm he is working in.
2. He has to consistently examine the probabilities of transforming an ever-
changing economic environment into profitable business avenues.
3. He assists the business planning process of a firm.
4. He also carries cost-benefit analysis.
5. He assists the management in the decisions pertaining to internal functioning of a
firm such as changes in price, investment plans, type of goods /services to be
produced, inputs to be used, techniques of production to be employed, expansion/
contraction of firm, allocation of capital, location of new plants, quantity of output to
be produced, replacement of plant equipment, sales forecasting, inventory
forecasting, etc.
6. In addition, a managerial economist has to analyze changes in macro- economic
indicators such as national income, population, business cycles, and their possible
effect on the firm’s functioning.
7. He is also involved in advising the management on public relations, foreign
exchange, and trade. He guides the firm on the likely impact of changes in monetary
and fiscal policy on the firm’s functioning.
8. He also makes an economic analysis of the firms in competition. He has to
collect economic data and examine all crucial information about the environment in
which the firm operates.
9. The most significant function of a managerial economist is to conduct a detailed
research on industrial market.
10. In order to perform all these roles, a managerial economist has to conduct an
elaborate statistical analysis.
11. He must be vigilant and must have ability to cope up with the pressures.
12. He also provides management with economic information such as tax rates,
competitor’s price and product, etc. They give their valuable advice to government
authorities as well.

1.4 Elaborate -Economics in Business

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As mentioned above, firms consider its resources  when trying to reach its goals. What
is a firm anyway?  A firm is a collection of resources that is transformed into products
demanded by consumers. Simply saying, a firm is a business. It is an entity that
converts inputs (resources - land, labor, capital , entrepreneurship) to outputs (products
or services).
 
PROFIT MAXIMIZATION HYPOTHESIS
Throughout the discussion , we will assume that the main goal of the firm is to maximize
profit? Earning a profit is different from maximizing profit.  Maximizing profit involves
identifying the best price and quantity (produced) to get the highest profit as much as
possible.
 

Profit Maximization Rule Definition

The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must
choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue
(MR) and the Marginal Cost curve is rising. In other words, it must produce at a level
where MC = MR.
 

Profit Maximization Formula

The profit maximization rule formula is
MC = MR
Marginal Cost is the increase in cost by producing one more unit of the good.
Marginal Revenue is the change in total revenue as a result of changing the rate of
sales by one unit. Marginal Revenue is also the slope of Total Revenue. This means
that this is the amount to which we expect the Total Revenue to change as the quantity
being sold or demanded changes.
Total Revenue (TR) = Price x Quantity Sold
Profit = Total Revenue (TR)– Total Costs (TC) 
or
Net Income = Sales - Expenses (Accounting term)
Therefore, profit maximization occurs at the most significant gap or the biggest
difference between the total revenue and the total cost.
Why is the output chosen at MC = MR?
 

At A, Marginal Cost < Marginal Revenue, then for each additional unit produced,
revenue will be higher than the cost so that you will generate more. Why generate
more ? This is because you can still produce more while still having a an additional cost
that is lower than the additional revenue. Sellers have this mindset that they will keep on
producing or selling as long the additional cost is lower than the additional benefit (Cost-
Benefit analysis).
At B, Marginal Cost > Marginal Revenue, then for each extra unit produced, the cost will
be higher than revenue so that you will create less.
Thus, optimal quantity produced should be at MC = MR.
You might ask why go for “Q’ to optimize profit when the MR=MC. Why not go for A
when MR is greater than  MC? If we are to put values in this discussion, you will realize
that even though point A allows the firm to enjoy higher marginal ( additional) revenue
than its additional cost, the profit is still lower compared to when they operate at point Q.
This is the point of PROFIT MAXIMIZATION .  

Application of Marginal Cost = Marginal

Revenue
The MC = MR rule is quite versatile so that firms can apply the rule to many other
decisions.
For example, you can apply it to hours of operation. You decide to stay open as long as
the added revenue from the additional hour exceeds the cost of remaining open another
hour.
It can also be applied to advertising. You should increase the number of times you run
your TV commercial as long as the added revenue from running it one more time
outweighs the added cost of running it one more time.

Profit Maximization Example

In the early 1960s and before, airlines typically decided to fly additional routes by asking
whether the extra revenue from a flight (the Marginal Revenue) was higher than the per-
flight cost of the flight.
In other words, they used the rule Marginal Revenue = Total Cost/quantity
Then Continental Airlines broke from the norm and started running flights even when
the added revenues were below average cost. The other airlines thought Continental
was crazy – but Continental made huge profits.
Eventually, the other carriers followed suit. The per-flight cost consists of variable costs,
including jet fuel and pilot salaries, and those are very relevant to the decision about
whether to run another flight.
However, the per-flight cost also includes expenditures like rental of terminal space,
general and administrative costs, and so on. These costs do not change with an
increase in the number of flights, and therefore are irrelevant to that decision.

 
Limitations of the Profit Maximization Rule
(MC = MR)
 
Before we discuss the limitations, please remember that  Profit is TR less TC and TR is
Price X Quantity.
Further, changing the price can change the quantity being demanded, thus changing
the TR, the MR and the profit.  
(As early as now, please do know that Demand and Quantity Demanded are different.)
 
Limitations of MR=MC rule

1. Real World Data

In the real world, it is not so easy to know exactly your Marginal Revenue and Marginal
Cost of the last products sold. For example, it is difficult for firms to know the price
elasticity of demand ( degree of sensitivity of Demand brought by a change in price) for
their goods – which determines the MR.

2. Competition
The use of the profit maximization rule also depends on how other firms react. If you
increase your price, and other firms may follow, demand may be inelastic (not sensitive
to the change in price). But, if you are the only firm to increase the price, demand will be
elastic (sensitive to the change in price).

3. Demand Factors
It is difficult to isolate the effect of changing the price on demand. Demand may change
due to many other factors apart from price.

4. Barriers to Entry
Increasing prices to maximize profits in the short run could encourage more firms to
enter the market. Therefore firms may decide to make less than maximum profits and
pursue a higher market share.
 
Aside from profit maximization, the other economic objectives that a firm may
pursue are
 

1. market share
2. profit margin
3. return on investment
4. technological advancement
5. customer satisfaction
6. shareholder value

 
They may also pursue non-economic objectives such as:

1. workplace environment
2. product quality
3. service to community

2.2. Explore - Supply, Demand and Equilibrium

Table 1. Demand and Supply Schedule for Bananas

Price Quantity Demanded (Qd) Quantitiy Supplied (Qs)

50 6 0

75 4 4

100 2 8

125 0 12

 Demand is different from Quantity demanded (Qd); as supply is not synonymous to

quantity supplied (Qs). Demand refers to the different combinations of price and Qd.
When plotted on a graph, they form a demand curve. Quantity demanded (Qd) is just a
single point along that curve representing the quantity being demanded at a certain
price. The same goes for supply and quantity supplied. When p and Qs are plotted on
the graph, they form the supply curve. The table above shows the Qd in the 2 nd column.
Taken individually, these are just quantities demanded. At 75 , the Qd is 4. While at 50 ,
the Qd is 6. Taken as a whole (all prices with corresponding Qd), they form the demand.
This is the same with supply. The 3rd column shows the different Qs at a certain price
level. Say at 100 , the Qs is 8. Taken as a whole (different prices and their
corresponding Qs), they form  the supply.
 
As we plot the points of the demand and supply schedule, we notice that the demand
curve has a downward slope, while the supply curve has an upward slope.  This will be
discussed thoroughly in the Explain section of this module.
 
 
 Figure 1 shows the demand curve while figure 2 shows the supply curve. Putting the
two curves together will let you see the point in which they intersect. This is called
the market equilibrium. It is a situation wherein demand = supply because the buyer
and the seller have agreed to buy and sell at a certain price and quantity.
  Is there a chance that both sellers and buyers don’t agree in a certain price ? The
answer is yes.  Imagine your mom or your guardian going to the market to buy fish.
Most of the time, you will find her hopping from one vendor to another to inquire on the
price of a certain fish. She does that because she is trying to find the one who can sell
her the fish at a certain volume and price (assuming that all those fishes in that market
are of the same kind, quality and size - ceteris paribus ). Sometimes she would haggle
with the vendor until both of them agrees to buy and sell 4 kilos of fish at 75 pesos per
kilo.  Once they reach that point, that is what you call “equilibrium”.
 

 Ceteris paribusmeans all other factors are assumed to remain constant.

 Equilibrium priceis the amount or price that has been agreed on by both sellers
and buyers at a certain quantity. In the graph above, the P E  is 75..
 Equilibrium quantityis the number of goods/services that buyers and sellers
have agreed to transact (buy and sell) at a certain price. In the graph above, the
QE  is 4.
 
If Qd is greater than Qs at a certain price , there is a shortage. If Qd is lesser than Qs at
a certain price, there is a surplus. Technically, all points above the equilibrium show
consumer surpluses; while those below the equilibrium show shortages.  

2.3 Explain - Law of Demand and Law of

Supply
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Going back to the demand and supply of pizza (Task 2.b), you can observe that as
prices go up from 5 to 12, the quantity being demanded gradually decreases. If you start
from the bottom where price is 12 to the price of 5, you can see that the quantity
demanded increases. This is because buyers want to buy more, ceteris paribus (all
things remain constant), if the price is low; and will buy less if the price is high. This is a
normal reaction to price. This is the LAW OF DEMAND. There is, therefore, an indirect
or inverse relationship between price and quantity demanded. Hence, your demand
curve above is downward sloping (negative slope).
As far as sellers are concerned, these individuals will sell more if the price is high ; and
will do the opposite if the price is low, ceteris paribus. Why ? Firms sell ,usually and
normally, to maximize profit. Considering all things constant (ceteris paribus), sellers will
sell more if they see that the product can be sold at higher prices than before. They will
see it as a good earning opportunity. On the other hand, they will reduce the supply of a
certain product that has a declining value in the market because they will earn less from
it. This is the LAW OF SUPPLY. There is, therefore, a direct or positive relationship
between price and quantity supplied. Hence, the supply curve is upward sloping
(positive slope).
MOVEMENTS ALONG THE DEMAND AND SUPPLY CURVE
Market equilibrium may not be that easy to reach because buyers want a lower price
while sellers want a higher price. But take note, a change in price “only” will not change
the equilibrium point.  See the graph below. A change in the price from 1 dollar to 1.20
dollars will just move the Quantity demanded from 800 to 700. At the same time, this will
only change the quantity supplied from 500 to 600. At this point, there is clearly a
shortage (below equilibrium point). However, as you can see, the Equilibrium price is
still 1.40 dollars and the equilibrium quantity is still 600.  Let me highlight the fact that
even when prices change, there is still one demand and one supply curve in Figure 4.
 
Figure 4. Demand and  Supply curve  of Gasoline
 
Non-price factors affecting demand and supply
The fourth item in learning task 2.b shows you that an interesting news of a certain
product can affect demand. It is not just simply a mere movement of the point from the
bottom part of the demand curve to the upper part or vice versa. A positive “news” such
as this can entirely affect the demand curve as “demand” itself will increase.  An
increase in demand will cause the demand curve to shift to the right. A decrease in
demand means the curve will shift to the left.
When “ceteris paribus” is non-existent, it means that the other factors have changed. If
other factors change, the Law of Demand and the Law of Supply do not anymore apply.
For example, if the number of buyers and sellers increase, the quantity demanded and
quantity supplied will NOT increase. Why? It is because the entire demand and supply
will be the ones that will increase (remember that demand is not Qd and supply is not
Qs). Hence, demand and supply curves may reflect any change through a shift in the
entire curve to the left (decrease in demand /supply) or right (decrease in
demand/supply).  A shift in any or both curves will create a new equilibrium point.
Figure 5 shows a shift in the demand curve to the right which means that demand has
increased maybe due to a change in non-price factors. Notice that the quantity has
changed given a certain price, say P12.
 
 
Figure 5 . Demand Curve shifts to right
 
Figure 6 shows a decrease in demand brought by a change in a non-price factor.
Suppose the market is originally in equilibrium (point at which S1 and D1 intersects), a
decrease in demand tells us that a new equilibrium point is formed (point at which D2
and S1 intersects). This implies that when supply is constant and demand decreases for
some reason, the new equilibrium price (P2) will decrease. To help you better
understand, the illustration is simply telling us that when the willingness to buy goods is
lower than the willingness to sell, prices will go down.
 

Figure 6. Demand curve shifts to the left

 
 Figure 7 is a perfect example of a decrease in supply. If demand (D 1) is constant and
supply decreases (S2), prices will go up. This is because buyers will now try to compete
considering that there was a decrease in supply. A fewer quantity supplied (Q 1) has
generated a higher price (P1) because of the decrease of supply.
 

Figure 7. Supply  curves shifts to the left

 
Real-life example
The Covid 19 pandemic has awoken the sleeping “plantita/plantito” spirit in us. Many of
us never gave any interest to plants until we found ourselves with nothing much to do
during the quarantine period.  Along with fellow plantitas/plantitos, we started swapping
plants, and buying or selling them.  Maybe it was a bandwagon effect or maybe it was
something else more pure . Either way, the hype has pushed us to get all kinds of
caladiums, snakesplants, philodendrons , aglaonemas  , etc. We have searched far and
wide, from the mountains to online stores and to all gardens (both secluded and
accessible ). What happened? Those plants that were never worth a penny before this
all began now have price tags. Those selling at P100 are now sold at P500 or more.
The increase in demand has increased price! That’s not all, the closing of the borders
and the transportation issues (inter-island)  have reduced the availability of the plants.
The increase in demand and the decrease in supply (all at the same time) have pushed
the price farther.  
.
Figure 8. Caladium and Snake plant

2.4 Elaborate: Demand and Supply

Function Equations
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Demand and supply can be expressed in three forms:

1. Tabular – Demand and Supply Schedules

2. Graphical – Demand and Supply Curves
3. Mathematical – Demand and Supply equations
The first two, tabular and graphical, have been shown to you in the earlier parts of this
module. The third one –mathematical – will require you to refresh your learning about
linear equations.
Demand Function equation
Marketers , sales analysts and managers make use of forecasting to estimate sales.  At
the same time, other stakeholders also try to forecast supply given the existing market
price.  There are many tools that can be used and one of this is the demand function
equation.
Earlier in this module, we discussed that price can affect Qd/Qs and  the other non-price
factors can affect  demand/supply. While there is a higher-level statistical tool that we
can use to estimate demand/supply, we will have to push them back for later topics. For
now, we will use the linear equation to estimate demand or supply.
The equation of any straight line, called a linear equation, can be written
as: y = mx + b, where m is the slope of the line and b is the y-intercept. The y-intercept
of this line is the value of y at the point where the line crosses the y axis.
In demand function equation, we follow Q = a + bP where a is the y-intecept and b is the
slope.  To get the demand function equation, we follow 3 simple steps:

1. Get the slope: b =  ( Q2-Q1)/ (P2-P1)

In Table 1: Demand and Supply of Pizza, let us say that price has increased from P8 to
P9. We recognize that Q1= 600 and Q2 = 550. Based on the formula, b = - 50. Why
negative ? It is because an increase in price has decreased Qd (Law of demand –
inverse relationship between price and Qd).
 

2. Find the y –intercept (a)

The “a” is actually the Qd when price is 0. If that is not seen on the table, then we
compute for  “a” by using the formula Q=a + bp .

 Q = a + bp (replace Q and p with any available values available in the problem)

 In my case, I will use Q=600 and P=8. You can use Q=550 and P=9. Either way,
we get the same answer.  
Q= a + bp
600= a – 50 (8)
600= a -400
a=1,000
 

3. Write the demand function equation

Q = 1,000-50P
 
 
Now, is the demand function still reflective of the demand for pizza as shown in Task
2.b? The answer is yes. Without looking at the table, use Q= 1,000-50P to  forecast Qd
is if price is 12. After getting your answer by means of substitution, check the table
(pizza demand schedule ) and see if you have the same value. The demand function is
the mathematical representation of the relationship between Qd and Price.
 
 
SUPPLY FUNCTION
For supply function equation, we follow the same process. However, instead of  Qd, we
use Qs.  
 
Step 1: Get the slope (use any point).
P1  = 5
P2  = 6
Qs1 = 300
Qs2 = 400
 
b=(400-300) / (6-5)  = 100
 
Step 2. Get the Y -intercept .
Qs=a + bp
400 = a +100 (6)
 400 = a + 600
a = -200
 * most of the the time,  the Y-intercept is positive
 
 
Step 3. Write the supply function equation.
Qs = -200 + 100P
 
 
 
Equilibrium point
 To solve for equilibrium price,
Equate Qd= Qs functions to find equilibrium price and quantity.
  1000 - 50 P = -200 + 100 P
                                    -50 P - 100P  = -1000-200
                                        -150P    = -1200
                                        PE = 8
 
To find equilibrium quantity,
1000-50(8) = 600
Or
-200+100(8) = 600