Managerial Economics – ECO555

CHAPTER 1 : INTRODUCTION TO
MANAGERIAL ECONOMICS

I. Definition of Managerial Economics

II. Circular Flow of Economic Activity

III. Nature of Firms

1. Definition of Firms

2. Why Firm Exist?

3. Goals of Firms

4. Other Economic Goals

5. Non-Economic Goals

6. Constraint Faced By Firm

7. What is Profit?

8. Functions of Profits

9. Calculation of Profit

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 Managerial Economics – ECO555

CHAPTER 1 : INTRODUCTION TO MANAGERIAL ECONOMICS

I. Definition of Managerial Economics

It is an application of economic theory and the tools of analysis of decision

science to examine how a firm can achieve its aims or objectives most
efficiently.

Produce 0r Buy?
Problems faced by Technique of Production
management What to Produce?
Medium of Promotion

Economic Managerial Decision

Theory Economics Sciences

Theory of Consumer Math

Behavior Statistics
Theory of the Firm
Theory of Market
Structures & Pricing

Optimal
Solution

Diagram 1 : The Nature of Managerial Economics

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 Managerial Economics – ECO555

II. Circular Flow of Economic Activity

The circular flow of economic activities describes the way in which a

country’s economy flows backward and forward between the sectors in the
economy. It shows how the household and firm interact in the resource and
product markets.

Goods and services Goods and services

Product
market
Payment for Payment for
goods and services goods and services

Household Firms

Factor
income
payment
Factor
market
Economic resources Land, labor, capital, entrepreneur
Outer loop – physical flows inner loop – money flows

Diagram 2 : The Circular Flow Model

From the circular flow diagram, the main function of the firm is to purchase
resources, combine these resources and transform them into goods and
services for the consumers. The owners of resources will then use the income
generated to purchase the goods and services produced by firms.

In the process of producing goods and services to society, firms provide

employment to workers and pay taxes to the government. Government will
then use the tax money to provide services such as national defense and
education.

III. Nature of Firms

1. Definition of Firm
A firm is an organization that combines and organizes resources for
the purpose of producing goods and/or services for sale.

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 Managerial Economics – ECO555

2. Why Firm Exist?

Firms exist because it is very costly for individual to enter into each step
of production and distribution process.

3. Goals of Firms
Maximizing profit

4. Other Economic Goals

Maximizing sales
Maximizing market share
Produced technologically advanced product

5. Non-Economic Goals
Produce environmental friendly products
Provide a good place for employees
Provide good products and/or services to customer

6. Constraint Faced By Firm

Financial
Moral
Technological
Environmental
Availability of resources
Legal

7. What is Profit?
Reward for bearing risk
Reward due to monopoly status
Reward for innovation
Reward due to imperfect market mechanism

8. Functions of Profits
Signaling changes in the rate of production
Signaling for reallocation of resources due to changing in demand
and taste

9. Calculation of Profit
Profit =TR - TC
Accounting Profit = TR - Explicit Costs
Economic Profit = TR - Exp Costs - Imp Costs

Notes:

• EXPLICIT COSTS
The actual expenditures of the firm required to hire or purchase
inputs

• IMPLICIT COSTS
The value of the inputs owned and used by the firm

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 Managerial Economics – ECO555

PRACTICE QUESTIONS

1. Illustrate using a diagram the circular flow of economic activity.

2. Explain 3 objectives of a firm.

3. Explain briefly how managerial economics can help the manager

in decision-making. Give specific example.