Lecture 01: Nature and

MANAGERIAL ECONOMICS Scope of Managerial

Economics
MANAGERIAL ECONOMICS: DEFINITION

Economics is a social science which studies human behavior in relation

to optimizing allocation of available resources to achieve the given
ends

According to E.F. Brigham and J. L. Pappas, managerial economics is

“the application of economic theory and methodology to business administration
practice”

EMBA 508: MANAGERIAL ECONOMICS

ROLE OF MANAGERIAL ECONOMICS
Management Decision Problems

Economic Concepts Decision Sciences

Managerial Economics

Optimal Solutions to Management

Decision Problems

EMBA 508: MANAGERIAL ECONOMICS

MANAGERIAL ECONOMICS:
CHARACTERISTICS
Managerial economics applies economic theory and methods to
business and administrative decision making
 It uses the tools and techniques of economic analysis to solve managerial problems
and links traditional economics with the decision sciences
 It tells managers how things should be done to achieve organizational objectives
efficiently
 It helps to recognize how economic forces affect organization and describes the
economic consequences of managerial behavior

EMBA 508: MANAGERIAL ECONOMICS

EMBA 508: MANAGERIAL ECONOMICS
THEORY OF THE FIRM
The basic model of the business enterprise
 A business enterprise is a combination of people, physical and financial assets and
information

EMBA 508: MANAGERIAL ECONOMICS

THEORY OF THE FIRM (CONT.)
A firm is thought to have profit maximization as its primary goal
 Firm’s manager is assumed to be working to maximize the firm’s short-term profits
 The emphasis on profit has been broaden to encompass uncertainty and time value of
money
 Therefore, in the complete business model, the primary goal of the firm is long-term
expected value maximization

EMBA 508: MANAGERIAL ECONOMICS

THEORY OF THE FIRM: DEFINING VALUE
Value of the firm is the present value of the firm’s expected future net
cash flows
 Net cash flows can be equated to profit
 Thus the present value is the value of expected profits discounted back to the present
at an appropriate interest rate
𝑛
𝜋1 𝜋2 𝜋𝑛 𝜋𝑡
𝑃𝑉 = 1
+ 2
+ ⋯ + 𝑛
=
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑡
𝑡=1

𝑛 𝑛
𝜋𝑡 𝑇𝑅𝑡 − 𝑇𝐶𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 = =
(1 + 𝑟)𝑡 (1 + 𝑟)𝑡
𝑡=1 𝑡=1

EMBA 508: MANAGERIAL ECONOMICS

EXPECTED VALUE MAXIMIZATION
Expected value maximization relates to the various functional
departments of the firm, also illustrates the value of forecasting

Total Revenues (TR) = Marketing department; primarily responsible for

promotion and sales
Total Cost (TC) = Production department; primarily responsible for
costs
i (Discount Factor) = Finance department; primarily responsible for the
acquisition of capital

EMBA 508: MANAGERIAL ECONOMICS

THEORY OF THE FIRM: CONSTRAINTS &
LIMITATIONS
Manager must consider how various external constraints affect their
ability to achieve organizational objectives
a. Skilled labor
b. Raw materials
c. Energy
d. Specialized machineries
e. Warehouse space
f. Amount of investment funds available for a particular project or activity
g. Legal or contractual restrictions

The theory ignores the possibilities of satisfying, managerial self-

dealing and voluntary social responsibility on the part of the business

EMBA 508: MANAGERIAL ECONOMICS

BUSINESS PROFIT & ECONOMIC PROFIT
Without profit motive business enterprise would fail to operate
 It plays an important role in the efficient allocation of economic resources

Business Profit is the residuals of sales revenue minus the explicit

accounting costs of doing business
Profit = Total Revenues – Total Cost
Economic profit equals to business profit minus the implicit costs of
capital and any other owner-provided inputs
 Implicit cost reflects the opportunity cost for the effort of the owner-
entrepreneurs

EMBA 508: MANAGERIAL ECONOMICS

VARIABILITY OF BUSINESS PROFITS:
RELEVANT THEORIES
Frictional Profit Theory
 Abnormal profits observed following unanticipated changes in demand or cost
conditions
 Example- a rise in the use of aluminum in automobiles results a lower profits to the
steel manufacturers

Monopoly Profit Theory

 Above-normal profit caused by barriers to entry that limit competition
 Barriers are high capital requirement, patents, import protection etc.

Innovation Profit Theory

 Above-normal profit that follow successful invention or modernization

Compensatory Profit Theory

 Above-normal rate of returns that reward efficiency

EMBA 508: MANAGERIAL ECONOMICS

ROLE OF PROFIT TO THE ECONOMY
Economic profit plays an important role in the market based economy
 Above-normal returns serve as a signal of industry expansion
 Expansion by established firms or entry by new competitors occurs quickly
 Below-normal profit provides a signal for contraction and exit

Economic profits also affect the allocation of scare economic resources

Thus profits play a critical role both in
 providing an incentive for innovation and productive efficiency
 Allocating scare resources

EMBA 508: MANAGERIAL ECONOMICS

THE CHANGING ENVIRONMENT OF
MANAGERIAL ECONOMICS

Globalization of economic activity

 Goods and services
 Capital
 Technology
 Skilled labor

Technological change
 Telecommunication advances
 The internet and the World Wide Web

EMBA 508: MANAGERIAL ECONOMICS