The Fundamentals of Managerial Economics

 
Economics
 the ‘Study of allocation of scarce resources, among alternative uses’. (Rao)
 the social science that studies the behavior of individuals, households, and organizations (called
economic actors, players, or agents), when they manage or use scarce resources, which have
alternative uses, to achieve desired ends. (Wikipedia)
 a social science concerned with man’s problem of using scarce resources to satisfy human wants.
(Pagoso, et al)
 Study of how people use their scarce resources to satisfy their unlimited wants;
 About making choices
 The problem is that wants or desires are virtually unlimited while the resources available to
satisfy these wants are scarce. Economics studies how people use their scarce resources in an
attempt to satisfy their unlimited wants.
 
Scarcity
- Occurs when the amount of people’s desire exceeds the amount available at a price of zero.
- A resource is scarce when it is not freely available or when its price exceeds zero.
- Goods and services that are truly free are not the subject matter of economics. Without scarcity,
there would be no economic problem and no need for prices.
- Resources are always scarce;
 They are not only scarce, but also have alternative uses
- Optimum allocation is required;
 It is about making of choices or decision-making.
 Allocation problems are faced by individuals, organizations and nations
Economics deals with:
 How an individual consumer allocates his scarce resources among alternative uses?
- To get the maximum satisfaction
 How will an individual producer will attain its aim of least cost combination of inputs to get a given
quantities of output.
- To achieve efficiency
 How an individual firm/Industry attains equilibrium.
- To attain profit maximizing level of output
- Maximize profit or minimize cost
- Maximize wealth or value
 How a country reach equilibrium
- To allocate limited resources in a way that desired goals are achieved
 
Resources
- The inputs, or factors of production, used to produce the goods and services that humans want.
 Labor
- The physical and mental effort used to produce goods and services.
 Capital
- Physical capital- Manufactured items (tools, buildings) used to produce goods and
services.
- Human capital- Knowledge and skills people acquire to increase their labor productivity.
 Natural resources
- All “gifts of nature” used to produce goods and services; which includes bodies of water,
trees, oil reserves, minerals, and animals
- These can be renewable or exhaustible
 Entrepreneurial ability
- Managerial and organizational skills needed to start a firm. The talent, combined with the
willingness to take risk of profit or loss.
 
 

Goods
- A tangible product used to satisfy human wants.
Services
- An activity, or intangible product, used to satisfy human wants
 
Economic decision makers
Households
- Consumers- Demand goods and services
- Resource Owners- Supply the resources
Firms
- Demand goods and services
- Supply the resources
Government
- Demand goods and services
- Supply the resources
Rest of the world
- Demand goods and services
- Supply the resources
 
Market
- A set of arrangements by which buyers and sellers carry out exchange of mutually agreeable terms
- Bring together buyers and sellers
- Determine price and quantity
Product Market- Market where goods and services are sold or exchanged
Resource Market- Market where resource is bought or sold
 
Circular flow model
- Diagram that traces the flow of resources, product income, and revenue among economic decision
makers
- Shows the flow of the following among the economic decision makers:
 Resources
 Products
 Income
 Revenue
- Shows interaction between the households and firms

   
Microeconomics
 The study of economic behavior in particular markets
 Individual economic choices
 Markets coordinating the choices of the economic decision makers
 Individual pieces of the puzzle
Macroeconomics
 The study of economic behavior of entire economies
 Performance of the economy as a whole
 Big picture
Normative economics
 A normative economic statement concerns what should be; it reflects an opinion and cannot be
shown to be true or false by reference to the facts.
 Normative economic statement
 Opinion
 ‘What should be’
Positive economics
 A positive economic statement concerns what is; it can be supported or rejected by reference to
facts.
 Positive economic statement Assertion about economic reality
 Supported or rejected by evidence
 True or false
 ‘What is’
 
Application of economics in decision making
 
Managerial economics
 Special branch of economics bridging the gap between the abstract theory and managerial practice
“It is the application of economic analysis to business problems; it has its origin in theoretical
microeconomics.” – Howard Davies and Pun-Lee Lam
“Integration of economic theory with business practice for the purpose of facilitating decision-making and
forward planning” -Milton H. Spencer
“Price theory in the service of business executives is known as Managerial economics” - Donald Stevenson
Watson
 Economics in general takes a ‘positive’ and predictive approach not prescriptive or ‘normative’
 trying to explain “what is” not what “should be”
 the main objective is to understand how a market economy works
 Not very concerned about the descriptive realism of assumptions: “I assume X” does not mean “I
believe X to be true”
 Some real tension if the models are used for prescription
 assume “perfect knowledge”: OK for model-building
 cannot say to a manager: “behave AS IF you had perfect knowledge”
Assist in decision making
 Adopt a general perspective, not a sample of one
 Simple models provide stepping stone to more complexity and realism
 Thinking logically has a value itself and can expose sloppy thinking
Why study managerial economics?
 A powerful “analytical engine”.
 A broader perspective on the firm.
o what is a firm?
o what are the firm’s overall objectives?
o what pressures drive the firm towards profit and away from profit
 The basis for some of the more rigorous analysis of issues in Marketing and Strategic Management
 Managerial economics is the application of economic theory (particularly microeconomic theory) to
practical problem solving.
 Managerial economics can be used to make better management decisions.
 Managerial economics pertains to decision making about the optimal allocation of scare resources
to competing activities both the private & public sectors.
  Managerial economics incorporates elements of both micro and macro economics. It uses both
descriptive and prescriptive models and the analytical tools of mathematical economics and
econometrics (prescriptive models).
 The rapid internationalization of the marketplace makes the decision-making tools of managerial
economics more valuable than ever

Problem Solving Principle

Problem: Over-bidding OVI gas tract
In 1992, a young geologist was preparing a bid recommendation for an oil tract on the outer
continental shelf in the Gulf of Mexico. He suspected that this new tract of land contained a large
accumulation of oil because the adjacent tract contained several productive wells—wells that his company,
Oil Ventures International (OVI), already owned. The geologist estimated both the amount of oil the tract
was likely to contain and what competitors were likely to bid; then, given these estimates, he recommended
a bid of $5 million. No competitors had neighboring tracts, so none suspected a large accumulation of oil.
Surprisingly, OVI’s senior management ignored the recommendation (Senior managers were
rewarded for acquiring reserves regardless of their profitability) and submitted a bid of $20 million, and the
company won the tract—over the next highest bid of $750,000.
What, if anything, is wrong?
 
The goal of this text is to provide tools to help identify and solve problems like this.
Two distinct steps:
1) Figure out what’s wrong
◦ i.e., why overbidding occurred
2) Figure out how to fix it
 
Model of behavior
Both steps require a model of behavior
 Why are people making mistakes?
 What can we do to make them change?
Economists use the rational-actor paradigm to model behavior.
The rational actor paradigm states:
 People act rationally, optimally, self-interestedly
Meaning, they respond to incentives – to change behavior you must change incentives
 
How to find source of the problem?
1) Who is making the bad decision?
Letting someone with better information or incentives make the decision
2) Does the decision maker have enough information to make a good decision?
Giving the decision maker more information
3) Does the decision maker have the incentive to make a good decision?
Changing the decision maker’s incentives
 
Solutions of the problem
1) Who is making the bad decision?
Senior management made the bad decision to overbid.
2) Does the decision maker have enough information to make a good decision?
They had enough information to make the right decision.
3) Does the decision maker have the incentive to make a good decision?
They didn't have the incentive to do so.
 
A bonus system created incentives to over-bid.
 Senior managers were rewarded for acquiring reserves regardless of their profitability.
 They had the young geologist "do what he could" to increase the size of estimated reserves.
 Bonuses also created an incentive to manipulate the reserve estimate.
 

Now that we know what is wrong, how do we fix it?

Let someone else decide? NO
Change information flow? NO
Change incentives? YES
Change performance evaluation metric
Ex. Increased profitability as measurement of success instead of increased acquired reserves
Reward scheme
Ex. Make bonuses tied to profitability, not acquired reserves.
 
How to develop problem solving skills
 Think about the problem from the organization’s point of view.
 Think about the organizational design.
 What is the trade-off?
 Don’t define the problem as the lack of your solution.
 Avoid jargon.
 
Problem: NAR
In 2006, a TV reporter was sent into a National Auto Repair (NAR) shop with a perfectly good car.
The reporter came out with a new muffler and transmission — and a bill for over $ 8,000.
The news story badly hurt NAR's profits.
How do you solve this problem?
 
1) Who is making the bad decision?
The mechanic recommended unnecessary repairs.
2) Does the decision maker have enough information to make a good decision?
Yes, in fact, the mechanic is the only one with enough information to know whether repairs are
necessary.
3) Does the decision maker have the incentive to make a good decision?
No, the mechanic is evaluated based on the amount of repair work he does, and receives bonuses or
commissions tied to the amount of repair work.
 
There was an incentive issue
NAR tried two solutions
1) reorganized into two divisions — led to colluding
2) adopted flat pay — led to less incentive to work hard
Suggested resolution:
Add an additional performance evaluation metric to original commission scheme
Ex. Sporadically send in "secret shoppers" like the news reporter. This shows the trade-offs you
face when creating solutions.