Chapter one

Managerial Economics
It is a special branch of economics bridging the gap between the economic theory and
managerial practice.

Scope of Managerial Economics

■ The scope of managerial economics is a continual process, as it is a developing
science.
■ Demand analysis and forecasting, profit management, and capital management are
also considered under the scope of managerial economics.
Managerial Economics – Micro & Macroeconomics
 Macroeconomics deals with the study of entire economy. It considers all the
factors such as government policies, business cycles, national income, etc.
 Microeconomics includes the analysis of small individual units of economy such as
individual firms, individual industry, or a single individual consumer.

Positive or normative Economics

 Positive economics is descriptive in character. It describes economic activities as they
are.
 Normative economics passes judgments of value.
 Managerial economics draws from descriptive economics and tries to pass
judgments of value in the context of the firm.

Basic Economic Concepts

Scarcity (እጥረት)
Thus, the term scarcity reflects the imbalance between our wants and the means to satisfy those
wants. It is also important not to confuse with scarcity and shortage.

Choice
Due to the problem of scarcity, individuals, firms and government are forced to choose as to what
output to produce, in what quantity, and what output not to produce

Scarcity → limited resource → limited output → we might not satisfy all our
wants →choice involves costs → opportunity cost
An opportunity cost is the amount or value of the next best alternative that must be sacrificed (forgone) in
order to obtain one more unit of a product.

A. Theory of the Firm

It is the microeconomic concept founded in neoclassical economics that states that a firm
exists and make decisions to maximize profits.

The theory has been debated and expanded to consider whether a company's goal is to
maximize profits in the short-term or long-term.

B. Role and Function of a FIRM

Role/ Function of Firms:

1. Deciding what to produce and how to produce.

2. Production or acquiring inputs that the firm intends to sell
3. Market and sell its output or the products that it has obtained
4. Finance the firm's activities of acquiring and selling or the controlling the financial
5. Investing in capital and new technology to provide new goods and services for the
consumer in given country

Different Economics

(Consumers, Producers and Government)

C. What is Profit?
Profit - is the surplus revenue after a firm has paid all its costs.
 Michael Porter’s “Five Competitive Forces”:
 Market entry conditions for new firms
 Market rivalry amongst current firms
 Market power of input suppliers

Types of Profits
1. Frictional profit theory - Abnormal profits observed following unanticipated changes in
demand or cost conditions
2. monopoly profit theory - Above-normal profits caused by barriers to entry that limit
competition
3. innovation profit theory - Above-normal profits that follow successful invention or
modernization
4. Compensatory profit theory - above-normal rates of return that reward firms for
extraordinary success in meeting customer needs, maintaining efficient operations
D. Profit Maximization
 An assumption in classical economics is that firms seek to maximize profits.

Profit = Total Revenue (TR) – Total Costs (TC).

 A firm can maximize profits if it produces at an output ; whereby:-

Marginal Revenue (MR) = Marginal Cost (MC)

Profits Maximization Basics

• Profit maximization is not entirely without merit.

Sales Revenue Maximization

 The model was developed by Baumol (1959) who argued that managers have
discretion in setting goals and that sales revenue maximization was a more likely
short-run objective than profit maximization firms.

Risks of focusing on Profit maximization

Solely focusing on profit maximization comes with a level of risk in regards to public
perception and a loss of goodwill between the company, consumers, investors, and the public.

Limitations of Profit Maximization

  It is not so easy to know exactly your marginal revenue and the marginal cost of last
goods sold.

 It also depends on how other firms react.

E. Value Maximization Vs Profit maximization

Profit Maximization - is a short-term objective that assure the growth of the capital

Value Maximization - is a long- term objective that undertakes safe actions in order to
increase the market value of its common stock over time - more complete model of a firm

Social Responsibility of Business

■ firms are primarily economic entities and can be expected to analyze social
responsibility from within the context of the economic model of the firm.

Types of Firms
Individual entrepreneurs
Private companies
Public limited companies
Co-operatives/social ventures
Government-owned companies

Chapter two
Demand and Supply
Demand Theory

 Demand for the good is the various quantities of that good

consumers are willing and able to buy at a given price over a given period
of time.

 Desire + ability to pay for the good.

Law of Demand

the law of demand states that quantity demanded of a good decrease as

price increase and vise versa.
 Demand schedule is the table that presents the quantities demanded at
each price level during a specific time period.

Demand curve is a graph of r/n ship b/n the quantity demand of the good
and its price citrus paribus

The market demand curve & schedule

 Market demand is the sum total of goods bought by all individual

consumers
The Price System: allocating resources and government
regulations
why the price doesn’t adjust and there are different mechanisms to adjust:

1. Price rationing

 The process by which the market system allocates goods and services to consumers when
quantity demanded exceeds quantity supplied.

2. Price ceiling and Price floor / Government regulations

3. Price Ceiling- is legally imposed maximum price on the market. Transactions above this price is
prohibited

4. Price Floor- is legally imposed minimum price on the market. Transactions below this price is
prohibited

3. Other Price adjustment mechanisms

i. Queuing - waiting in line as a means of distributing goods and services
ii. favored customers - those who receive special treatment from dealers during
situations of excess demand.
iii. ration coupons - tickets or coupons that entitle individuals to purchase a
certain amount of a given product per month.
iv. black market - a market in which illegal trading takes place at market-
determined prices

Supply and Demand and Market Efficiency

 Consumer surplus (CS): is the amount consumer’s benefit by being able to

purchase a product for a price that is less than what they would be willing
to pay
 Producer surplus (PS): is the difference between the price for which a
producer would be willing to provide a good or service and the actual price
at which the good or service is sold

Elasticity of Demand and Supply

Elasticity
Elasticity is a measure of how quantity Q (demanded or supplied) responds to change in the
determining factors F (such as own price, income or price of other goods).
 How Elasticity Works

A product is considered to be elastic if the quantity demand of the product changes drastically
when its price increases or decreases.

Elasticity of Demand
1. Price elasticity of demand
Is the responsiveness of quantity demanded to a change in price.

When Price increases, the quantity demanded falls but we want to know how fast
quantity demanded will fall.

Ed= %∆Q (change in quantity)

%∆P (change in price)

Ed > 1; demand is elastic. i.e. quantity demanded is more sensitive to price change

Ed < 1; demand is inelastic. i.e. quantity demanded is less sensitive to price change

Ed =1; unitary elastic; i.e. the proportionate change in both Q and P is the same

■ When demand is elastic, quantity changes by a greater percentage than

price, so revenue will rise following a price decrease and revenue fall following a price
increase.

Income elasticity of demand Edy

 measures the responsiveness of demand to a change in consumer income (y)
 Cross price elasticity of demand
 It enables us to predict how much the demand curve for the first product
shift when the price of the second product changes.

■ CEdab= %∆Qa
%∆Pb
Elasticity of supply (Es)
Price elasticity of supply is how responsive is supply to a change
in price
Es = %∆Q
%∆P
Example - If the price of banana rise from 2 birr/kg to 3 birr/kg the quantity
supplied rise from 20 kg to 25kg, then the price elasticity of supply would be: Es =
0.5
Demand Forecasting

■ Common business forecasts

– GDP

– Components of GDP (Consumption expenditure, residential

construction, producer durable equipment expenditure)

– Industry forecasts (sales of products across an industry)

– Sales of a specific product

Chapter Three
Production Function and Economics of a firm
Production Function
■ In economics, a production function gives the technological relation
between

Quantities of physical inputs and quantities of output of goods

 ■ Production Function: defines the relationship between inputs and the
maximum amount that can be produced within a given period of time with a
given level of technology

Q=f(X1, X2, ..., Xk); Q = Level of Output; X1, X2, ...,Xk= inputs used in
production

Iso-quant and Iso-cost

The cost-minimizing equilibrium condition
At the point where a line is just tangent to a curve, the two have the same slope. At
each point of tangency, the following must be true:

MP L PL
slope of isoquant =− = slope of isocost =−
MP K PK

Dividing both sides by PL and multiplying both sides by MPK, we get

MP L MP K
=
PL PK

Chapter four
Cost of production
The bases of firms decisions making
 The bases of decision-making:
1. The market price of output

2. The techniques of production that are available

3. The prices of inputs

 – Explicit Costs /Accounting Costs
■ arise from transactions in which the firm purchases
inputs or the services of inputs from other parties
Implicit costs /Economic Costs - opportunity costs
look at the gains and losses of one course of action versus another.
■ Sunk and incremental costs
Sunk costs - are costs that do not vary according to different decisions.
■ Private costs Vs Social Costs
– Private costs - refer to costs that accrue directly to the
individuals performing a particular activity (internal costs)
Social costs - include external costs that are passed on to other parties,
are often difficult to value.
■ Historical Vs current costs
Historical costs - represent actual cash outlay and this is what
accountants record and measure
Current costs - refer to the amount that would be paid for an item under
present market conditions

■ Types of costs in Short run

– Total fixed cost (TFC) – the cost incurred by the firm that
does not depend on how much output it produces
– Total variable cost (TVC) – the cost incurred by the firm
that depends on how much output it produces
 – Total Cost (TC) – the sum of total fixed and total variable
cost at each output
– Marginal Cost (MC) – the change in total cost that results
from a one-unit change in output
MC = DTC/DQ = DTVC/DQ
– Average Fixed Cost (AFC) – total fixed cost divided by the
amount of output
AFC = TFC/Q
– Average Variable Cost (AVC) – total variable cost divided
by the amount of output
AVC = TVC/Q
– Average Total Cost (ATC) – total cost divided by the output -
ATC = TC/Q , ATC = AFC + AVC

Short run Costs

 Marginal cost (MC) - The increase in total cost that results from
producing one more unit of output.

Marginal Cost
The MC curve is U-shaped. MC falls to begin with as output rises, because of increasing
returns, and then, after reaching outputQ1, it begins to rise because of diminishing returns

Average variable cost

■ The AVC curve is also U-shaped - for similar reasons as for the MC
curve.
LONG-RUN COSTS: ECONOMIES AND DISECONOMIES OF
SCALE
 increasing returns to scale, or economies of scale - an increase in a firm’s scale of production leads to
lower costs per unit produced.

 constant returns to scale An increase in a firm’s scale of production has no effect on costs per unit
produced.

 decreasing returns to scale, or diseconomies of scale An increase in a firm’s scale of production leads to
higher costs per unit produced.

 long-run average cost curve (LRAC) A graph that shows the different scales on which a firm can choose
to operate in the long run.