MANAGERIAL ECONOMICS – ECO556

CHAPTER ONE: INTRODUCTION TO MANAGERIAL ECONOMICS

A. Definition of Managerial Economics:

It is 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.

B. Firm in macroeconomic analysis

Circular flow of income 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. A simple circular flow assumes that the economy is divided into only into two
sectors.

a) 2 Sector Economy - The Simple Circular Flow

We assumed that:
i) households receive their income from the firm by providing factors of production they own
ii) firms sell their entire output (supply of goods & services) to households
iii) households spend their entire income on goods and services. So, all goods produced are sold.
Purchase of goods and services

supply of goods & services

FIRMS HOUSEHOLD

supply of factors of production

wages, interest, rent, profit

(i) The household is the owner of factors of production and they are suppliers and sellers of factors of
production (resources) to the firms whilst firms are the buyers.
(ii) The bottom half of the diagram shows the flow of the factors of production owned by households
to the firms.
(iii) The firms in return pay wages, rent, interest and profits to household as income.
(iv) The top half of the flow shows the flow of goods and services produced from households to firms
and the corresponding flow of money payments for goods and services from households to
firms as households’ consumption.
(v) The circular flow of income illustrates the basic principle of national income accounting where
the value of total outputs equals the value of total income.
(vi) The above diagram shows how two sectors interact in the product market and resource market.
(vii) The illustration assumed that household spends all their income to buy goods and services.
(viii) But, in the real life, household does not spend all their income for consumption. They also
save part of their income.

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(ix) So, what happens if the household does not consume all their income to buy goods and services
but save part of it in the Financial Institutions?

C. The Rationale of the firm

It would be very costly for individual household to enter into each production and distribution
process. Thus, a firm should exist to purchase these goods and transform them into goods and
services for sale. Resource owners (households) then purchase these goods and services with
the income generated form the sale of their services or resources.

(The economies generated in production and distribution would lower the cost of production
and provide higher returns to resource owners.

I. Objectives of the firm

The primary goal of a firm is to maximize profit (minimize cost).

What is profit?

Profit is a reward for:

Bearing risks
An entrepreneur will bear all the risk associated with production. The reward for the risk is profit.

Imperfect market mechanism

In imperfect market, firms can generate profit since there is less competition

Monopoly status
If a firm is a monopoly, it is able to curtail/prevent other firms form entering the market. Thus, it
is able to enjoy profits for long period of time.

Innovations
Development of new products, new production techniques, and new modes of marketing will
provide higher return.

Function of profit

Profits act as a signal for reallocation of resources to reflect changing demand and taste.

How to calculate profit?

Profit = TR – TC
Accounting profit = TR – explicit costs
Economic profit = TR – explicit costs – implicit costs

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Other goals:
Sales maximization
Revenue Maximization
Market share maximization
Employment

Working environment for workers

Provide good product and services to customer
Act as a good citizen

II. Decision Problems

Firms usually face many constraints such as:

1. Legal constraint
- it includes the array of federal, state, and local laws that must be obeyed by all citizens,
both individual and corporate. Areas where managers seem to have some legal difficulty
include environmental law, especially those relating to pollution and the disposal of
hazardous wastes, and employment law, including wrongful termination and sexual
harassment matters.

2. Moral constraint
- it applies to actions that are not illegal but are sufficiently inconsistent with generally
accepted standards of behavior to be considered improper.

3. Contractual constraint
- it binds the firm because of some prior agreement such as a long-term lease on a building,
or a contract with a labor union that represents the firm’s employees.

4. Financial constraint
- it occurs when a department of a firm is assigned a budget for the next year and managers
are given orders to maximize production subject to this budgeted amount.

5. Technological constraint
- it sets physical limits on the amount of output per unit of time that can be generated by
particular machines or workers.