Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

OFFICE OF THE VICE-PRESIDENT FOR BRANCHES AND CAMPUSES
SANTA ROSA CAMPUS
City of Santa Rosa, Laguna

_______________________________________________________________________________________________________

INSTRUCTIONAL MATERIAL FOR

MANAGERIAL ECONOMICS
(GE40133)

ENHANCED BY:

JOSEFINA T. COLCOL

March 2122
 CHAPTER 11

THE NATURE, SCOPE AND PRACTICE OF MANAGERIAL ECONOMICS

Learning Objectives: This chapter provides introduction of managerial economics and on how
the economic concepts, theories, and methodologies help managers to improve their
decision-making. This part also stresses the importance of managerial economics to the
firms. At the end of this chapter, the readers will be able to define managerial
economics, establish the relation of managerial economics to other branches of learning,
and demonstrate the use of managerial economics in the real-world managerial decision
making.

1.1 Definition of Managerial Economics and its Nature

One standard definition for economics is the study of the production, distribution, and
consumption of goods and services. Secondly, it the study of choice related to the allocation of
scarce resources. The first definition indicates that economics includes any business, nonprofit
organization, or administrative unit. The second definition establishes that economics is at the
core of what managers of these organizations do. We use economics to examine how
managers can design organizations that motivate individuals to make choices that will increase
a firm’s value. This module discusses the economic concepts and principles from the
perspective of “managerial economics,” which is a subfield of economics that places special
emphasis on the choice aspect in the second definition.

Managerial economics is a branch of economics that applies microeconomic concepts,

methods, and analysis to examine how an organization or business can achieve its aims and
objectives most efficiently through decision-making. Thus, the purpose of managerial economics
is to provide economic method and scientific reasoning to solve managerial decision problems.
These economic theories and methods involved with two different conceptual approaches to the
study of economics such as microeconomics and macroeconomics. Microeconomics studies
phenomena related to goods and services from the perspective of individual decision-making
entities—that is, households and businesses. Macroeconomics approaches the same
phenomena at an aggregate level, for example, the total consumption and production of a
region. Microeconomics and macroeconomics each have their merits. The microeconomic
approach is essential for understanding the behavior of atomic entities in an economy.
However, understanding the systematic interaction of the many households and businesses
would be too complex to derive from descriptions of the individual units. The macroeconomic
approach provides measures and theories to understand the overall systematic behavior of an
economy. Since the purpose of managerial economics is to apply economics for the
improvement of managerial decisions in an organization, most of the subject material in
managerial economics has a microeconomic focus. However, since managers must consider
the state of their environment in making decisions and the environment includes the overall

1 Most of the discussions were derived from Principles of Managerial Economics available at Creative CommonsNonCommercial-ShareAlike 4.0
International License (http://creativecommons.org/licenses/by-nc-sa/4.0/).

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economy, an understanding of how to interpret and forecast macroeconomic measures is useful
in making managerial decisions.

Specifically, managerial economics deals with microeconomic reasoning on real-world

problems such as pricing and production decisions in selecting best strategy in difference
competitive environments. These business decisions can be analyzed through:

1. Risk Analysis – Various uncertainty models, decision rules and risk quantification
techniques are used to assess the riskiness of a decision.
2. Production Analysis – Microeconomic techniques are used to analyze production
efficiency, optimum resource allocation, costs, economies of scale, and to estimate the
firm’s costs of production.
3. Pricing Analysis – Microeconomic techniques are used to examine various pricing
decisions including transfer pricing, joint product pricing, price discrimination, price
elasticity estimations, and optimal pricing method.
4. Budgeting – Investment theory is used to examine a firm’s capital purchasing decisions.

1.2 Why Managerial Economics Is Relevant for Managers

In a civilized society, we rely on others in the society to produce and distribute nearly all the
goods and services we need. However, the sources of those goods and services are usually not
other individuals but organizations created for the explicit purpose of producing and distributing
goods and services. Nearly every organization in our society—whether it is a business,
nonprofit entity, or governmental unit—can

be viewed as providing a set of goods, services, or both. The responsibility for overseeing and
making decisions for these organizations is the role of executives and managers. Most readers
will readily acknowledge that the subject matter of economics applies to their organizations and
to their roles as managers. However, some readers may question whether their own
understanding of economics is essential, just as they may recognize that physical sciences like
chemistry and physics are at work in their lives but have determined they can function
successfully without a deep understanding of those subjects. Whether or not the readers are
skeptical about the need to study and understand economics per se, most will recognize the
value of studying applied business disciplines like marketing, production/operations
management, finance, and business strategy. These subjects form the core of the curriculum for
most academic business and management programs, and most managers can readily describe
their role in their organization in terms of one or more of these applied subjects. A careful
examination of the literature for any of these subjects will reveal that economics provides key
terminology and a theoretical foundation. Although we can apply techniques from marketing,
production/operations management, and finance without understanding the underlying
economics, anyone who wants to understand the why and how behind the

technique needs to appreciate the economic rationale for the technique. We live in a world with
scarce resources, which is why economics is a practical science. We cannot have everything
we want. Further, others want the same scarce resources we want.

Organizations that provide goods and services will survive and thrive only if they meet
the needs for which they were created and do so effectively. Since the organization’s customers
also have limited resources, they will not allocate their scarce resources to acquire something of

3
little or no value. And even if the goods or services are of value, when another organization can
meet the same need with a more favorable exchange for the customer, the customer will shift to
the other supplier. Put another way, the organization must create value for their customers,
which is the difference between what they acquire and what they produce. Thus, those
managers who understand economics have a competitive advantage in creating value.

1.3 Managerial Economics Is Applicable to Different Types of Organizations

The organization providing goods and services will often be called a “business” or a “firm,”
terms that connote a for-profit organization. And in some portions in the following discussions,
we discuss principles that presume the underlying goal of the organization is to create profit.
However, managerial economics is relevant to nonprofit organizations and government
agencies as well as conventional, for-profit businesses. Although the underlying objective may
change based on the type of organization, all these organizational types exist for the purpose of
creating goods or services for persons or other organizations. Managerial economics also
addresses another class of manager: the regulator. The economic exchanges that result from
organizations and persons trying to achieve their individual objectives may not result in the best
overall pattern of exchange unless there is some regulatory guidance. Economics provides a
framework for analyzing regulation, both the effect on decision making by the regulated entities
and the
policy decisions of the regulator.

1.4 Social Responsibility of Business

In modern capitalist economies, business firms contribute significantly to economic welfare.

Within free markets, firms compete to supply the goods and services that consumers demand.
Pursuing the profit motive, they constantly strive to produce goods of higher quality at lower
costs. By investing in research and development and pursuing technological innovation, they
endeavor to create new and improved goods and services. In most cases, the economic actions
of firms (spurred by the profit motive) promote social welfare as well: business production
contributes to economic growth, provides widespread employment, and raises standards of
living. The objective of value maximization implies that management’s primary responsibility is
to the firm’s shareholders. But the firm has other stakeholders as well: its customers, its
workers, even the local community to which it might pay taxes. This observation raises an
important question: To what extent might management decisions be influenced by the likely
effects of its actions on these parties? For instance, suppose management believes that
downsizing its workforce is necessary to increase profitability. Should it uncompromisingly
pursue maximum profits even if this significantly increases unemployment?

Alternatively, suppose that because of weakened international competition, the firm has
the opportunity to profit by significantly raising prices. Should it do so? Finally, suppose that the
firm could dramatically cut its production costs with the side effect of generating a modest
amount of pollution. Should it ignore such adverse environmental side effects? All these
examples suggest potential trade-offs between value maximization and other possible
objectives and social values. Although the customary goal of management is value
maximization, there are circumstances in which business leaders choose to pursue other
objectives at the expense of some foregone profits. For instance, management might decide
that retaining 100 jobs at a regional factory is worth a modest reduction in profit. Value
maximization is not the only model of managerial behavior. Nonetheless, the available evidence
suggests that it offers the best description of a private firm’s ultimate objectives and actions.

4
1.5 Social Responsibility of Business and Social Contract2

It is evident from above, the social responsibility of business implies that a corporate
enterprise has to serve interests other than that of common shareholders who, of course,
expect that their rate of return, value or wealth should be maximized. But in today’s world the
interest of other stakeholders, community and environment must be protected and promoted.
Social responsibility of business enterprises to the various stakeholders and society in general
is the result of a Social Responsibility of Business Enterprises towards Stakeholders and
Society in General contract as shown in the figure below.

Environment
Figure: Responsibilities of Business
Employees Enterprises towards Stakeholders to
Business Enterprise Shareholders
Society in General

Consumers

Society

Social contract is a set of rules that defines the agreed interrelationship between various
elements of a society. The social contract often involves a quid pro quo (i.e. something given in
exchange for another). In the social contract, one party to the contract gives something and
expects a certain thing or behavior pattern from the other. In the present context the social
contract is concerned with the relationship of a business enterprise with various stakeholders
such as shareholders, employees, consumers, government, and society in general. The
business enterprises happen to have resources because society consisting of various
stakeholders has given them this right and therefore it expects from them to use them to for
serving the interests of all of them. Though all stakeholders including the society in general are
affected by the business activities of a corporate enterprise, managers may not acknowledge
responsibility to them. Social responsibility of business implies that corporate managers must
promote the interests of all stakeholders not merely of shareholders who happen to be the so-
called owners of the business enterprises.

1. Responsibility to Shareholders:

In the context of good corporate governance, a corporate enterprise must recognize the
rights of shareholders and protect their interests. It should respect shareholders’ right to
information and respect their right to submit proposals to vote and to ask questions at the
annual general body meeting. The corporate enterprise should observe the best code of
conduct in its dealings with the shareholders. However, the corporate Board and management
try to increase profits or shareholders’ value but in pursuing this objective, they should protect
the interests of employees, consumers, and other stakeholders. Its special responsibility is that
in its efforts to increase profits or shareholders’ value it should not pollute the environment.

2. Responsibility to Employees:

2 https://www.economicsdiscussion.net/business/social-responsibility/social-responsibility-of-business/10141

5
 The success of a business enterprise depends to a large extent on the morale of its
employees. Employees make valuable contribution to the activities of a business organization.
The corporate enterprise should have good and fair employment practices and industrial
relations to enhance its productivity. It must recognize the rights of workers or employees to
freedom of association and free collective bargaining. Besides, it should not discriminate
between various employees. The most important responsibility of a corporate enterprise
towards employees is the payment of fair wages to them and provide healthy and good working
conditions. The business enterprises should recognize the need for providing essential labor
welfare activities to their employees, especially they should take care of women workers.
Besides, the enterprises should make arrange-ments for proper training and education of the
workers to enhance their skills.

3. Responsibility to Consumers:

Some economists think that consumer is a king who directs the business enterprises to
produce goods and services to satisfy his wants. However, in the modern times this may not be
strictly true, but the companies must acknowledge their responsibilities to protect their interests
in undertaking their productive activities. Invoking the notion of social contract, the management
expert Peter Drucker observes, “The customer is the foundation of a business and keeps it in
existence. He alone gives employment. To meet the wants and needs of a consumer, the
society entrusts wealth-producing resources to the business enterprise”. In view of above, the
business enterprises should recognize the rights of consumers and under-stand their needs and
wants and produce goods or services accordingly.

4. Obligation towards the Environment:

The foremost responsibility of business enterprises is to ensure that they should not
damage the environment and for this purpose they should reduce as much as possible air and
water pollution by their productive activities. They should not dump their toxic waste products in
rivers and streams to avoid their pollution. Pollution of environment poses a great health hazard
for the people and is a cause of several respiratory and skin diseases. In economic theory
pollution of environment is regarded as social cost that must be minimized. There is now a
growing awareness towards reduction in environment pollution. According to the recent findings
the climate change is occurring due to greater emission of carbon dioxide and other pollutants.
Therefore, the corporate enterprises should adopt high standards of environmental protection
and ensure that they are implemented regardless of enforcement of any environment laws
passed by the government. Many countries including India have passed laws to protect the
environment, but they are not properly and strictly enforced. Business enterprises in their
attempt to maximize profits recklessly and negligently pollute the environment. Therefore, it is required that
government should take tough measures and enforce environment laws strictly if environment is to be
protected.

5. Responsibility to Society in General:

Business enterprises function by public consent with the basic objective of producing
goods and services to meet the needs of the society and provide employment to the people.
The traditional view is that in performing this function businesses maximize profits or
shareholders’ value and doing so they do not behave in any socially irresponsible way.

6
According to Adam Smith whose invisible hand theorem is often quoted that while maximizing
their profits, businessmen are led by an invisible hand to promote the interests of the society. To
quote him, “An individual or business generally, indeed neither intends to promote the public
interest, nor knows how much he is promoting it. He intends only his own gains, and he is in
this, as in many other cases, led by an invisible hand to promote an end which was no part of
his intention. By pursuing his own interest, he frequently promotes that of the society more
effectively than when he really intends to promote it”. In the present world where there are
monopolies, oligopolies in product and factor markets and there are externalities, especially
detrimental externalities such as environment pollution by the activities of business enterprises
maximization of private profits does not always lead to the maximization of social benefit. In fact,
in such imperfect market conditions, consumers are exploited by raising of prices much above
the cost of production, workers are exploited as they are not paid fair wages equal to the value
of their marginal product. Besides, there are harmful external effects to which are not given due
considerations by private enterprises in making their business decisions. Therefore, there is
urgent need to make business enterprises behave in a socially responsible manner and to work
for promoting social interests.

Assessment 1

1. Discuss and integrate microeconomics and macroeconomics in making managerial

decisions by citing examples. (5pts.)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

2. How does the scarcity of resources affect the firm’s decision making? Justify your
answer through discussing specific situations. (5pts.)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

3. Does regulating a firm will be significant for making optimal use of the resources and
production of goods and services? (5pts.)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

4. Having said that most firms chose to maximize their profit, do you think it is a hindrance
in their contribution to economic welfare? Justify your answer. (5pts.)
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________

7
 CHAPTER 2

ECONOMIC DECISION MAKING

Learning Objectives: This chapter discusses the basic steps in decision making and introduces
profit-maximization as a main goal of business managers. The readers will be able to
identify and apply the basic steps of decision making to realize profit-maximization.

The best way to become acquainted with managerial economics is to come face to face with
real-world decision-making problems. Every decision can be framed and analyzed using a
common approach based on six steps, as Figure below indicates.

The Basic Steps in Decision

Making

The process of decision making can be broken down into six basic steps.

Step 1. Define the Problem

What is the problem the manager faces? Who is the decision maker? What is the decision
setting or context, and how does it influence managerial objectives or options?

8
 Decisions do not occur in a vacuum. Many come about as part of the firm’s planning process.
Others are prompted by new opportunities or new problems. It is natural to ask, what brought
about the need for the decision? What is the decision all about? A key part of problem definition
involves identifying the context. Most of the decisions we study take place in the private sector.
Managers representing their respective firms are responsible for the decisions made.

Step 2. Determine the Objective

What is the decision maker’s goal? How should the decision maker value outcomes with
respect to this goal? What if he or she is pursuing multiple, conflicting objectives? When it
comes to economic decisions, it is a truism that “you can’t always get what you want.” But to
make any progress at all in your choice, you have to know what you want. In most private-sector
decisions, profit is the principal objective of the firm and the usual barometer of its performance.
Thus, among alternative courses of action, the manager will select the one that will maximize
the profit of the firm.

In practice, profit maximization and benefit-cost analysis are not always unambiguous guides to
decision making. One difficulty is posed by the timing of benefits and costs. Both private and
public investments involve trade-offs between present and future benefits and costs.

Uncertainty poses a second difficulty. In some economic decisions, risks are minimal. The
presence of risk and uncertainty has a direct bearing on the way the decision maker thinks
about his or her objective.

Step 3. Explore the Alternatives

What are the alternative courses of action? What are the variables under the decision maker’s
control? What constraints limit the choice of options? After addressing the question “What do
we want?” it is natural to ask, “What are our options?” Given human limitations, decision makers
cannot hope to identify and evaluate all possible options. Still, one would hope that attractive
options would not be overlooked or, if discovered, not mistakenly dismissed. Moreover, a sound
decision framework should be able to uncover options in the course of the analysis.

Most managerial decisions involve more than a once-and-for-all choice from among a set of
options. Typically, the manager faces a sequence of decisions from among alternatives. In view
of the myriad uncertainties facing managers, most ongoing decisions should best be viewed as
contingent plans.

Step 4. Predict the Consequences

What are the consequences of each alternative action? Should conditions change, how would
this affect outcomes? If outcomes are uncertain, what is the likelihood of each? Can better
information be acquired to predict outcomes? Depending on the situation, the task of predicting
the consequences may be straightforward or formidable. Sometimes elementary arithmetic
suffices. For instance, the simplest profit calculation requires only subtracting costs from
revenues. The choice between two safety programs might be made according to which saves
the greater number of lives per dollar expended. Here the use of arithmetic division is the key to
identifying the preferred alternative.

MODELS

9
 In more complicated situations, however, the decision maker often must rely on a model
to describe how options translate into outcomes. A model is a simplified description of a
process, relationship, or other phenomenon. By deliberate intent, a model focuses on a few key
features of a problem to examine carefully how they work while ignoring other complicating and
less important factors. The main purposes of models are to explain and to predict—to account
for past outcomes and to forecast future ones.

Other models rest on statistical, legal, and scientific relationships. The construction and
configuration of the new bridge (and its likely environmental impact) and the plan to convert
utilities to coal depend in large part on engineering predictions. Evaluations of test-marketing
results rely heavily on statistical models. Legal models, interpretations of statutes, precedents,
and the like are pertinent to predictions of a firm’s potential patent liability and to the outcome in
other legal disputes.
Key distinction can be drawn between deterministic and probabilistic models. A deterministic
model is one in which the outcome is certain (or close enough to a sure thing that it can be
taken as certain) while a probabilistic model accounts for a range of possible future outcomes,
each with a probability attached.

Step 5. Make a Choice

After all the analysis is done, what is the preferred course of action? Once the decision
maker has put the problem in context, formalized key objectives, and identified available
alternatives, how does he or she go about finding a preferred course of action?

In most decisions, the objectives and outcomes are directly quantifiable. Thus, a private
firm (such as the carmaker) can compute the profit results alternative price and output plans.
Analogously, a government decision maker may know the computed net benefits (benefits
minus costs) of different program options. The decision maker could determine a preferred
course of action by enumeration, that is, by testing several alternatives and selecting the one
that best meets the objective. This is fine for decisions involving a small number of choices, but
it is impractical for more complex problems. Expanding the enumerated list could reduce this
risk, but at considerable cost.

Fortunately, the decision maker need not rely on the painstaking method of enumeration
to solve such problems. A variety of methods can identify and cut directly to the best, or optimal,
decision. These methods rely to varying extents on marginal analysis, decision trees, game
theory, benefit-cost analysis, and linear programming. These approaches are important not only
for computing optimal decisions but also for checking why they are optimal.

Step 6: Perform Sensitivity Analysis

What features of the problem determine the optimal choice of action? How does the optimal
decision change if conditions in the problem are altered? Is the choice sensitive to key
economic variables about which the decision maker is uncertain?

In tackling and solving a decision problem, it is important to understand and be able to

explain to others the “why” of your decision. The solution, after all, did not come out of thin air. It
depended on your stated objectives, the way you structured the problem (including the set of
options you considered), and your method of predicting outcomes. Thus, sensitivity analysis
considers how an optimal decision is affected if key economic facts or conditions vary.

10
2.1 Public Decisions: Economic View

In government decisions, the question of objectives is much broader than simply an

assessment of profit. Most observers would agree that the purpose of public decisions is to
promote the welfare of society, where the term society is meant to include all the people whose
interests are affected when a particular decision is made. The difficulty in applying the social
welfare criterion in such a general form is that public decisions inevitably carry different benefits
and costs to the many groups they affect. Some groups will gain, and others will lose from any
public decision. In our earlier example of the bridge, businesses and commuters in the region
can expect to gain, but nearby neighbors who suffer extra traffic, noise, and exhaust emissions
will lose. The program to convert utilities from oil to coal will benefit the nation by reducing our
dependence on foreign oil. However, it will increase many utilities’ costs of producing electricity,
which will mean higher electric bills for many residents. The accompanying air pollution will
bring adverse health and aesthetic effects in urban areas. Strip mining has its own economic
and environmental costs, as does nuclear power. In short, any significant government program
will bring a variety of new benefits and costs to different affected groups.

The important question is: How do we weigh these benefits and costs to make a decision
that is best for society as a whole? One answer is provided by benefit-cost analysis, the
principal analytical framework used in guiding public decisions. Benefit-cost analysis begins with
the systematic enumeration of all the potential benefits and costs of a particular public decision.
It goes on to measure or estimate the dollar magnitudes of these benefits and costs. Finally, it
follows the decision rule: Undertake the project or program if and only if its total benefits exceed
its total costs. Benefit-cost analysis is similar to the profit calculation of the private firm with one
key difference: Whereas the firm considers only the revenue it accrues and the cost it incurs,
public decisions account for all benefits, whether or not recipients pay for them (that is,
regardless of whether revenue is generated) and all costs (direct and indirect).

Much of economic analysis is built on a description of ultra-rational self-interested

individuals and profit-maximizing businesses. While this framework does an admirable job of
describing buyers and sellers in markets, workers interacting in organizations, and individuals
grappling with major life-time decisions, we all know that real-world human behavior is much
more complicated than this.

Twin lessons emerge from behavioral economics. On the one hand, personal and business
decisions are frequently marked by biases, mistakes, and pitfalls. We are not as smart or as
efficient as we think we are. On the other, decision makers are capable of learning from their
mistakes. Indeed, new methods and organizations—distinct from the traditional managerial
functions of private firms or the policy initiatives of government institutions—are emerging all the
time. Philanthropic organizations with financial clout play an influential role in social programs.
Organizations that promote and support open source research insist that scientists make their
data and findings available to all. When it comes to targeted social innovations (whether in the
areas of poverty, obesity, delinquency, or educational attainment), governments are
increasingly likely to partner with profit and nonprofit enterprises to seek more efficient
solutions.

2.2 Decision within Firms: Profit-Maximization

The main goal of a firm’s managers is to maximize the enterprise’s profit – either for its private
owners or for its shareholders. This goal implies that decisions that increase revenues to be
more than costs or reduce costs to be less than revenues, should be selected. This goal will be

11
analyzed using demand forecasting techniques, marginal analysis, cost analysis, and pricing
techniques which will be discussed on the following chapters.

Managerial economics is based on a model of the firm: how firms behave and what objectives
they pursue. The main principle of this model, or theory of the firm, is that management strives
to maximize the firm’s profits. This objective is unambiguous for decisions involving predictable
revenues and costs occurring during the same period of time. However, a more precise profit
criterion is needed when a firm’s revenues and costs are uncertain and accrue at different times
in the future. The most general theory of the firm states that “Management’s primary goal is to
maximize the value of the firm”.

The firm’s value is defined as the present value of its expected future profits. Thus, in making
any decision, the manager must attempt to predict its impact on future profit flows and
determine whether, indeed, it will add to the value of the firm. Although value maximization is
the standard assumption in managerial economics, three other decision models should be
noted. The model of satisficing behavior posits that the typical firm strives for a satisfactory level
of performance rather than attempting to maximize its objective. Thus, a firm might aspire to a
level of annual profit, say $40 million, and be satisfied with policies that achieve this benchmark.
More generally, the firm may seek to achieve acceptable levels of performance with respect to
multiple objectives (profitability being only one such objective).

A second behavioral model posits that the firm attempts to maximize total sales subject
to achieving an acceptable level of profit. Total dollar sales are a visible benchmark of
managerial success. For instance, the business press puts particular emphasis on the firm’s
market share. In addition, a variety of studies show a close link between executive
compensation and company sales. Thus, top management’s self-interest may lie as much in
sales maximization as in value maximization.

A third issue centers on the social responsibility of business. In modern capitalist

economies, business firms contribute significantly to economic welfare. Within free markets,
firms compete to supply the goods and services that consumers demand. Pursuing the profit
motive, they constantly strive to produce goods of higher quality at lower costs. By investing in
research and development and pursuing technological innovation, they endeavor to create new
and improved goods and services. In the large majority of cases, the economic actions of firms
(spurred by the profit motive) promote social welfare as well: business production contributes to
economic growth, provides widespread employment, and raises standards of living.

The objective of value maximization implies that management’s primary responsibility is

to the firm’s shareholders. But the firm has other stakeholders as well: its customers, its
workers, even the local community to which it might pay taxes. This observation raises an
important question: To what extent might management decisions be influenced by the likely
effects of its actions on these parties? For instance, suppose management believes that
downsizing its workforce is necessary to increase profitability. Should it uncompromisingly
pursue maximum profits even if this significantly increases unemployment? Alternatively,
suppose that because of weakened international competition, the firm has the opportunity to
profit by significantly raising prices. Should it do so? Finally, suppose that the firm could
dramatically cut its production costs with the side effect of generating a modest amount of
pollution. Should it ignore such adverse environmental side effects?

12
 All of these examples suggest potential trade-offs between value maximization and other
possible objectives and social values. Although the customary goal of management is value
maximization, there are circumstances in which business leaders choose to pursue other
objectives at the expense of some foregone profits. For instance, management might decide
that retaining 100 jobs at a regional factory is worth a modest reduction in profit. To sum up,
value maximization is not the only model of managerial behavior. Nonetheless, the available
evidence suggests that it offers the best description of a private firm’s ultimate objectives and
actions.

2.3 Optimal Decision using Marginal Analysis

Marginal analysis is a method used to determine the optimal output level that will
maximize the firm’s profit. looks at the change in profit that results from making a small change
in a decision variable. We will look once again at the two components of profit, revenue, and
cost, and highlight the key features of marginal revenue and marginal cost. These marginal
measurements not only provide a numerical value to the responsiveness of the function to
changes in the quantity but also can indicate whether the business would benefit from
increasing or decreasing the planned production volume and in some cases can even help
determine the optimal level of planned production. The marginal revenue measures the change
in revenue in response to a unit increase in production level or quantity. The marginal cost
measures the change in cost corresponding to a unit increase in the production level. The
marginal profit measures the change in profit resulting from a unit increase in the quantity.
Marginal measures for economic functions are related to the operating volume and may change
if assessed at a different operating volume level.

Marginal revenue (MR) is the extra revenue that an additional unit of product will bring to
the firm. It can also be described as the change in total revenue over the change in the number
of units sold (from Q0 to Q1). This can be expressed as:

Marginal Revenue = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 = ∆𝑹 = 𝑹𝟏 𝑹𝟎

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑶𝒖𝒕𝒑𝒖𝒕 ∆𝑸
𝑸𝟏 𝑸𝟎
Marginal cost (MC) is the additional cost of producing an extra unit of output. The algebraic
definition is:

Marginal Cost = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒔𝒕 = ∆𝑪 = 𝑪𝟏 𝑪𝟎

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑶𝒖𝒕𝒑𝒖𝒕∆𝑸 𝑸𝟏 𝑸𝟎

In general terms, marginal cost at each level of production includes any additional costs
required to produce next time. For instance, if producing additional vehicle requires building new
factory, the marginal cost of those extra vehicles includes the cost of the new factory. In
practice, the analysis is segregated into short-run and long-run cases where marginal costs
include all costs which vary with the level of production and other costs are considered fixed
costs. This concept will be discussed further in Chapter 6.

Profit maximization of the firms will be realized when optimal output is determined. Profit
maximization assumes that there is some output level that is most profitable. A firm might sell
huge amount at very low prices but discover that profits are low or negative. To avoid this, a firm
should sell output and charge price at MR = MC. This condition is called MR=MC rule. At this
quantity, the slopes of the revenue and cost functions are equal; the revenue tangent is parallel
to the cost line. But this simply says that marginal revenue equals marginal cost. At this optimal

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output, the gap between revenue and cost is neither widening nor narrowing. Thus, maximum
profit is attained.

Assessment 2

1. Complete the chart below by using the steps of the economic decision making.

The ABCD Grill House is selling an average of 200 units of grilled

whole chicken per day using the electric griller but there will be an
electric interruption within the area during their operating hours and
Situation so, it will affect their grilled chicken production for that day. The firm
also expects an increase in the demand for grilled chicken
considering that many households also use an electric powered
stove and buying cooked meat will be their alternative.

Define the Problem

Determine the
Objective

Explore the
Alternatives

Predict the
Consequences

Make a Choice

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 Perform
Sensitivity
Analysis

2. How do you see the partnership between government and private firms in producing public
goods? Does it convert to efficiency of the government programs? Justify your answer.

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