Fundamentals of Managerial Economics

Lecture 1
Lecture Outlines:
1. General Foundation of Managerial Economics
2. Economic Approach
3. Circular Flow of Activity
4. Natural of the Firm
5. Objectives of the Firms
6. Market Dynamics and Equilibrium
7. Elasticity of Demand
Introduction of Economics
• Economics is the social science that study how to solve the economic problem by
using the scarcity resources efficient to produce valuable goods and services and
distributed it in a regular markets to individuals, organization and governments.

• Any production process face an scarcity inputs, accordingly countries, business

and entrepreneur have to use these resources efficient and avoid waste of
resources.
Kinds of Economics
• The Economics topics always covering many social, financial and political topics
such as how the rational individual uses to measure his benefit (social), what is
the ideal point of production the firm must achieve it (financial) and how the
decision of fixed exchange rate can affect the international relations between
countries (political). The two main pillars of economics will always be :

1. Microeconomics

2. Macroeconomics
Microeconomics
• Founded by Adam Smith – father of economics.

• The microeconomics is the branch of economics that study the behavior and how
the individual and business takes decision according to the different kinds of
markets.

• It deals with different kinds of topics such as how the prices is determine and
what is the profitable position for the business in certain kind of market.
Macroeconomics
• Founded by Adam Smith – “classical school” before it replaced by the
revolutionary John Maynard Keynes – “Keynesian school”.

• The macroeconomics is the branch of economics that study the behavior of the
economy as a whole and what is meant by the business cycle and the tools that
government should have to affect of the economy and control it enthusiasm.
Managerial Economics
• Managerial economics is the study of how scarce resources are directed most efficiently
to achieve managerial goals. It is a valuable tool for analyzing business situations to take
better decisions.

• It is the field of economics concerned with markets and firms where the applicability and
explanatory power of the theory of perfect competition is questionable because for
some reason there is insufficient competition.

• Managerial economics describes, what is the observed economic phenomenon (positive

economics) and prescribes what ought to be (normative economics)
Economic Circular Flow
• The fundamental economic activities between households and firms are shown in
the diagram. The circular flows of economic activities are explained in a clockwise
and counterclockwise flow of goods and services.

• The four sectors namely households, business, government and the rest of the world
can also be considered to see the flow of economic activities. The circular flow of
activity is a chain in which production creates income, income generates spending
and spending in turn induces production.
Economic Circular Flow – Cont’d
• The economy comprises of the interaction of households, firms, government and
other nations.

• Households own resources and supply factor services like land, raw material, labor
and capital to the firms which helps them to produce goods and services. In turn,
firms pay rent for land, wages for their labor and interest against the capital invested
by the households.

• The earnings of the household are used to purchase goods and services from the
firms to fulfill their needs and wants, the remaining is saved and it goes to the
capital market and is converted as investments in various businesses.
Economic Circular Flow – Cont’d
Economic Circular Flow – Cont’d
• The household and business firms have to pay taxes to the government for enjoying
the services provided.

• On the other hand firms and households purchase goods and services (import) from
various countries of the world.

• Firms tend to sell their products to 10 the foreign customers (export) who earn
income for the firm and foreign exchange for the country.

• Therefore, it is clear that households supply input factors, which flow to firms.
Goods and services produced by firms flow to households. Payment flows in the
opposite direction
Economic Circular Flow – Cont’d
• One of the main reason lead the circular to continuous flow is voluntary engage of
mutual advantages between the householder and the firms, as the natural of
householder is to maximize their satisfaction (which never reaches), while the
natural of the Firms in to maximize their profit (which never reaches).

• Also The major objectives of the firm are:

• To maximize the Customer and Stakeholders Satisfaction

• To maximize Shareholder’s Return on Investment

• To maximize the Growth of the Organization

Define Market
• A Market was an actual place where Buyers – Demand side meet with sellers –
supply side as they voluntary engage in face to face Bargaining to exchange
benefits (achieving satisfaction and maximize profit) and their interactions
affected and coordinated by a to set prices that determine according to market
forces.
I need the I need the
max. max. profit
satisfaction
Market Forces
• Market forces are the actions of buyers and sellers that cause the prices of goods
and services to change without being controlled by the government directly.

• The market forces are the economic forces of supply and demand.
Demand Force
• The quantity demanded of a good or service is the amount that consumers plan
to buy during a particular time period, and at a particular price.

• The demand curve is a relationship between the market price of good and the
quantity demanded of that good. Other things are hold constant.
Demand Force – Cont,
• The statistician found that as the price of a product increase the quantity demand
on it decrease (Inverse Relation). The main reasons are:

1. The substitution effect: as people will tend to substitute and replace high price
product with low price products

2. The income effect: as if the price of a product increase while the people income
is constant, the individual will not be able to buy the same quantity he used to
purchase before.
Demand Force – Cont,
• There are other factors that affect on the force of demand other than price.

• Factors affect on demand:

1. The average income

2. The taste of the consumers

3. The size of the market

4. The expected price

Supply Force
• The supply side of the market typically involves the terms on which businesses
produce & sell their products. The quantity supplied of a good or service is the
amount that producers plan to sell during a given time period at a particular price.

• The supply curve shows the direct relation between the quantity of goods and
service that the producers willing to supply and the price level
Supply Force – Cont,
• The main reasons behind that direct relation is the profitability, as if the
producers intended to increase production there cost of production will increase
which can not be compensate unless the price increase.

• N.B.: the cost of production or the total cost that the producer will bear consist of
variable cost and fixed cost. The variable cost such as cost of material while the
fixed cost as the rent.
Supply Force – Cont,
• There are other factors that affect on the force of supply other than price.

• Factors affect on supply:

1. The cost of production

2. The government fiscal policy

3. the level of technology used

Market equilibrium
• Equilibrium is a situation in which opposing forces balance each other.
Equilibrium in a market occurs when the price balances the plans of buyers and
sellers.

• The equilibrium price is the price at which the quantity demanded equals the
quantity supplied.

• The equilibrium quantity is the quantity bought and sold at the equilibrium price.
Market equilibrium – cont,
• The equilibrium price comes at the intersection of the supply and demand curves.

• at higher prices, the supplies want to sell more than demands want to buy, the
result is a surplus, while at the lower price the market shows a shortage on excess
of quantity demanded over quantity supplied.
 Pricing policy
• Pricing policy refers how a company sets the prices of its products and services based
on costs, value, demand, and competition.

• One of the main factors that affect the pricing decision is the respond of the market
demand to any change in price, which is called and measured by elasticity of demand.

• Price elasticity of demand (Ed) : It measures how much the quantity demanded of
good changes when its price changes.
 Pricing policy – Cont,
A) The factors affect the Ed:

1. The kind of the product:

2. The length of the time period:

3. The percentage of income spend on product:

 Pricing policy – The factors affect the Ed:
1. The kind of the product:

• For necessities like food, fuel, demand tends to be inelastic. Such items cannot
easily be substitute when their prices rise. By contrast, you can easily substitute
other goods when luxuries like purchasing a perfume “elastic”.

• Inelastic product: If the price increase by a large amount, Quantity demand

decrease but with small amount.

• Elastic product: If the price increase by a large amount, Quantity demand decrease
but with small amount.
 Pricing policy – The factors affect the Ed:
2. The time period:

• The length of time that people have to respond to the price changes also plays a
role as in short run it may be inelastic but in long run it is elastic.

3. The percentage of income spend on product:

• As if the product that its price change by large percent represent a small
proportion of the individual income, so the product will be inelastic and vice
versa.
 Pricing policy – Cont,:
B) Calculating Elasticity:

% change in Quantitydemand
Pr ice elasticity of demand 
% change in price

N.B: Drop the minus signs , so elasticity are All positive.

 Pricing policy – Cont,:
Kinds of elasticity of demand
• When a 1 percent changes in
price calls forth more than a 1
percent change in quantity
demanded, the good has price
elastic demanded.
• When the percentage change in
Quantity is exactly the same as
the percentage change in price,
the good has unit elastic
demand.
• When a 1 percent changes in
price produces less than a 1
percent change in Quantity
demanded, the good has price
inelastic demand.
 Pricing policy – Cont,:

Example on Calculating Elasticity of

Demand

In the following figure,

price was 90 & Quantity demanded was 240
units. A price increase to 110 led consumers
to reduce their purchases to 160 units. So
consumers move from point “A” to “B”.
Pricing policy – The factors affect the Ed:
The following table shows how we calculate price elasticity.
•The P increase is 20%, with the resulting Quantity decrease being 40%.
The price elasticity of demand is evidently Ed = 40/20 = 2. The price elasticity is
greater than 1, & this good therefore has price elastic demand in the region from A
to B.
 Pricing policy – Cont,:
Elasticity and Revenue:
•Many businesses want to know whether raising price will raise or lower revenues.
•Let’s look for the relationship between price elasticity and total revenue.
Total Revenue: equal to price times quantity “P × Q”.
if you know the price elasticity of demand, you know what will happen to total revenue
when price changes:
1) When demand is price inelastic, a price decrease reduces total revenue.
2) When demand is price elastic, price decrease increase total
revenue.
 Profit Maximization
•Suppose that the minimum cost of producing units of output is given by C(q) (the cost
function).
•Suppose further that the total revenues of the firm are determined by the output of the
firm and denote this functional relationship as R(q). Then the relationship between the
output of the firm and its profits, the profit function, is
π(q) = R(q) − C(q).
 Profit Maximization – Cont,
•The firm’s quasi-rents measure the benefit of the firm of staying in business. They are the
difference between its revenues from staying in business and what is required for the firm
to stay in business, its avoidable costs.
•Quasi-rents provide a contribution towards the firm’s sunk costs .Of course, in the long-
run, all costs are variable, and the difference between total revenues and total costs is
economic profit.