University of the Punjab, Jhelum

Campus

Managerial Economics
by
Rahat Noman

Lecture 2
Nature and scope of Managerial Economics

• Managerial economics helps managers

recognize how economic forces affect
organizations and describes the economic
consequences of managerial behavior. It also
links economic concepts and quantitative
methods to develop vital tools for managerial
decision making. This process is illustrated in
Figure 1.1
Nature and scope of Managerial Economics cont..
• Managerial economics identifies ways to
achieve goals efficiently. Which includes
maximization of profits and to capture higher
market share.
• Managerial economics can be used to identify
pricing and production strategies to help
meet this short-run objective quickly and
effectively.
 Theory of firm
• Firms are useful for producing and distributing goods and
services.
Expected value maximization
• business enterprise represents a series of contractual
relationships that specify the rights and responsibilities of various
parties(Fig 1.2). People directly involved include customers,
management, employees, and suppliers. Society is also involved
because businesses use scarce resources, pay taxes, provide
employment opportunities, and produce much of society’s
material and services output. The model of business is called the
theory of the firm. In its simplest version, the firm is thought to
have profit maximization as its primary goal.
Fig 1.2 The firm can be viewed as a series of contractual relationships that connect
suppliers, investors, workers, and management in a joint effort to serve customers.
• The value of the firm is the present value of the firm’s
expected future net cash flows.
• Value of the Firm= Present Value of Expected Future Profits.

• Here, π1, π2, …, πn represent expected profits in each year, t,

and i is the appropriate interest, or discount, rate. The final
form for Equation (1.1) is simply a short hand expression in
which sigma (Σ) stands for “sum up” or “add together.”
Profits (π) are equal to total revenues (TR) minus total costs (TC), Equation
(1.1) can be rewritten as (Because π=TR-TC)

This expanded equation can be used to examine how the expected

value maximization model relates to a firm’s various functional
departments. The marketing department often has primary
responsibility for promotion and sales (TR); the production department
has primary responsibility for development costs (TC)
Constraints and the Theory of the Firm
• Organizations frequently face limited availability of essential
inputs, such as skilled labor, raw materials, energy, specialized
machinery, and warehouse space. Managers often face limitations
on the amount of investment funds available for a particular
project or activity. These factors can affect the profit of the firms.
Business Versus Economic Profit
• Profit is usually defined as the residual of sales revenue minus the
costs of doing business by using generally accepted accounting
principles (GAAP). It is the amount available to fund equity capital
after payment for all other resources used by the firm. This
definition of profit is accounting profit, or business profit.
 Economic Profit

• In economic terms, profit is business profit minus the implicit

(noncash) costs of capital and other owner-provided inputs used
by the firm. This profit concept is called economic profit.
• Economic profit is determined by economic principles, not GAAP.
Just like accounting profit, costs are deducted from revenues.
Economic profit uses implicit costs, not just explicit costs. Implicit
costs are considered opportunity costs and are normally the
company's own resources. Examples of implicit costs include
company-owned buildings, equipment and self-employment
resources. Economic profit computations are not normally limited
to time periods like accounting profit computations are. Economic
profit is used more to judge total value of the company somewhat
like the performance metric economic value added (EVA) would
and is helpful in calculating total production costs.
 Variability of Business Profits

• In practice, reported profits fluctuate widely.

Table 1.1 shows business profits for a sample
of 30 well-known industrial giants: companies
that comprise the Dow Jones Industrial
Average. Business profit is often measured in
dollar terms or as a percentage of sales
revenue, called profit margin, as in Table 1.1.
Variability of Business Profits
 WHY DO PROFITS VARY AMONG FIRMS?

Disequilibrium Profit Theories

• Frictional profit theory: One explanation of economic profits
or losses is frictional profit theory. It states that markets are
sometimes in disequilibrium because of changes in demand.
Unanticipated shocks produce positive or negative economic
profits for some firms. For example
i. New user-friendly software's increases demand for high-
powered personal computers (PCs).
ii. A rise in the use of plastics and aluminium in automobiles
drives down the profits of steel manufacturers.
• Monopoly profit theory: It is an extension of frictional profit
theory. Some firms earn above-normal profits because they
are protected from competition by high barriers to entry.
Import protection enable some firms to build monopoly
positions that allow above-normal profits for extended
periods (for example Toyota and Honda market in Pakistan).
Compensatory Profit Theories
• Innovation profit theory describes above-normal profits that
arise from successful invention or modernization. For example,
innovation profit theory suggests that Microsoft Corporation has
earned superior rates of return because it successfully introduced
and marketed the graphical user interface, a superior image-
based rather than command based approach to computer
software instructions.

• Similarly, Apple Corporation has earned above-normal rates of

return as an early innovator with its iPod line of portable digital
music and video players.
• In general, compensatory profit theory describes above-
normal rates of return that reward firms for extraordinary
success in meeting customer needs and maintaining efficient
operations.