M E 1&2

Introduction to Managerial Economics

Importance of the course for Managers
Theory of the firm
Circular Flow of Economic Activity
Value of the firm
Principal-agent problem
Nature and functions of profit
The Circular Flow of Economic Activity
Optimization Techniques
• What is Economics-
• “Oikonomos” : From Greek word “one who manages a household/household
manager”
• Aristotle called it the science of ‘household management’
• Genesis : scarcity in relation to wants
• Unlimited wants ( Unattainable even in the richest of economy)
• Limited resources
• Human wants refer to all goods and services that human desire
• Resources: inputs or factors producing goods and services we want
• land, labor, capital, etc
• If no scarcity like say sand in the desert, air (good air has become scarce)
• NO Economics
• Economics deals with allocation of resources among alternative uses to satisfy
human wants
• Steel can be used to build car or bridge; land can be used to cultivate or build a factory
• Study of how to use/allocate scarce resources to produce goods and services that
have value, and distribute them among individuals
• Scarcity is essentially the essence of economics
• Economics because of scarcity
• Because of unlimited wants vis-à-vis limited resources, imp
that society makes best use of limited resources
• brings in concept of Efficiency
• Efficiency- use in such manner that highest combination of
quantity and quality of goods are produced, given tech and
resources
• In economics, we say that an economy is in a state of
efficiency when it cannot make anyone economically better
off without making someone else worse off.
• Also known as Pareto efficiency.
• Questionable from equity point of view
• Pareto efficiency means that if poor remain where there are and the
rich are becoming richer, we have still not entered Pareto efficient
state
• For our purpose we can say that resources are being used efficiently
when by reallocating resources we cannot produce more of one good
without reducing the production of any other good.
• Two pillars of Economics: SCARCITY & EFFICIENCY
• Origin of Management –
• In 19th Century big firms came up in US like Railways, AT&T, US steel, GE
• Difficult to manage with double entry book- keeping, devised by Wedgwood
• With double entry one could know from where money was coming and steps required to
make more
• But using accounts to manage large corporation required new approach
• Enter young Prof of Accountancy James Mckinsey with a breakthrough book published in
1922 – “Budgetary Control”
• Not how business has been doing, rather draw up accounts for an imaginary corporate
future
• Implied business plans, goals, and then compare with actual results and revise
accordingly
• Helped managers in setting out vision for future
• Consultancy became popular because Glass-Steagall Act of 1933 forbade law firms,
accountancy firms and banks to conduct independent financial research into deals they
were brokering
• Made legal requirements for banks to hire management consultants
• In 1965 Justice Dept in USA banned IBM from providing advice on how to install or use
computers, giving another business opportunity for management consultants.
• Opened flood gates for management
• Management: to achieve some goal or objective subject to some constraints( similarity with
Economics: satisfy wants with limited resources)
• Constraints are limitation of resources at disposal of managers of
• Firm
• Bank
• Not for profit organization- hospital, university, Govt
• Objective could be: Ex: max profit, Treat patients, Good education with limited inputs
• Limitation of resources: budgetary constraints, limited man-power, etc
• What is the importance of this course to you: Relevance of Economics for
Management
• Why Study : apply economic theory to business problems
• How to use economic analysis to make decisions to achieve organization’s
goal
• For example to increase revenue, are you going to increase or reduce the
price
• Whether the new ad campaign will be really effective in terms of increasing
sales
• Whether money should be spent on improving quality of the product, or on
sales promotion of existing product
 Managerial Economics Defined
The application of economic theory to examine how an organization can achieve its aims
or objectives most efficiently.
• applications of economic theory
• quantitative methods
• statistical methods
• Mathematical Economics
• Expresses and analyzes economic models using the tools of mathematics.
• Econometrics
• Employs statistical methods to estimate and test economic models using empirical data: stochastic
approach
• Economic Models
• Abstract from details
• Focus on most important determinants of economic behavior – cause and effect
• Evaluating Economic Models
• A model is accepted if it predicts accurately and if the predictions follow logically from the
assumptions.
 Methodology
• In economics, explanation and prediction are based on theories.
• Theories are developed to explain observed phenomena in terms of a set of basic rules and
assumptions.
• Complex nature- why because study behavior and decisions of different people : some
producing, some consuming, investing, saving
• So make assumptions to turn complexity into simplicity: for example buying decisions
influenced by several factors, but take one at a time
• Postulate a model, say a relation between price and quantity( based on real world observation
or otherwise from some theory)
• A model is a mathematical representation, based on economic theory, of a firm, a market, or
some other entity.
• Abstract from details
• Focus on most important determinants of economic behavior – cause and effect from
some theory( whether quantity dependent on price, or otherwise)
• Collect data and then analyse using statistics, maths, logic, etc
The role of assumptions
• Assumptions
• simplify the complex world : Make it easier to understand
• Focus our thinking on essence of the problem
• Short-run or long-run effects
• assumptions about individuals
• Rationality
• More to less
• Transitivity of preferences
• Selfish motive that is in self interest
• Individuals possess information
• Bounded rationality
• All do not think in the same way---some will buy , some will
sell 11
 Beware of some common fallacies
1. The post hoc fallacy ( after this therefore necessarily because of this)
involves the inference of causality.
• The post hoc fallacy occurs when we assume that, because one event
occurred before another event, the first event caused the second event
• Example: Great Depression of the 1930s in the United States. Some
people had observed that periods of business expansion were preceded
or accompanied by rising prices.
• From this, they concluded that the appropriate remedy for depression was
to raise wages and prices. This idea led to a host of legislation and
regulations to prop up wages and prices in an inefficient manner.
• However these did not work and recovery occurred with WW II with the
accompanied increase in expenditure.
 2. Ceteris paribus
• Failure to hold other things constant. A second pitfall is failure to hold other
things constant when thinking about an issue
• Price-quantity demand relationship inverse based on this

• If things are changing fast, then ceteris paribus assumption may lead to faulty
policies
 3.The fallacy of composition

• Sometimes we assume that what holds true for part of a system also holds
true for the whole.
• In economics, however, we often find that the whole is different from the
sum of the parts.
• Ex1: If one farmer has a bumper crop, she has a higher income; if all farmers
produce a record crop, farm incomes will fall.
• Ex2: If one person receives a great deal more money, that person will be
better off; if everyone receives a great deal more money, the society is likely
to be worse off.
Positive vs. Normative analysis
• Positive statements
• Attempt to describe the world as it is/ based on facts, rather than value judgements
• Confirm or refute by examining evidence
• ● positive analysis Analysis describing relationships of cause and effect

Prices rise when the government increases the quantity of money.

Positive – describes a relationship, could use data to confirm or refute.
• Normative statements
• Attempt to prescribe how the world should be/norms of fairness/ value judgment
• ● normative analysis Analysis examining questions of what ought to be.

A tax cut is needed to stimulate the economy.

Normative –value judgment
Present debate on revival of economy: fiscal , monetary, or combination

15
• Theory of Firm
• What is a Firm: One which combines and organizes resources for the purpose of producing
goods and/or services for sale.
• Internalizes transactions, reducing transactions costs.
• Otherwise inefficient and costly to entrepreneurs to enforce contracts with workers, owners
of capital for each separate step of the production and distribution process
• These resource owners then use their income to buy goods and services produced by firms,
thereby completing the circular flow of economic activity
• So Managerial economics begins by having a theory of firm, which is then used to analyze
managerial decision making
• Goal could be to maximize short run profit, or in some case look at long run profits
• As both important, theory of firm postulates that the primary goal of managers is to maximize
the value of the firm.
Value of the Firm

The present value of all expected future profits

1 2 n n
t
PV  1
 2
  n
 t
(1  r ) (1  r ) (1  r ) t 1 (1  r )

n
t n
TRt  TCt
Value of Firm   t
 t
t 1 (1  r ) t 1 (1  r )
• Business or Accounting Profit: Total revenue minus the explicit or accounting
costs of production.
• Economic Profit: Total revenue minus the explicit and implicit costs of
production.*
• Opportunity Cost: Implicit value of a resource in its best alternative use.
• Risk-Bearing Theories of Profit: above normal profit required as premium for
risk. Same applies in case of shares vis-a –vis bonds
• Frictional Theory of Profit: arising out of spurt in demand , eventually coming
down due to competition, technology
• Monopoly Theory of Profit: because of no competition
• Innovation Theory of Profit: due to successful innovation(Apple)
• Managerial Efficiency Theory of Profit: as a result of managerial efficiency, i.e,
earn more than an average firm’s earning of rate of return
• Other theories of firm have also been proposed
• Sales maximization
• Adequate rate of profit
• Management utility maximization
• Principle-agent problem
• In modern corporation there is separation of management from ownership
• Managers more interested in maximizing their utility, measured in terms of salaries ,
perks, stock options, etc, than in maximizing profits
• That is agent (manager) more interested in maximizing his/her benefits than
maximizing principal (owner’s ) interest.
• Resolve by tying manager’s reward with other firm’s performance in industry
• Satisficing behavior
• Managers may not be able to maximize profits, but aim at some satisfactory level of
performance in terms of sales , profits, market share , etc.
The circular flow

20
• Circular-flow diagram : A typical economy
• Visual model of the economy
• Shows how dollars flow through markets among households and firms
• Decision makers
• Firms & Households
• Markets
• For goods and services
• For factors of production
• Firms
• Produce goods and services and sells
• Buys and Use factors of production / inputs
• Households
• Own factors of production and sells
• Buys and Consume goods and services 21
• Micro and Macro
• Economics is study of allocation of scarce resources to produce goods and services of value to
satisfy human wants
• Implies any economy concerned with three basic problems: What to Produce, How to Produce,
and For Whom to Produce
• Microeconomics
• Branch of economics that deals with the behavior of individual economic units—
consumers, firms, workers, and investors—as well as the markets that these units
comprise.
• Relevance to Managerial Economics
• Adam Smith is usually considered the founder of the field of microeconomics
• In The Wealth of Nations (1776), Smith considered how individual prices are set, and inquired
into the strengths and weaknesses of the market mechanism.
• Invisible hand solving the three problems of any economy: WHAT, HOW, & FOR WHOM
• An example of these decisions using the price signals: buying and selling car
• Identified the remarkable efficiency properties of markets and saw that economic benefit
comes from the self-interested actions of individuals.
 Real versus Nominal Prices
● Nominal price Absolute price of a good, unadjusted for inflation.

● Real price Price adjusted for inflation.

● Consumer Price Index Measure of the aggregate price level of a

representative basket of goods
● Producer Price Index Measure of the aggregate price level for
intermediate products and wholesale goods.

Suppose price of milk is Rs 50 per liter, and inflation as measured by CPI has gone up
from 100 to 200, then the nominal price of milk is Rs 100 and the real price of milk is
only Rs 50.
 What Is a Market?

● Market Collection of buyers and sellers that, through their actual or

potential interactions, determine the price of a product or set of products

- Any institutional arrangement where buyers and sellers agree to exchange

goods and services at mutually agreed price

● Perfectly competitive market Market with many buyers and sellers, so

that no single buyer or seller has a significant impact on price.

- Different kinds of markets depending on the number of buyers and sellers,

such as a single seller which is a monopoly
• Macroeconomics
• is concerned with the overall performance of the economy.
• Study of the total or aggregate level of output, income, employment, consumption, investment, and prices for the economy viewed as a
whole.
• is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.
• macroeconomics Branch of economics that deals with aggregate economic variables, such as the level and growth rate
of national output, interest rates, unemployment, and inflation.
• Why study
• Tells you about the business environment in which firm operates
• Provides background for managerial decision making
• Evolution of Macroeconomics: John Maynard Keynes published his revolutionary General Theory of
Employment, Interest and Money.
• At the time, England and the United States were still stuck in the Great Depression of the 1930s, with over one-
quarter of the American labor force unemployed.
• Keynes developed an analysis of what causes upswings and downswings in the economy: business cycles
• Today, macroeconomics examines a wide variety of areas, such as how total investment and consumption are
determined, how central banks manage money and interest rates, what causes international financial crises, and
why some nations grow rapidly while others stagnate.
• Can study macro without the intricacies of micro, like driving a car without knowing how the engine functions.
But when something goes wrong then need to look into the micro, ie , individual’s behavior.
• Some Important Concepts
• All economic activities give rise to some benefits, but also involve some costs
• Aim of economic decisions is to maximize net benefits
• Brings in concept of Marginality: change due to increase or decrease by one unit of
measurement
• Concept of margin important in all decisions, as against total or average(revenue, cost)
• Marginal Utility
• Utility: satisfaction derived from consuming; util
• Cardinal and ordinal measurement of Utility
• Marginal Utility: Change in total utility when consumption changes by one unit; that is at the
margin
• Marginal Cost: change in total cost when production changes by one unit
• Marginal Revenue: change in total revenue when production changes by one unit
• Net benefits increase so long as marginal or extra benefit exceeds marginal or extra cost
• Maximized when marginal benefit equal marginal cost
• Opportunity Cost: OC is what is given up to get something else/ the next best use that is foregone
Optimization Techniques
• To achieve aims and objectives efficiently, using knowledge of economics is
what Managerial economics is all about
• Examples
• Firms maximize profit by producing and selling an optimal quantity of goods
• Firms minimize their cost of production by using an optimal combination of inputs
• Also as : Consumers maximize utility by purchasing an optimal combination of goods
• How to go about attaining these
• What are the optimization techniques
• Relation between Total, Average, Marginal is important
• Suppose a functional form : TR = 100Q - 10Q2
• Average is total divided by independent variable
• Marginal is change in total per unit change in independent variable.
Expressing Economic Relationships

Equations: TR = 100Q - 10Q2

Tables: Q
TR
0
0
1
90
2 3 4 5 6
160 210 240 250 240
TR
300

250

Graphs:
200

150

100

50

0
0 1 2 3 4 5 6 7

Q
Total, Average, and Marginal Revenue

TR = PQ Q TR AR MR
0 0 - -
AR = TR/Q 1 90 90 90
MR = TR/Q 2 160 80 70
3 210 70 50
4 240 60 30
5 250 50 10
6 240 40 -10
• Relation between average and marginal
• If marginal is increasing then average will increase
• If marginal is decreasing, so long it is more than average, average keeps on
increasing
• Till marginal equals the average, whence average becomes maximum
• If marginal is below the average, the average starts decreasing
• Holds in case of average revenue and marginal revenue
• Holds in case of average product and marginal product
• Total revenue maximum when MR is = 0
• Total product maximum when MP is = 0
• In a similar fashion
• If marginal is decreasing, average keeps on decreasing
• Even if marginal is increasing, so long it is less than average, average
keeps on decreasing
• Till marginal becomes equal to average, whence average is minimum
• If marginal is above the average, the average starts increasing
• Holds in case of average cost and marginal cost
 TR
300

250

200
Total Revenue 150

100

50

0
0 1 2 3 4 5 6 7

AR, MR
120

100

Average and 80

Marginal Revenue 60

40

20

0
0 1 2 3 4 5 6 7
-20

-40

Q
Total, Average, and Marginal Cost

Q TC AC MC
0 20 - -
AC = TC/Q 1 140 140 120
2 160 80 20
MC = TC/Q 3 180 60 20
4 240 60 60
5 480 96 240
Geometric Relationships
• The slope of a tangent to a total curve at a point is equal to the marginal value at
that point
• The slope of a ray from the origin to a point on a total curve is equal to the
average value at that point
• A marginal value is positive, zero, and negative, respectively, when a total curve
slopes upward, is horizontal, and slopes downward
• A marginal value is above, equal to, and below an average value, respectively,
when the slope of the average curve is positive, zero, and negative
• Profit maximization: if MR> MC, then more inflow than outflow
if MR < MC, then inflow less than outflow
if MR = MC, then profit maximum

• Applies to any activity: essence of marginal analysis

Concept of the Derivative

The derivative of Y with respect to X is

equal to the limit of the ratio Y/X as X
approaches zero.

dY Y
 lim
dX X 0 X
Rules of Differentiation
Constant Function Rule
The derivative of a constant, Y = f(X) =
a, is zero for all values of a (the
constant).

Y  f (X )  a
dY
0
dX
Rules of Differentiation
Power Function Rule
The derivative of a power function, where
a and b are constants, is defined as
follows.

Y  f (X )  aX b
dY
 b  a X b 1
dX
Rules of Differentiation
Sum-and-Differences Rule
The derivative of the sum or difference of two
functions, U and V, is defined as follows.

U  g(X ) V  h( X ) Y  U V

dY dU dV
 
dX dX dX
Rules of Differentiation
Product Rule
The derivative of the product of two
functions, U and V, is defined as follows.

U  g(X ) V  h( X ) Y  U V

dY dV dU
U V
dX dX dX
Rules of Differentiation
Quotient Rule
The derivative of the ratio of two
functions, U and V, is defined as follows.

U
U  g(X ) V  h( X ) Y
V

dY


V dU
dX  
 U dV
dX 
dX V
2
Rules of Differentiation
Chain Rule
The derivative of a function that is a function
of X is defined as follows.

Y  f (U ) U  g(X )

dY dY dU
 
dX dU dX
Optimization with Calculus
 
Example 1
• 
Example 2
• 
Example 3
• 
Example 4
• Given
TR = 45Q – 0.5Q2
TC = Q3 – 8Q2 + 57Q + 2
• Determine Q that maximizes profit (π):
π = 45Q – 0.5Q2 – (Q3 – 8Q2 + 57Q + 2)
Example
• 
4: Solution
Quadratic Formula
• Write the equation in the following form:
aX2 + bX + c = 0

• The solutions have the following form:

 b  b  4ac
2

2a
Multivariate Optimization
• Objective function Y = f(X1, X2, ..., Xk)
• Find all Xi such that ∂Y/∂Xi = 0
• Partial derivative:
∂Y/∂Xi = dY/dXi while all Xj (where j ≠ i) are held constant
Example 5
• Determine the values of X and Y that maximize the following profit
function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Solution
∂π/∂X = 80 – 4X – Y = 0
∂π/∂Y = -X – 6Y + 100 = 0
Solve simultaneously
X = 16.52 and Y = 13.92
Constrained Optimization
• Define an objective mathematically as a function
of one or more choice variables
• Define one or more constraints on the values of
the objective function and/or the choice variables
• Determine the values of the choice variables that
maximize or minimize the objective function while
satisfying all of the constraints
Constrained Optimization
• Substitution Method
Substitute constraints into the objective function and then maximize the
objective function
• Lagrangian Method
Form the Lagrangian function by adding the Lagrangian variables and
constraints to the objective function and then maximize the Lagrangian
function
Example 6
• Use the substitution method to maximize the following profit
function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Subject to the following constraint:
X + Y = 12
Example 6: Solution
• Substitute X = 12 – Y into profit:
π = 80(12 – Y) – 2(12 – Y)2 – (12 – Y)Y – 3Y2 + 100Y
π = – 4Y2 + 56Y + 672
• Solve as univariate function:
dπ/dY = – 8Y + 56 = 0
Y = 7 and X = 5
Example 7
• Use the Lagrangian method to maximize the following profit function:
π = 80X – 2X2 – XY – 3Y2 + 100Y
• Subject to the following constraint:
X + Y = 12
Example 7: Solution
• Form the Lagrangian function
L = 80X – 2X2 – XY – 3Y2 + 100Y + (X + Y – 12)
• Find the partial derivatives and solve simultaneously
dL/dX = 80 – 4X –Y +  = 0
dL/dY = – X – 6Y + 100 +  = 0
dL/d = X + Y – 12 = 0
• Solution: X = 5, Y = 7, and  = -53
Interpretation of the Lagrangian Multiplier, 

• Lambda, , is the derivative of the optimal value of

the objective function with respect to the
constraint
In Example 7,  = -53, so a one-unit increase in the value
of the constraint (from -12 to -11) will cause profit to
decrease by approximately 53 units
Actual decrease is 66.5 units