Managerial Economics CAC 405

FUNDAMENTALS OF MANAGERIAL
ECONOMICS
By; Dr. Jacob Azaare.
Email: jazaare@cktutas.edu.gh
Tel: 0240465185
• Office: SCIS Building, Office # 2
• Office Hours: Wednesday, 1:00-3:00 pm, or by appointment

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 Textbooks & Prerequisites:

Textbooks
• McGuigan, J., Moyer, R. and Harris, F. Managerial Economics:
Applications, Strategy, and Tactics. 11th Edition.
• Baye, M., & Prince, J. (2022). Managerial economics and business
strategy (10th Ed.). McGraw-Hill.
Prerequisites:
• Principles of microeconomics and macroeconomics
• Basic algebra

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
  What is Managerial Economics?
» The Decision-Making Model and
the Responsibilities of
Management
  » The Role of Profits?
» Shareholder Wealth Maximization
  and the Real Option Value
  » The Principal-Agent Problem
» Objectives in the Public Sector
and Not-for-Profit Organizations
 
 Seven Principles of Microeconomics
» What are the principles of how
  people make decisions?
» What are the principles of how
people interact?
What Economics Is All About
 
• Scarcity: the limited nature of society’s resources
»All decisions involve tradeoffs
» Efficiency: when society gets the
most from its scarce resources
 
• Economics: the study of how
society manages its scarce
resources, e.g.
»how households decide what
to buy,
how much to work, save, and
spend
»how firms decide how much
to produce,
how many workers to hire
»how society decides how to
divide its resources between
national defense, consumer
goods, protecting the
environment, and other needs.
Economic theory helps managers 3
understand real-world business problems
 Economics, Management and Managerial
Economics
• Economics profession has had essentially two theoretical systems, one
to explain the small picture, the other to explain the big picture (micro
and macro are the Greek words, respectively, for “small” and “big”).
• Microeconomics examines the behavior of basic elements in
the economy, including individual agents (such as households
and firms or as buyers and sellers) and markets, and their
interactions.

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 Economics, Management and Managerial
Economics
• Macroeconomics analyzes the entire economy and issues
affecting it, including unemployment, inflation, economic
growth, and monetary and fiscal policy.
• Management encompasses all business and organizational
activities that coordinate the efforts of people to accomplish
desired goals and objectives using available resources efficiently
and effectively.
• Management comprises planning, organizing, staffing, leading or
directing, and controlling an organization or effort for the
purpose of accomplishing a goal. Resourcing encompasses the
deployment and manipulation of human resources, financial
resources, technological resources, and natural resources.
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 What is Managerial
Economics?
 The application of microeconomics to
problems faced by decision makers in
the private, public, and not-for-profit
  sectors.
 Managerial economics extracts
from microeconomic theory those
concepts and techniques that
enable managers
» to allocate efficiently scarce
resources available to the
organization,
» to plan corporate strategy,
» and to execute effective tactics.
Managerial
 
Economics
 
  All managerial decision making seeks to
1.
  identify the alternatives,
2. select the choice that
accomplishes the objective(s) in
the most efficient manner,
3. taking into account the
constraints
4. and the likely actions and
reactions of rival decision
makers.
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 To Expand Capacity or Not?
An example of a simplified decision problem
 Should Honda or Toyota expand its capacity in North   problem
America?
 In part, it must consider current and future
demand and what other firms are likely to do.
 Background: Both companies face increasing
demand for their U.S.-manufactured vehicles,
especially Toyota Camrys and Honda Accords.
Camrys and Accords rate extremely highly in
consumer reports of durability and reliability.
The demand for used Accords is so strong that
they depreciate only 45 percent in their first
four years. Other competing vehicles may
depreciate as much as 65 percent in the same
period. Hence, both companies are attempting
to expand their already substantial assembly
operations in North America.
 But how?
To Expand Capacity or Not?
An example of a simplified decision
•  How to expand capacity?
• They have identified two possible strategies: S1(New),
  S2(Used)
  • S1(New) is to expand capacity with new facilities
  • S2(Used) is to purchase used facilities from GM
• The new plants will likely receive
substantial public subsidies through
reduced property taxes. The older
plants already possess an enormous
infrastructure of local suppliers and
  regulatory relief.
• Capacity for making cars is a long term
project, so these firms should think in
terms of the present value (PV) of future
  profits.
• The objective of managers is to maximize
the present value of the expected future 7
profit from the expansion.
 To Expand Capacity or Not?
  An example of a simplified decision problem
• This problem can be summarized as follows:
• Objective Function:
  » Maximize PV of profits {S1(New), S2(Used)}
• Decision Rule:
» Choose S1 if PV {Profits of S1 } > PV { Profits of S2 }
» Choose S2 if PV { Profits of S1 } < PV { Profits of S2 }
» If equal profits, then flip a coin
» If negative profits for both, then don’t expand at all
 
This simple illustration shows how resource-allocation decisions of
managers attempt to maximize the value of their firms across
forward-looking dynamic strategies for growth while respecting all
ethical, legal, and regulatory constraints 8
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  Responsibility of Management
•  Managers are responsible for a number of goals:
» Managers solve problems before they become a
  crisis
» Managers select strategies to try to assure the
  success of the firm
» Managers create an organizational
culture attune to the mission of the
  organization
» Senior management establish a
  vision for the firm
» Managers motivate and promote
  teamwork
» Managers promote the profitability
  of the firm
» And many managers see it in their
long-run interest to promote
sustainability of their enterprise in
  their environment.
 
The Role of Profits?
•  Economic Profit
» the difference between total
 
revenues and total economic cost
»Profits play an important role in
guiding the decisions of resource
allocation and determine the type
and quantity of goods and services
that are produced and sold, as well
as the resulting derived demand for
  resources
• We’d expect high profit areas to attract
investment
• We’d expect low profit areas to lose
  investment
»Shouldn’t then all industries
earn the same profit eventually?
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 Theories of Why Profit Varies Exercise 1
Across Industries  

• In 2006, firms in the drug

industry earned an average

1. Risk-Bearing Theory of Profit return on net worth of 22

2. Temporary Disequilibrium Theory of Profit
3. Monopoly Theory of Profit
4. Innovation Theory of Profit
percent, compared with an
average return of 14 percent
earned by over 1,400 firms
followed by Value Line.
Which theory or theories of
profit do you think best

5. Managerial Efficiency Theory of Profit explain(s) the performance of

the drug industry? 11
 Objective of the Firm
• What is the relationship between maximizing profit
and maximizing the value of a firm?
• Does the goal of maximizing profit the same as
that of maximizing the value of a firm?
• Note: Value of a firm
»Price for which it can be sold
»Shareholder wealth is a measure of the value of a
firm and equal to the value of a firm’s common
stock
Objective of the Firm
• The simple profit maximization as an
objective of management are
insightful, but it ignores the timing and
  risk of profit streams.
»Risk premium: accounts for risk
of not knowing future profits.
»The larger the risk, the higher the
risk premium, & the lower the
 
firm’s value
• Shareholder wealth maximization as
an objective overcomes above
 
limitations.
»equal to the present value of all
future cash returns (profit)
expected to be generated by the
firm for the benefit of its owners.
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 Determinants of Firm Value
p t = REVENUE – COST = TRt – TCt = Pt·Qt –
Some Common Mistakes
Managers Make
Vt·Qt - Ft  
   
• The present value of discounted cash flows: • Never increase output simply to
N
  reduce average costs
S (p t ) / (1+ke)t =
• Pursuit of market share usually
t=1
 
N   reduces profit
• Maximizing total revenue
S (PtQt – VtQt – Ft) / (1+ke)t
reduces profit
 
t. =1  
• Whatever lowers the perceived • Cost-plus pricing formulas
risk of the firm (ke) will also don’t produce profit-
raise firm value.
maximizing prices
• Whatever raises the price of the
product (Pt) or the quantity sold
(Qt) will raise firm value.
• Whatever raises variable cost
(Vt)or fixed cost (Ft) will
reduce firm value. 14
Implications of Shareholder
Wealth Maximization
• Short-term cash flows reflect only a
  small fraction of the firm’s share price
» The first 5 years of expected dividend
payouts explain only 18 percent and
the first 10 years only 35 percent of
the share prices of NYSE stocks.
» Stock price also reflects the firm’s
strategic investment opportunities
(the “embedded real options”) a
  management team develops.
• The goal of shareholder wealth
maximization requires a long-term
focus. Managers must anticipate and
manage changes in competition,
technology, and regulation, and make
contingency plans.
Shareholder Wealth Maximization:
  Necessary Conditions
• Managers should concentrate on maximizing
shareholder value alone only if three
  conditions are met.
1. Complete markets:- liquid markets for firm's
inputs, output and by-products (including
  polluting by-products).
2. No significant asymmetric information:
buyers
  and sellers all know the same things.
3. Known recontracting costs: future input costs
are part of the present value of expected cash
flows.
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• Agency costs are associated with
Separation of Ownership & Control
 
•  Principal-agent problem
»Conflict that arises
when goals of
management (agent) do
not match goals of owner
  (principal)
»Shareholders
  (principals) want profit
»Managers (agents) want
  leisure & security
•  Two common problems
1. often hard to observe
  managerial effort
2. random disturbances in
Agency Costs
resolving conflicts of interest among
shareholders, managers, and lenders.
1. Extending grants of stock or deferred
stock options
• It helps to make workers act more
like owners of firm to try to raise
the price of the stock, but is a cost
2. Bonuses or other compensation can be
an incentive, but clearly is also a “cost”
of solving agency problems
3. Internal audits and accounting
oversight boards to monitor the firm
4. Bonding expenditures and fraud
liability insurance
5. Costs of complex internal approval
processes to avoid adverse managerial 16
 Corporate Control Mechanisms
 
• Require managers to hold stipulated
  amount of firm’s equity
»Extending to all workers stock
options, bonuses, and grants of
stock to help make workers act
  more like owners of firm
• Increase percentage of outsiders
  serving on board of directors
• Finance corporate investments
with debt instead of equity

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 Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
 

Instead of profit, NFP organizations may have as their goals:

1.Maximizing the quantity and quality of output,
subject to a breakeven constraint.
2. Maximizing the outcomes preferred by the NFP
contributors.
3. Maximizing the longevity of the NFP
administrators.
Knowing their goals, helps to understand their
behavior.
» Using cost-benefit analysis, we can evaluate their
efficiency in terms of maximizing benefits for a
given cost; or minimizing costs for a given benefit; 19
 Seven Principles of Microeconomics
 
1. How people make decisions
2. How people interact

The principles of
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs: 
• Individuals and Households 
• Firms 
• Society 20
 • Principle #1: People Face Tradeoffs
• Society faces an important tradeoff: 
• efficiency vs. equality 
• Efficiency: when society gets the most from its scarce resources 
• Equality: when prosperity is distributed uniformly among
society’s members
• Tradeoff: To achieve greater equality, could redistribute income
from wealthy to poor. 
But this reduces incentive to work and produce, shrinks the size of
the economic “pie.”
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 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
• Making decisions requires comparing the costs and
benefits of alternative choices. 
• The opportunity cost (economics cost) of any
item is whatever must be given up to obtain it. 
• It is the relevant cost for decision making.
Examples: The opportunity cost of studying in CKTUTAS? 
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 HOW PEOPLE MAKE DECISIONS
Total Economic Cost
 
Economic Cost of Resources • Total Economic Cost
•  Economic cost of using any resource is: »Sum of opportunity costs of both market-supplied
resources
»What firm owners must give up to use the &owner-supplied resources
  resource
• Explicit Costs
  »Hence an Opportunity cost »Monetary payments to owners of market-supplied
•  Market-supplied resources resources
• Implicit Costs
  »Owned by others & hired, rented, or leased
»Nonmonetary opportunity costs of using owner-supplied
•  Owner-supplied resources resources
»Owned & used by the firm »Include opportunity cost of cash provided by owners
 
(equity capital), of using land or capital owned by the
» Economic cost includes the “normal” firm,
rate of return on capital contributions and of owner’s time spent managing or working for the
by the firm’s partners firm
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 HOW PEOPLE MAKE DECISIONS
Economic Profit vs. Accounting Profit
 
•Economic profit = Total revenue – Total
economic cost
= Total revenue – Explicit costs–
Implicit costs
 
•Accounting profit = Total revenue – Explicit
costs
 
• Accounting profit does not subtract
implicit costs from total revenue
• Firm owners must cover all costs of
all resources used by the firm
» Objective is to maximize economic profit

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HOW PEOPLE MAKE DECISIONS

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 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at
the Margin
  Rational people
» systematically and purposefully
do the best they can to achieve
their objectives.
» make decisions by evaluating
costs and benefits of marginal
changes–incremental
  adjustments to an existing plan.
• Marginal benefit
 
• Marginal cost
Principle #4: People Respond to
Incentives
• Incentive: something that induces
a person to act, i.e. the prospect of
a reward or punishment.
• Rational people respond to
incentives.
 
 
Examples:
»When gas prices rise, consumers
buy more hybrid cars and fewer gas
guzzling SUVs.
 
»When cigarette taxes increase,
teen smoking falls.
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 Exercise 3
Applying the principles
 
You are selling your 1996 Honda. You have already spent
  $1000 on repairs.
At the last minute, the transmission dies. You can pay
  $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
  transmission repaired? Explain.
A. Blue book value is $6500 if transmission works, $5700 if it
  doesn’t
B. Blue book value is $6000 if transmission works, $5500 if it
doesn’t
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 The principles of
 
 
HOW PEOPLE INTERACT
Principle #5: Trade Can Make
Everyone Better Off Principle #6: Markets Are Usually A
Good Way to Organize Economic
• Rather than being self-sufficient,   
Activity
 
people can specialize in
• Market: a group of buyers and
producing one good or service
sellers (need not be in a single
and exchange it for other goods. location)
• Countries also benefit from  
trade & specialization:  • “Organize economic activity”
»Get a better price abroad for goods  
means determining
they produce  
»what goods to produce
»Buy other goods more cheaply from  
»how to produce them
abroad than could be produced at »how much of each to produce
 
home
•   »who gets them

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 Principle #6: Markets Are Usually A
Good Way
to Organize Economic Activity
 
• A market economy allocates resources
through the decentralized decisions of
many households and firms as they
  interact in markets.
• Famous insight by Adam
Smith in The Wealth of
Nations (1776):
Each of these households
and firms
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acts as if “led by an
 HOW PEOPLE INTERACT
• Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
• The invisible hand works through the price system:
»The interaction of buyers and sellers  determines prices.
»Each price reflects the good’s value to buyers and the cost
of producing the good.
»Prices guide self-interested households and firms to make
decisions that, in many cases, maximize society’s economic
well-being.

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 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve Market
Outcomes
• Important role for govt: enforce property rights (with police, courts)
• People are less inclined to work, produce, invest, or purchase if large
risk of their property being stolen.
• Market failure: when the market fails to allocate society’s resources
efficiently
• Causes:
» Externalities, when the production or consumption of a good affects
bystanders (e.g. pollution)
»Market power, a single buyer or seller has substantial influence on
market price (e.g. monopoly)
• In such cases, public policy may promote efficiency.
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 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
 

• Govt may alter market outcome to promote equity

• If the market’s distribution of economic well-being is

not desirable, tax or welfare policies can change how
the economic “pie” is divided.
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 SUMMARY
 

 
Seven principles of decision making are:
1. People face tradeoffs.
2. The cost of any action is measured in terms of foregone
opportunities.
3. Rational people make decisions by comparing marginal costs
and marginal benefits.
4. People respond to incentives.
5. Trade can be mutually beneficial.
6. Markets are usually a good way of coordinating trade.
7. Govt can potentially improve market outcomes if there is a
market failure or if the market outcome is inequitable.
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Price-Takers vs. Price-Setters
•  Price-taking firm
 
»Cannot set price of its product
»Price is determined strictly by market forces of
 
demand & supply
•  Price-setting firm
 
»Can set price of its product
»Has a degree of market power, which is ability to raise
price without losing all sales

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