ADMKEW HAILE

Admkew Haile
 Managerial Economics
Managerial economics deals with
microeconomic reasoning on real world
problems such as managerial decisions,
selecting the best strategy in different
competitive environments, and
making efficient choices.
Managerial economics -Applies economic
tools and techniques to business and
administrative decision making
Managerial economics prescribes rules for
improving managerial decisions.
Admkew Haile
Managerial economics also helps managers recognize how

economic forces affect organizations and describes the

economic consequences of managerial behavior.
It links economic concepts with quantitative methods to

develop vital tools for managerial decision making.

This process is illustrated in Figure 1.1.

Evaluating Choices/ Alternatives

Managerial economics identifies ways to efficiently

achieve goals.
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For example, suppose a small business seeks
rapid growth to reach a size that permits
efficient use of national media advertising.
Managerial economics can be used to identify
pricing and production strategies to help meet
this short-run objective quickly and effectively.
Similarly, managerial economics provides
production and marketing rules that
permit the company to maximize net
profits once it has achieved growth or
market share objectives.

Admkew Haile
Should Toyota expand its capacity (S1)? In part, it must

consider current and future demand and what other firms

are likely to do.

Capacity for making cars is a long term project, so Toyota

should think in terms of the present value (PV) of future

profits (S2).

Admkew Haile
Figure 1.1: Relationship Between Managerial
Economics and Related Disciplines
Problems faced by
decision makers
Economic in management
Decision
theory sciences
Managerial economics applies
and extends economics and the
decision sciences to solve
managerial problems

Solutions to
decision problems
faced by managers

Admkew Haile
 Figure 1.2: Managerial Economics Is a Tool for
Improving Management Decision Making
Management Decision Problems
•Product Selection, Output, and
Pricing
•Internet Strategy
Economic Concepts •Organization Design Quantitative Methods
•Marginal Analysis •Product Development and •Numerical Analysis
•Theory of Consumer Demand Promotion Strategy •Statistical Estimation
•Theory of the Firm •Worker Hiring and Training •Forecasting Procedures
•Industrial Organization and •Investment and Financing •Game Theory Concepts
Firm Behavior •Optimization Techniques
•Public Choice Theory •Information Systems
Managerial Economics
Use of Economic Concepts and
Quantitative Methods to Solve
Management Decision
Problems

Optimal Solutions to
Management
Decision Problems

Admkew Haile
Managerial economics uses economic concepts and

quantitative methods to solve managerial problems.

Managerial economics has applications in both profit

and not-for-profit sectors. For example, an

administrator of a nonprofit hospital strives to provide
the best medical care possible given limited medical
staff, equipment, and related resources. Using the tools
and concepts of managerial economics, the
administrator can determine the optimal allocation of
these limited resources.
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In short, managerial economics helps managers

arrive at a set of operating rules that aid in the

efficient use of scarce human and capital
resources.
By following these rules, businesses, nonprofit

organizations, and government agencies are able

to meet objectives efficiently.

Admkew Haile
 Some Management Decision Problems
 Demand Analysis & Forecasting
 Product pricing and output decision
 Buy or lease decisions [vehicles]
 Production techniques [capital vs. labor]
 Inventory levels – JIT
 Advertising media [ TV, newspaper, radio]
 Labor hiring and training
 Investment and Financing
 Managerial Economics :Integrates and applies microeconomic
theory and methods to decision making problems faced by
private, public, and not-for-profit organizations.

Admkew Haile
 Basic Decision Making Model
Statement of the problem - [ International competition

threatening Black and Decker’s profits ]

Identification of objectives - [ Maintain or gain market

share ]
Identify possible solutions - [ Changing production

techniques, market strategies, etc. ]

Select the best solution from an array of alternative

solutions.
Implement the decision.
Evaluate performance
Admkew Haile (Sensitivity analysis)-
Common Managerial Questions
 What to produce?

 Determine what price to charge.

 Determine the optimal resource use.

 Choose feasible investment projects.

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Management Theories of the Firm.
At its simplest level, a business enterprise
represents a series of contractual relationships that
specify the rights and responsibilities of various
parties (see Figure 1.3).
People directly involved include customers,
stockholders, 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.

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Firms are useful devices for producing and

distributing goods and services.

They are economic entities and are best analyzed

in the context of an economic model.

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Figure 1.3: The Corporation/Firm as a Legal
Device
Society
Supplier Investment

Firm
Management Employee
s

Customers

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The firm can be viewed as a confluence (coming
together,convergent) of contractual relationships
that connect suppliers, investors, workers, and
management in a joint effort to serve customers.

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Expected Value Maximization
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.
The firm’s owner-manager is assumed to be
working to maximize the firm’s short-run profits.
Today, the emphasis on profits has been broadened
to encompass uncertainty and the time value of
money.

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In this more complete model, the primary goal of

the firm is long-term expected value maximization.

The value of the firm is the present value of the

firm’s expected future net cash flows. If cash flows

are equated to profits for simplicity, the value of
the firm today, or its present value, is the value of
expected profits or cash flows, discounted back to
the present at an appropriate interest rate.
Admkew Haile
 … Management Theories of the Firm.
 Value or profit maximization model-primary goal of
managers (popular theory)
 Sales maximization model- managers seek to maximize
sales after an adequate profit is achieved to satisfy
shareholders
 Management Utility maximization model - managers
may seek to maximize their compensation [salaries,
fringe benefits, stock options], the size of their staff,
extent of their control over the corporation
=>(principal-agent problem).
 Management satisfying behavior- managers seek to
achieve satisfactory results in terms of growth in sales,
profits, and market share.
Admkew Haile
 Responsibility of Management
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 (adjust)to the mission of the
organization
Senior management establish a vision for
the firm
Admkew Haile
 …Responsibility of Management
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.
Managers who fail at these responsibilities are
reviled,(sufferable)(unloved)
Admkew Haile
 The present value of the firm’s future net earnings.

•The objective of the firm is to maximize the value of the

firm, the true measure of business success.
•Value of the Firm = Present Value of Expected Future
Profits
•Two key questions are the measure of value and how
managers add value to the firm
1 2 n
V = [--------] + [ --------] + . . . + [ -------- ]
(1+r)1 (1+r)2 (1+r)n

N t
V =  [ ------- ] , t = 1, 2, ... , N
t = 1 (1+r)t

Value =  [(TRt - TCt)/(1+r)t], t = 1, 2, ... , N

Admkew Haile
 Managerial Economics
Objective Function:
Max PV of profits {S1, S2}
S1 could be expand capacity and S2 not to
expand capacity yet at this time.
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

Admkew Haile
Broad Definition of Value
Profit = Total Rev - Total Cost
 = P . Qd - VC . Qs - F
where profit, P = price,
Qd = quantity demanded,
VC = variable cost per unit,
Qs = quantity supplied,
F = total fixed costs

Admkew Haile
 Determinants of Value of the Firm
N t N P . Qd - VC . Qs - F
V = [ ------- ] =  [---------------------- ]
t=1 (1+r)t t=1 (1+r)t

Whatever raises the price of the product and/or

the quantity of the product sold
Whatever lowers the variable and fixed costs
Whatever lower the “r” (discount rate or the
perceived “risk” of investment)

Admkew Haile
 Value maximization as a Team Effort
The marketing department has the
responsibility for increasing sales by
using the most effective promotional
strategy [radio, TV, Newspaper ads]
The production department has the
responsibility for minimizing costs by
using new methods of production.
The finance department has a major
responsibility of acquiring capital for the
firm
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Admkew Haile
 Major Constraints to value maximization
a. Resource scarcity or constraints
i.e. limited availability of essential input such as
skilled labor, raw material, energy, machinery
warehouse, etc.

b. Contractual Obligations
Meeting nutritional requirements for feed mixture,
reliability requirements.

c. Legal restrictions
Minimum wage laws, health and safety standards,
pollution emission standards, fuel efficiency
requirements, fair pricing, etc.
Admkew Haile
 Profits (Accounting vs Economic)
The general public and the business
community typically define profit as the
residual of sales revenue minus the explicit
costs of doing business.
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.

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The economist also defines profit as the excess of

revenues over costs.

However, inputs provided by owners, including
entrepreneurial effort and capital, are resources that
must be compensated. The economist includes a normal
rate of return on equity capital plus an opportunity cost
for the effort of the owner-entrepreneur as costs of
doing business, just as the interest paid on debt and the
wages are costs in calculating business profit.
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The risk-adjusted normal rate of return on capital is the
minimum return necessary to attract and retain
investment.
Similarly, the opportunity cost of owner effort is
determined by the value that could be received in
alternative employment.
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 frequently referred to as
economic profit.

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a. Business or accounting profits refer to the difference
between total revenue and explicit costs.

Accounting (Business) Profit = TR-Explicit costs

Profit(Econ) = Total revenue - Total costs

=Total Revenue - [Explicit costs +

Implicit costs]

Admkew Haile
WHY DO PROFITS VARY AMONG FIRMS?
Even after risk adjustment and modification
to account for the effects of accounting error
and bias, ROE numbers reflect significant
variation in economic profits. Many firms
earn significant economic profits or
experience meaningful economic losses at
any given point.
To better understand real-world differences
in profit rates, it is necessary to examine
theories used to explain profit variations.
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Theories of Why Profits Exist
 Frictional Theory of Economic
Profits
 Monopoly Theory of Economic
Profits
 Innovation Theory of Economic
Profits
 Compensatory Theory of Economic
Profits
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Frictional Theory of Economic Profits
One explanation of economic profits or losses is
frictional profit theory.
It states that markets are sometimes in
disequilibrium because of unanticipated changes
in demand or cost conditions.
Unanticipated shocks produce positive or
negative economic profits for some firms.
For example, automated teller machines (ATMs)
make it possible for customers of financial
institutions to easily obtain cash, enter deposits,
and make loan payments.
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ATMs render obsolete many of the functions that
used to be carried out at branch offices and foster
ongoing consolidation in the industry. Similarly,
new user-friendly software increases demand for
high-powered personal computers (PCs) and boosts
returns for efficient PC manufacturers.
Alternatively, a rise in the use of plastics and
aluminum in automobiles drives down the profits
of steel manufacturers.

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Over time, barring impassable barriers to
entry and exit, resources flow into or out of
financial institutions, computer
manufacturers, and steel manufacturers, thus
driving rates of return back to normal levels.
During interim periods, profits might be
above or below normal because of frictional
factors that prevent instantaneous
adjustment to new market conditions.

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Monopoly Theory of Economic Profits
A further explanation of above-normal
profits, monopoly profit theory, is an
extension of frictional profit theory.
This theory asserts that some firms are
sheltered from competition by high barriers
to entry.
Economies of scale, high capital
requirements, patents, or import protection
enable some firms to build monopoly
positions that allow above-normal profits for
extended periods.
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Monopoly profits can even arise because of luck

or happenstance (being in the right industry at

the right time) or from anticompetitive behavior.
 Unlike other potential sources of above-

normal profits, monopoly profits are often

seen as unwarranted.
Thus, monopoly profits are usually taxed

or otherwise regulated.
Admkew Haile
Figure 1 A Tariff to Extract Foreign
Monopoly
Price and Profit
Cost
p2 S
p1 R
c2 MC + t = AC + t
G

c1 H F MC = AC

D
MR
o Quantity
q2 q1

Admkew Haile
Innovation Theory of Economic Profits
An additional theory of economic profits,
innovation profit theory, describes the above-
normal profits that arise following successful
invention or modernization.
For example, innovation profit theory suggests that
Microsoft Corporation has earned superior rates of
return because it successfully developed,
introduced, and marketed the Graphical User
Interface, a superior image based rather than
command-based approach to computer software
instructions.
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Microsoft has continued to earn above-normal returns

as other firms scramble to offer a wide variety of “user

friendly” software for personal and business
applications. Only after competitors have introduced
and successfully saturated the market for user-friendly
software will Microsoft profits be driven down to
normal levels.
Similarly, McDonald’s Corporation earned above-

normal rates of return as an early innovator in the fast-

food business.Admkew Haile
With increased competition from Burger
King, Wendy’s, and a host of national and
regional competitors, McDonald’s, like Apple,
IBM, Xerox, and other early innovators, has
seen its above-normal returns decline. As in
the case of frictional or disequilibrium profits,
profits that are due to innovation are
susceptible to the onslaught of competition
from new and established competitors.
Admkew Haile
Compensatory Theory of Economic Profits
Compensatory profit theory describes above-
normal rates of return that reward firms for
extraordinary success in meeting customer
needs, maintaining efficient operations, and
so forth.
If firms that operate at the industry’s
average level of efficiency receive normal
rates of return, it is reasonable to expect
firms operating at above-average levels of
efficiency to earn above-normal rates of
return.
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Inefficient firms can be expected to earn

unsatisfactory, below normal rates of return.

Compensatory profit theory also recognizes

economic profit as an important reward to the

entrepreneurial function of owners and
managers.
Every firm and product starts as an idea for
better serving some established or perceived
need of existing or potential customers.
Admkew Haile
This need remains unmet until an
individual takes the initiative to design,
plan, and implement a solution.
The opportunity for economic profits is an
important motivation for such
entrepreneurial activity.
ASSIGNMENT – 1

Explain the theories that justify for the prevalence

of profit differences among firms and support
each theory with practical five examples.
Admkew Haile