Faculty of Commerce

Managerial Economics
Bachelor of Commerce in Entrepreneurship Management
Lecture 1
The Nature and Scope of Managerial Economics
By
Felix Maoni
fmaoni@poly.ac.mw/0888614779
 Managerial Economics: Subject Matter

 The application of economic theory and the tools of decision science to

examine how an organization can achieve its aims or objectives most
efficiently in an environment it operates.

 Webster- “Managerial economics is the application of economic theory

and quantitative methods (mathematics and statistics) to the
managerial decision-making process”

 The meaning of this definition can be best examined with aid of figure
below:

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 Managerial Decision Problems

Economic theory Decision Sciences

Microeconomics Mathematical Economics
Macroeconomics Statistics, Econometrics

MANAGERIAL ECONOMICS
Application of economic theory
and decision science tools to solve
managerial decision problems

OPTIMAL SOLUTION TO
MANAGERIAL DECISION PROBLEMS

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 Managerial Decision Problems:
 Managerial decision problems arise in any organization when they
seek to achieve some goal or objective subject to resource and other
constraints.
 Examples of issues include product selection, output level and
pricing, organization design, product development and promotion
strategy, employee recruitment and training, investment and
financing, globalization and competition.
 Examples in public entities.
 A hospital may seek to treat as many patients as possible at an
adequate medical standard with its limited physical resources (i.e.
physicians, technicians, nurses, equipment, beds etc.) and budget.
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 Relationship to Economic Theory

Economic Theory
• Economic theories seek to explain and predict economic behaviour
using economic models.
 Models are the simplified representation or abstraction of the real
world phenomenon.
 They suppress many details of an event to focus on few important
events or factors, often using behavioural assumptions.
 Example: Neoclassical Theory of the Firm which assumes that
firms maximize profits subject to some constraints. Level of output
and price are thus determined based on this assumption. However,
firms may pursue other objectives. 5
 Relationship to Decision Sciences
 Decision sciences use the tools of mathematical economics and
econometrics to construct and estimate decision models .
 Mathematical economics formalize the economic relationship
postulated by economic theory using mathematical equation or
expression.
 Econometrics apply statistical tools (regression analysis) to estimate the
model parameters which determine the direction and magnitude as well
as statistical significance of the relationship.
 To estimate the empirical relationship between quantity demanded and
price, we collect data on Q, Y, P, Pc, Ps and Z and estimate the model
parameters using regression model (direction and magnitude)
 Use this information to make demand forecast and find optimal
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 Relationship with functional Areas of Business Administration
Studies.
 Business administration studies include other disciplines (professions)
like accounting, finance, marketing, personnel or human resource
management, and production.
 These disciplines study the business environment in which businesses
operates and provide background information for managerial decision
making.
 Hence managerial economics use economic theory and management
science tools to examine how a firm can achieve its objectives
efficiently within the business environment in which it operates.

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Theory of the Firm

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 Firm Defined

 Firm is an organization that combines and organizes resources for

the purpose of producing goods and/or services for sale.
 For instance; there are millions of firms in the world. These include
proprietorship (i.e. firms owned by one individual), partnership and
corporations (i.e. owned by stockholders).
 Firms produce more than 80 percent of all good and services
consumed in the world. The remainder is produced by the
government and non profit organizations such as private college,
hospitals, museums and foundations.
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 Objective of the Firm in Neoclassical Model

 The neoclassical theory of a firm assumes that the firm seeks to

maximize profits (and minimize cost) given some constraints in the
short-run and maximize firm value in the long-run.
 On the basis of that it predicts how much of a particular commodity
the firm should produce under different forms of market structure or
organization.

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 Value of the Firm

 The theory of the firm postulates that the primary objective of the firm
is to maximize the wealth or value of the firm.
 The value of the firm is given by the present value of all expected future
profits i.e. the discounted Kwacha of profit in the future is worth less
than a Kwacha profit today,
 In uncertain/risky environment higher discount rate is used hence the
PV is smaller.
1 2 n n
t
PV    
(1  r )
1
(1  r ) 2
(1  r ) n
t 1 (1  r ) t
n
t
TRt  TCt n
Value of Firm   
t 1 (1  r ) t
t 1 (1  r ) t
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 Example:- Theory of firm, Value of the firm and PV

The owner of a firm expects to receive a profit of $ 100 in each of the

next three years and to be able to sell the firm at the end of the third
year for $ 700. The owner believes that the appropriate discount rate
for the firm is 10 percent per year.

Calculate (a) the value of the firm (PV) (b) the value of the firm when
a discount rate of 20 percent (c) what is the effect on the value of the
firm of using a higher discount rate.

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 Theory of firm-Value of the firm-PV

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

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 Constraints on Operation of the Firm

 Firms face many constraints in pursuing their objective of

maximizing the firms value. Limited in terms of:
 Availability of essential inputs eg skilled labour and raw materials.
 Sufficient factory and warehousing space and the amount of
capital funds available for a given production project.
 Government controls and regulations (legal constraints) i.e.
minimum wage, healthy and safety standards, unfair business
practices law.
 Firms will therefore maximize its value subject to such constraints
(constrained optimization).
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 Alternative Theories

 The theory of firm has also been criticized as being much narrow
and unrealistic. i.e. is profit the only objective that firms pursue?
 For this reason, broader theories of the firm have been proposed.
 The most prominent among these are models postulate that the
primary objective of the firm is the maximization of sales, the
maximization of management utility and satisfying behavior.

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 Sales Maximization

 This model was first introduced by William Baumol

 According to the model, managers of modern corporations seek to
maximize sales after an adequate rate of profit has been earned to
satisfy stockholder.
 Sales (or total revenue, TR) will be at a maximum when the firm
produces a quantity that sets marginal revenue equal to zero (MR =
0)

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Sales Maximization Model

MR = 0
where
Q = 50

MR = MC
where
Q = 40
 Management utility maximization
 The model (introduced by Oliver Williamson) postulates that with the
advent of the modern corporation and resulting separation of
management from ownership there is diverging interests between
managers and owners.
 Managers are more interested in maximizing their utility measured in
terms of their compensation (i.e. salaries, stock options etc.), the size of
their staff, extent of control over the corporation, lavish offices etc. than
maximizing corporate profits.
 This referred to as the Principle-agent problem. i.e Agents (Managers) are
more interested in maximizing their benefits than maximizing profits or
firm value for the principal (Owners).
 The problem can be resolved by tying the managers reward to the firm’s
performance relative to other firms in the same industry, use of term
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contracts, threat of mergers etc.
 Satisficing behavior

 Proposed by Cyert and March

 This stems from the great complexity of running the large modern
corporation- a task often complicated by uncertainty and a lack of
adequate data.
 Manager are not able to maximize profits but can only strive for
some satisfactory goal in terms of sales, profit, growth, market share
and so on.
 This situation is called satisficing behaivour (H. Simon) hence
corporations are not maximizing but rather satisficing.
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Nature and Function of Profits

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Definitions of Profit

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 Accounting Profits Vs Economic Profits


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 Example on business and economic profit

A person managing a dry- cleaning store for $ 30,000 per year decides
to open a new one. The revenues of the store during the first year of
operation are $ 100,000 and the expenses are $ 10,000 for supplies, $
35,000 for salaries, $ 8,000 for rent, and $ 2,000 for utilities. The person
also used $5,000 for interest on a bank loan. Assume that income and
business taxes are zero and the repayment of the principal of the loan
does not start before three years (suppose r=10%).

Calculate (a) the explicit cost (b) the implicit costs (c) the business
profit, (d) the Economic profit (e) normal return on investment and also
(f) indicate whether the person should open the dry-cleaning store.
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 The trade-off between profit and costs -Value of the firm
a. Expenses is the explicit costs- the expenses are $ 10,000 for supplies, $
35,000 for salaries, $ 8,000 for rent, and $ 2,000 for utilities as well as
interest $ 5,000 – total amout is $ 60,000.
b. The Implicit costs are the entrepreneeur’s foregone salary- $ 30,000.
c. The business profit = total revenues - the explicit costs = $ 100,000 - $
60,000= $ 40,000
d. The Economic profit = total revenues – (the explicit costs + Implicit costs) =
100,000 – ($ 60,000 + $ 30,000) = $ 10,000.
e. The normal return on investment = The Implicit costs =$ 30,000.
f. PV=10,000/(1+0.10)....or roughly we can say that the person would earn
economic profit $ 10,000 per year, therefore, the person should open24 the
 Theories of Profit

Risk-Bearing Theories of Profit

 Argue that above-normal returns are required by firms to enter and
remain in some fields such as petroleum exploration with above
average risk.
 Similarly expected returns on stocks has to be higher than on bonds
because of the greater risk of stocks.
Frictional Theory of Profit
 Argue that profits arise as a result of friction or disturbances from
long-run equilibrium.
 In LR perfectly competitive equilibrium firms tend to earn normal
return (adjusted for risk) or zero economic profit. At anytime firms
not operating in equilibrium earn supernormal profits or incur 25
 Theories of Profit
Monopoly Theory of Profit
 Firms with monopoly power can restrict output and charge higher
prices than under perfect competition, thereby earning a profit.
 Restricted or barriers to entry into the industry allows firms to
continue earning supernormal profits even in the long-run.
 Monopoly power arises due to:
a. Firms control of supply of essential raw materials
b. Economies of scale in production of good
c. Ownership of patents
d. Government restriction that prohibit competition in the industry.
e. High initial cost of investment of sunk costs.
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 Theories of Profit
Innovation Theory of Profit
 Postulates that economic profit is the reward for the introduction of
a successful innovation.
 e.g Steven Job, the founder of the Apple Computer Company
became a millonaire in 1977
 Patents protect investors to earn a reasonable return on their
investment before others imitate their innovation.
 Successful innovation encourage the flow of technology as well as
profit
Managerial Efficiency Theory of Profit
 Rest on the observation that if average firm earns only a normal
return on its investment in LR then more efficient than average
would earn above-normal returns (economic profit) 27
 Function of Profit

 Profit is a signal that guides the allocation of society’s resources.

1. High profits in an industry are a signal that buyers want more of
what the industry produces.
2. Provide signals to firms to either enter or exit the market in the
long-run.
3. Provide crucial signals for reallocation of society resources to reflect
changes in consumers’ tastes and demand overtime.

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