Managerial Economics Overview PDF

BM1704 MANAGERIAL ECONOMICS OVERVIEW Concepts in Managerial Economics Managerial Economics It applies economic tools and techniques to business and administrative...

BM1704 MANAGERIAL ECONOMICS OVERVIEW Concepts in Managerial Economics Managerial Economics It applies economic tools and techniques to business and administrative decision-making. It is also the study of how to direct scarce resources in a way that most efficiently achieves a managerial goal. Three (3) Basic Economic Questions: What commodities should be produced? How should those commodities be produced? For whom are those commodities produced? Theory of the Firm It is the basic model of business, which means that firms are useful for producing and distributing goods and services. The main goal of the firm is to earn profit. However, this goal is short-term and does not consider other factors which may affect profit. Recently, the main goal of the firm has been expanded to include the factor of uncertainty and the time value of money. In this more complete model, the primary goal of the firm is the long-term expected value maximization. This means that the firm seeks to optimize its profits in the light of uncertainty and the time value of money. Organization face constraints in their pursuit of profit optimization. They have limited availability of essential inputs, such as skilled labor, raw materials, specialized machinery, and warehouse space. Managers also face limits on the amount of funds available for a project or activity, or legal and contractual requirements. Managers make and implement decisions that directly answer two (2) of the major economic questions: What commodities should be made and how should those commodities be produced? They must decide what commodity or combination of commodities their firms should produce. They must also decide on the commodity’s price and how much they are willing to pay for various inputs. The manager’s tasks are grouped into three (3) major areas. First, managers help develop the firm’s goals. After the goals are established, managers must develop strategies to achieve those goals. Finally, managers must acquire and direct the resources necessary for achieving the firm’s goals. Explicit and Implicit Costs Businesses use two (2) kinds of inputs or resources. Market-supplied resources are resources that are owned by others and hired, rented, or leased by the business. Examples of these resources are labor from workers, raw materials purchased from suppliers, and capital equipment rented, or leased. The other category of resources is owner-supplied resources. These are resources owned and used by the firm. The three (3) most important types of owner-supplied resources are money provided to business by the owners, time and labor services provided by the firm’s owners, and any land, buildings, or capital owned by the firm. 01 Handout 1 *Property of STI Page 1 of 4  BM1704 Businesses incur opportunity costs for both categories of resources used. The total economic cost is the monetary cost of market-supplied resources and opportunity costs of owner-supplied resources. The monetary costs of market-supplied resources are what the business pays for the use of these resources. They are also known as explicit costs. Using owner-supplied resources does not require the firm to pay money. However, there is an opportunity cost involved here. For example, a business owns a building, which it uses for its own operations. If the business didn’t use this building, they could have rented or leased it to someone else and made a profit. Thus, there are opportunity costs involved in using owner-supplied resources. These opportunity costs are also known as implicit costs. Business/Accounting Profit vs. Economic Profit The Business Profit / Accounting Profit o To maximize profits, firms must recognize all costs, including opportunity costs. o Profit is usually defined 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 is the accounting profit, or business profit. o The accounting, or business view, considers only explicit costs. In an equation, it would be represented as such: 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 The Economic Profit o Economists also define profit as the excess of revenue over costs. However, inputs provided by the owner, including entrepreneurial effort and capital, are resources that must be compensated. The economists include opportunity cost in the costs of doing business. Economic profit, therefore, is the business profit minus the implicit costs of capital and any of the owner-provided inputs. o The economic view considers both explicit and implicit costs. In an equation, it would be represented as: 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 Disequilibrium Profit Theories Frictional profit theory – This theory states that markets are sometimes in disequilibrium because of unanticipated changes in demand or cost conditions. For example, a rise in environmental awareness increases the demand for “green” products, while driving down the demand for more environmentally-harmful products. Monopoly profit theory – This theory explains that some firms have above-normal profits because they are protected from competition by high barriers to entry. These firms may have high capital requirements, patents, or import protection. Innovation profit theory – This theory describes above-normal profits that arise following successful invention or modernization. Compensatory profit theory – This theory states that firms will have above-normal rates of return if they achieve extraordinary success in meeting customer needs and maintaining efficient operations. 01 Handout 1 *Property of STI Page 2 of 4  BM1704 Time Value of Money It is important to recognize what happens to money over time. A peso today is worth exactly one peso, however, a peso today does not buy as much goods as a peso did 30 years ago, because of inflation. Because of inflation, people would rather have their money right now (and buy lots of things for the same amount) rather than in the future (where inflation would cause them to buy less). Interest also plays an important role in the value of money. If an individual has P100 today, he/she can use it to buy a bond and earn interest. If there is a 10% interest rate, the P100 will be P110 after a year. When making business decisions, it is important that managers include the time value of money. If the firm spends money today to build a new factory, the firm will be giving up the opportunity to earn interest. The firm will generate profits in the future, but managers need to know whether or not those profits are large enough to offset the interest that was lost by not allowing the money to earn interest instead. The present value of money is the value of a future stream of revenue or costs in terms of their current value. Future revenues and costs are adjusted by a discount rate that reflects the firm’s time and risk preference. The present value is the amount that would have to be invested today at the prevailing interest rate to generate the given future value. The net present value is the present value of the income stream generated by a project minus the current cost of a project. If the net present value of a project is positive, then the project is profitable because the present value of the earnings from the project exceeds the current cost of the project. On the other hand, a manager should reject a proposal that has a negative present value, since the cost of such a project exceeds the present value of the income stream that a project generates. The formula for NPV can be written as: 𝐶𝐶𝑡𝑡 𝑁𝑁𝑁𝑁𝑁𝑁 = − 𝐶𝐶𝑜𝑜 (1 + 𝑟𝑟)𝑡𝑡 Where: 𝐶𝐶𝑡𝑡 = Net cash flow during time t 𝐶𝐶𝑜𝑜 = Total investment cost 𝑟𝑟 = Discount rate 𝑡𝑡 = Number of time periods Symbolically, the accept/reject criterion of the NPV method can be shown as: o If NPV> zero, accept the proposal o If NPV< zero, reject the proposal 01 Handout 1 *Property of STI Page 3 of 4  BM1704 Market Structures Perfect competition – This is the market structure with the highest degree of competition. Perfectly competitive markets have a large number of firms producing identical products. In a perfect competition, price is determined by supply and demand in the market, and the individual firm has no input on that price. The firm’s managers must determine what quantity of output to produce given the price. Monopolistic competition – This market structure also has a large number of firms but the goods produced by the firms isn’t identical – there are differences between goods. Because of these differences, customers develop preferences for one firm’s product over another firm’s product. Differing customer preferences mean that the managers of monopolistically competitive firms can choose both the profit-maximizing quantity and price. Oligopoly – This market structure is characterized by a small number of large firms. Because there is only a small number of firms, rivals are easily identifiable. The close interaction among rivals leads to mutual interdependence – each firm’s actions can affect other firms. Decision making in oligopoly means that firms would have to consider how their rivals respond to their actions. Monopoly – This is a single firm producing a commodity that has no close substitutes. Thus, monopolies don’t have to consider direct competition. However, monopolies are still constrained by consumer demand – if the consumer believes that the monopoly’s price is too high, the consumer will not buy the product. References Baye, M., & Prince, J. (2013). Managerial economics and strategy, 8e. New York : McGraw Hill. Bentzen, E., & Hirschey, M. (2016). Managerial economics. Hampshire: Cengage Learning. Graham, R. (2013). Managerial economics for dummies. New Jersey: John Wiley & Sons. Thomas, C., & Maurice, S. (2015). Managerial economics: Foundations of business analysis and strategy. New York: McGraw Hill Education. 01 Handout 1 *Property of STI Page 4 of 4