MANAGERIAL ECONOMICS (MECO 211) PRELIM various kinds of risks and other emergency expenses.

Nobody will
bear risk unless there is expectation of profit.

WEEK 1: INTRODUCTION AND GOALS OF THE FIRM

Temporary disequilibrium theory of profit
MANAGERIAL ECONOMICS
It states that markets are sometimes in disequilibrium because of
• Managerial economics is the application of microeconomics
unanticipated changes in demand or cost conditions. Unanticipated
to problems faced by decision makers in the private, public, and
shocks produce positive or negative economic profits for some firms.
not-for-profit sectors.
Monopoly theory of profit.
• Managerial economics assists managers in efficiently
allocating scarce resources, planning corporate strategy, and This theory asserts that some firms are sheltered from competition by
executing effective tactics. high barriers to entry. Firms with monopoly power restrict output and
charge higher prices under perfect competition. This causes above-
• Managerial economics extracts from microeconomic theory
normal profits to be earned by the monopolistic firms.
those concepts and techniques that enable managers to select
strategic direction, to allocate efficiently the resource available
to the organization, and to respond effectively to tactical issues.
Innovation theory of profit posits that the main function of an
• Decision making in managerial economics seeks to do the entrepreneur is to introduce innovations and the profit in the form of
following: reward is given for his performance.
• Identify the alternatives,
• Select the choice that accomplishes the objective(s) in The managerial efficiency theory of profit holds that firms that
the most efficient manner. enjoy higher levels of profit do so because they are more efficient than
their competitors. Economic profit is an important mechanism for the
• Taking into account the constraints
efficient reallocation of resources in a free-enterprise economy
• And the likely actions and reactions of rival decision
makers.
OBJECTIVE OF THE FIRM
• Wealth maximization of shareholders implies forward
The Decision-Making Model in managerial economics
looking, long-run-oriented, dynamic strategies that anticipate
• Managers are responsible for proactively solving problems in change in a risky market environment, and maximize the
the current business model, for setting stretch goals, present value of expected cash flows
establishing the vision, and setting strategy for monitoring
• Shareholder wealth – a measure of the value of a firm.
teamwork, and integrating the operations, marketing, and
finance functions. • Shareholder wealth is equal to the value of a firm’s common
stock, which, in turn, is equal to the present value of all future
• The decision-making process
cash returns expected to be generated by the firm for the
• Establish the objectives benefit of its owners.

• Identify the problems • Profit maximization – objective of managers

• Examine possible alternative solutions

• Analyze alternatives and select the best SEPARATION OF OWNERSHIP AND CONTROL: THE PRINCIPAL-
AGENT PROBLEM
• Consider societal constraints
Profit maximization and shareholder wealth maximization are
• Consider organizational and input constraints very useful concepts when alternative choices can be easily identified
• Perform a sensitivity analysis and when the associated costs and revenues can be readily
estimated.
• Implement and monitor decision
Divergent Objectives and Agency Conflict
As sole proprietorships and closely held businesses grow into limited
THE ROLE OF PROFIT liability corporations, the owners (the principals) frequently delegate
decision-making authority to professional managers (the agents).
• Economic profit is the difference between total revenue (price Because the manager-agents usually have much less to lose than the
times units sold) and total economic cost. owner-principals, the agents often seek acceptable levels (rather than
• Economic profit guides decision makers, determining the a maximum) of profit and shareholder wealth while pursuing their own
types and quantity of goods or services that are produced and self-interests. This is known as a principal-agent problem or “agency
sold, as well as the resulting derived demand resources. conflict.”
Several theories of profit as identified below:
Agency Problems
• Risk-bearing theory of profit Two common factors that give rise to all principal-agent problems are
• Temporary Disequilibrium theory of profit the inherent unobservability of managerial effort and the presence of
random disturbances in team pro duction. The job performance of
• Monopoly theory of profit piecework garment workers is easily monitored, but the work effort of
salespeople and manufacturer’s trade representatives may not be
• Innovation theory of profit
observable at less-than-prohibitive cost. Directly observing
• Managerial efficiency theory of profit managerial input is even more problematic because managers
contribute what one might call “creative ingenuity.” Creative ingenuity
in anticipating problems before they arise is inherently unobservable.
The risk bearing theory of profit was developed by F.B Hawley in Owners know it when they see it, but often do not recognize when it is
1907 A.D. According to him, profit is a reward of risk bearing. The missing. As a result, in explaining fluctuations in company
main function of entrepreneur is to bear risk. Production involves performance, the manager’s creative ingenuity is often inseparable
from good and bad luck. Owners therefore find it difficult to know when
to reward managers for upturns and when to blame them for poor • In summary, marginal analysis instructs decision makers to
performance. determine the additional (marginal) costs and additional
• Agency costs – a costs associated with resolving conflicts of (marginal) benefits associated with a proposed action. Only if
interest among shareholders, managers, and lenders. Agency the marginal benefits exceed the marginal costs (that is, if net
costs include the cost of monitoring and bonding performance, marginal benefits are positive) should the action be taken
the cost of constructing contracts designed to minimize agency
conflicts, and the loss in efficiency resulting from unresolved
agent principal conflict Net Present Value Concept
• Net present value (NPV) is a financial metric that seeks to
capture the total value of an investment opportunity. The idea
Caveats to Maximizing Shareholder Value
behind NPV is to project all of the future cash inflows and
• Complete market – availability of firm’s inputs, output, and by outflows associated with an investment, discount all those
products. future cash flows to the present day, and then add the
• No significant asymmetric information – no known problems • NPV, or net present value, is how much an investment is worth
between sellers and buyers or misunderstanding and throughout its lifetime, discounted to today's value. The NPV
miscommunication with creditors and customers or within the formula is often used in investment banking and accounting to
organization. determine if an investment, project, or business will be
profitable in the long run.
• Known re-contracting costs – awareness on renewals of
contracts of the entity
Meaning and Measurement of Risk
WEEK 2: FUNDAMENTAL ECONOMIC CONCEPTS • Risk implies a change for some unfavorable outcome to occur.
MICROECONOMIC CONCEPTS IN MANAGERIAL ECONOMICS • Risk is a decision-making situation in which there is variability
in the possible outcomes, and the probabilities of these
• Demand and Supply outcomes can be specified by the decision maker.
• Marginal Analysis
• A decision is said to be risk free if the cash flow outcomes are
• Net Present value known with certainty

• Meaning and Measurement of Risk • Risk refers to the potential variability of outcomes from a
decision. The more variable these outcomes are, the greater
the risk.
Demand and Supply Analysis • It can be measured either by the standard deviation (an
• Demand and supply analysis is the study of how buyers and absolute measure of risk) or coefficient of variation (a
sellers interact to determine transaction prices and quantities. relative measure of risk).

• The law of supply and demand combines two fundamental • The relationship between risk and required return on an
economic principles describing how changes in the price of a investment can be defined as
resource, commodity, or product affect its supply and demand. • Required return = Risk-free return + Risk premium [2.9]
• As the price increases, supply rises while demand
declines. Conversely, as the price drops supply constricts • The risk-free rate of return refers to the return available
while demand grows. on an investment with no risk of default
• Levels of supply and demand for varying prices can be plotted • Investments involving greater risks must offer higher
on a graph as curves. The intersection of these curves marks
expected returns.
the equilibrium, or market-clearing price at which demand
equals supply, and represents the process of price discovery in
the marketplace
o Marginal use value – The additional value of the consumption
of one more unit; the greater the utilization already, the lower
the use value remaining.
Marginal Analysis o Marginal utility – The use value obtained from the last unit
• A basis for making various economic decisions that analyzes consumed.
the additional (marginal) benefits derived from a particular o Demand function – A relationship between quantity
decision and compares them with the additional (marginal) demanded and all the determinants of demand.
costs incurred. o Substitute goods – Alternative products whose demand
increases when the price of the focal product rises
• The familiar profit maximization rule for the firm of setting output o Complementary goods – Complements in consumption
at the point where “marginal cost equals marginal revenue” is whose demand decreases when the price of the focal product
one such example. Long-term investment decisions (capital rises.
expenditures) also are made using marginal analysis decision o Supply function – A relationship between quantity supplied
rules. Only if the expected return from an investment project and all the determinants of supply.
(that is, the marginal return to the firm) exceeds the cost of o Supply curve – A relationship between price and quantity
funds that must be acquired to finance the project (the marginal supplied, holding other determinants of supply constant.
cost of capital), should the project be undertaken. Following this o Marginal analysis – A basis for making various economic
important marginal decision rule leads to the maximization of decisions that analyzes the additional (marginal) benefits
shareholder wealth. derived from a particular decision and compares them with the
• A change in the level of an economic activity is desirable if the additional (marginal) costs incurred.
marginal benefits exceed the marginal (that is, the incremental) o Present value – The value today of a future amount of money
costs. If we define net marginal return as the difference or a series of future payments evaluated at the appropriate
between marginal benefits and marginal costs, then an discount rate.
equivalent optimality condition is that the level of the activity o Risk – A decision-making situation in which there is variability
should be increased to the point where the net marginal return in the possible outcomes, and the probabilities of these
is zero. outcomes can be specified by the decision maker.
o Probability – The percentage chance that a particular outcome
will occur
o Expected value – The weighted average of the possible
outcomes where the weights are the probabilities of the
respective outcomes.
o Standard deviation – A statistical measure of the dispersion
or variability of possible outcomes.