MANAGERIAL ECONOMICS

1.1 The Fundamental of Managerial Economics

➔​ 1.1.1. Distinguish economic versus accounting profit and costs

Accounting Profit = Total Revenue - Explicit Costs

(Costs that involve direct monetary payment, e.g., wages, rent, materials.)

Economic Profit = Total Revenue - (Explicit + Implicit Costs)

(Implicit costs include opportunity costs—what the firm sacrifices when choosing one option over another.)

Example:
A small coffee shop earns ₱500,000 in revenue annually. Its explicit costs (rent, wages, materials) total ₱300,000. The owner could
earn ₱150,000 annually if working elsewhere (opportunity cost of time).

Accounting profit: ₱500,000 - ₱300,000 = ₱200,000

Economic profit: ₱500,000 - ₱300,000 - ₱150,000 = ₱50,000

Exercise:
You own a sari-sari store that earns ₱800,000 annually. Explicit costs are ₱550,000, and you gave up a teaching job that paid
₱180,000.

What is your accounting profit?

What is your economic profit?

📍 Overview:
stresses that economic profit is more relevant for managerial decision-making because it reflects the true profitability of a business by
accounting for all opportunity costs, not just out-of-pocket expenses.

➔​ 1.1.2. Explain the role of profits in a market economy

Profits serve as signals: They indicate where resources should be allocated.

Incentive mechanism: High profits attract new firms; low profits drive firms out.
Efficient allocation: Resources flow toward industries and firms that provide the greatest value to consumers.

Example:
A new gadget earns high profits. As profits rise, other firms are attracted to the market. Over time, competition increases, driving
prices down and profits back to normal.

Exercise:
Why might high profits in the milk tea industry encourage more competition? How can that affect future profits of early milk tea
shops?

📍 Overview:
In a competitive market, profits guide the invisible hand by rewarding efficiency and penalizing waste, promoting innovation and optimal
use of resources.

➔​ 1.1.3. Apply the five forces framework to analyze the sustainability of an industry’s profits

Porter’s Five Forces:

1. Threat of New Entrants
2. Bargaining Power of Suppliers
3. Bargaining Power of Buyers
4. Threat of Substitutes
5. Industry Rivalry
 Example:
Mobile Phone Industry (Philippines):
High rivalry among brands (Samsung, Oppo, Xiaomi)
Low entry barrier for online-only brands
High buyer power due to many choices

📍 Overview:
Baye uses this framework to show how external forces shape profitability. For instance, if entry barriers are low, new competitors can
erode existing profits. Strategic thinking must consider these forces to sustain long-term profitability.

➔​ 1.1.4. Apply present value analysis to make decisions and value assets

Present Value (PV) = Future Cash Flows / (1 + r)^t

(Where r is the discount rate and t is the time period.)

Example:
Your company expects to earn ₱50,000 next year and ₱50,000 the year after. If the interest rate is 10%, what is the present value of
these earnings?

Exercise:
You expect ₱60,000 in Year 1 and ₱70,000 in Year 2. If the discount rate is 8%, what is the present value?

📍 Overview:
Baye emphasizes that managers must evaluate the present value of future profits and costs to make sound investment decisions. This
is crucial for capital budgeting, pricing, and valuation.

➔​ 1.1.5. Apply marginal analysis to determine the optimal level of a managerial control variable

Marginal Analysis: Examining the impact of small changes in a decision variable (like labor, advertising, price).
Optimal decision rule: Continue an activity until Marginal Benefit = Marginal Cost (MB = MC).

Example:
A bakery adds more workers.
The 4th worker increases output by 50 loaves (Marginal Benefit = ₱2 × 50 = ₱100).
If the worker costs ₱90 (Marginal Cost), hire.
If a worker costs ₱120, do not hire.

Exercise:
You run a delivery service. Adding another motorcycle will earn you ₱12,000 in monthly revenue, but it will cost ₱15,000 per month in
fuel, maintenance, and rider salary.
Should you buy another motorcycle? Why or why not?

📍 Overview:
Marginal analysis is at the heart of managerial economics. Baye uses it to guide optimal pricing, output, hiring, and other operational
decisions to maximize firm value.
1.2 The Theory Of Behavior
➔​ 1.2.1. Describe the fundamental characteristics of a consumer's preference ordering and how they affect their indifference
curves

📍 Overview:
Consumer preferences are assumed to follow these three axioms:
1. Completeness: Consumers can rank all bundles (A is better than B, or B is better than A, or indifferent).
2. Transitivity: If A is preferred to B, and B to C, then A is preferred to C.
3. More is better: Consumers prefer more of a good to less (non-satiation).

These assumptions shape indifference curves, which represent combinations of goods that give the consumer the same satisfaction.
Indifference curves show all combinations of two goods providing the same satisfaction.

Example:
Maria is equally happy consuming either:
2 apples & 1 banana
1 apple & 3 bananas

→ These combinations lie on the same indifference curve.

Key Properties of Indifference Curves (from Baye):

●​ Downward sloping
●​ Convex to the origin (due to diminishing marginal rate of substitution)
●​ Indifference curves never intersect

➔​ 1.2.2. Illustrate how changes in prices and income impact an individual’s opportunities

📍 Overview:
This refers to budget constraints. A consumer’s opportunity set depends on their income and the prices of goods. The budget line
shows all affordable combinations of two goods.

Price Change: Rotates the budget line (if the price of one good changes).
Income Change: Shifts the entire budget line inward or outward (parallel shift).

Example:
If income increases, consumers can afford more of both goods, expanding their choice set.
If the price of one good rises, that good becomes relatively more expensive, shrinking consumption possibilities.

A consumer’s budget constraint is based on income and prices.

Example:
Anna has ₱100. If apples cost ₱10 and bananas ₱20:
Max apples = 10
Max bananas = 5

If her income increases to ₱200 → her opportunity set expands

➔​ 1.2.3. Illustrate a consumer’s equilibrium choice and how it changes in response to changes in prices and income

📍 Overview:
A consumer’s equilibrium occurs where the budget line is tangent to the highest possible indifference curve. This is where:

Px/Py is the actual price ratio in the market.

When prices or income change: New budget lines are formed
The consumer finds a new tangency point (new optimal bundle)

Example:
If the price of good X falls, the budget line rotates outward for X. The new equilibrium typically involves more of X and possibly less
of Y.

➔​ 1.2.4. Separate the impact of a price change into substitution and income effects

📍 Overview:
When the price of a good changes, the total effect on quantity demanded can be split into:

1. Substitution Effect – Change in consumption due to the good becoming relatively cheaper or more expensive (holding utility
constant).
2. Income Effect – Change in consumption due to the change in purchasing power from the price change.

Summary:
Substitution Effect: Buy more of the now-cheaper good
Income Effect: Feeling richer or poorer due to price change
Total effect = Substitution + Income Effect

Normal Good:
Price ↓ → Substitution (+), Income (+) → Buy more

Inferior Good:
Price ↓ → Substitution (+), Income (–) → Net effect depends

Baye uses the Hicksian decomposition to explain this:

Hold utility constant to isolate substitution effect
Then allow movement to new higher or lower utility level to capture income effect

Example:
(Normal Good):
If price of rice decreases:
Substitution effect: Buy more rice, less of other goods
Income effect: You feel richer, may buy even more rice

Example
(Inferior Good):
If price of cheap noodles drops:
Substitution effect: Buy more noodles
Income effect: May actually buy fewer noodles and switch to better food (because of higher effective income)

1.3 The Organization of the Firm

➔​ 1.3.1. Economic trade-offs: Spot Exchange vs Contract vs Vertical Integration

📍 Overview:
Firms face trade-offs when acquiring inputs:
Spot Exchange: Purchase on the open market at current prices.
●​ Flexible, but risky due to price and supply uncertainty.
Contracts: Legally bind terms and prices.
●​ Reduces risk, but may be costly and inflexible.

Vertical Integration: Firm owns its input supplier.

●​ Full control, but costly and complex to manage.

Example:

A fast-food chain:
Spot exchange: Buys potatoes on the market
Contract: Signs annual agreement with a farm
Vertical integration: Buys and operates its own potato farm

➔​ 1.3.2. Four Types of Specialized Investments & the Hold-Up Problem

📍 Overview:
Specialized investments are assets that have more value in a particular relationship. These lead to "hold-up problems" — where one
party may exploit the other after the investment is made.

Types
1. Site specificity – Asset only valuable at a particular location
2. Physical asset specificity – Customized equipment
3. Human capital specificity – Skills/training specific to one firm
4. Dedicated assets – Large-scale investments for one buyer

Example:
A supplier builds a factory next to a car company (site specificity). If the car company switches partners, the factory loses value →
Hold-up problem risk.

➔​ 1.3.3. Optimal Manner of Procuring Inputs

📍 Overview:
Choice depends on cost, control, and risk.

Use:
Spot exchange for standard inputs
Contracts for moderately specific inputs
Vertical integration for highly specialized inputs or if opportunism risk is high

Example:
A clothing brand:
Buys fabric via spot exchange
Uses contracts for unique dyes
Vertically integrates for exclusive logos and prints

📍 Overview:
➔​ 1.3.4. Principal–Agent Problem: Owners vs Managers

Occurs when owners (principals) delegate control to managers (agents). Agents may act in self-interest (e.g., slack off, over-invest in
prestige projects) unless properly incentivized.

Example: A manager might prefer expanding office size instead of maximizing profit unless monitored or rewarded based on
performance.
 ➔​ 1.3.5. Three Forces Owners Use to Discipline Managers

📍 Bayes Tools
1. Incentive Contracts – Bonuses tied to profit or performance
2. Direct Monitoring – Audits, board supervision
3. Threat of Firing or Takeover – Fear of losing position or control

Example:
If a CEO’s bonus is tied to stock performance (incentive), and they're monitored by a board and at risk of replacement, they’re more
likely to act in shareholders' interests.

➔​ 1.3.6. Principal–Agent Problem: Managers vs Workers

📍 Overview: Managers (principals) hire workers (agents), but workers may shirk or reduce effort without monitoring or incentives.
Example: An employee might browse social media during work hours unless there's supervision or performance-based pay.

➔​ 1.3.7. Four Tools Managers Use to Mitigate Incentive Problems

📍 Bayes Tools
1. Fixed Wages + Monitoring – Stable salary plus supervision
2. Performance-Based Pay – Commissions or bonuses
3. Profit Sharing – Employees share in firm success
4. Efficiency Wages – Pay more to attract loyal and productive workers

Example:
A sales team:

Gets base pay (fixed wage)

Is tracked via call reports (monitoring)
Earns commission (performance-based)
Receives bonus if company meets targets (profit sharing)

Concepts Key Ideas Example

Spot vs. Contract vs. Integration Trade-off of cost, control, risk Fast-food chain sourcing

Specializes Investments Lead to hold up risk Factory near buyer

Principal-Agent Problem Misaligned goals between delegator and agent Owner vs. CEO, Manager vs. Worker

Incentive tools Align behavior goals Bonuses, monitoring, profit sharing

1.4 The Nature of Industry

➔​ 1.4.1. Calculate alternative measures of industry structure, conduct, and performance, and discuss their limitations.
The Structure-Conduct-Performance (SCP) paradigm, originally developed by Joe S. Bain in his book Industrial Organization, is a
foundational framework in industrial economics. While Michael Baye’s book Managerial Economics and Business Strategy builds on
this tradition, it also introduces alternative measures and critiques of the SCP model.
SCP Framework Overview
1.​ Structure: Refers to the characteristics of the market—number of firms, product differentiation, entry barriers, etc.
2.​ Conduct: Describes firm behavior—pricing strategies, advertising, R&D, collusion, etc.
3.​ Performance: Evaluates outcomes—efficiency, profitability, innovation, consumer welfare.

The SCP model assumes a causal chain: Structure → Conduct → Performance.

 Alternative Measures and Their Limitations (as discussed in Bayes approach)
1. Concentration Ratios (CR4, HHI)
●​ What they measure: Market dominance by top firms.
●​ Example: A CR4 of 80% in the U.S. soft drink industry suggests high concentration.
●​ Limitations:
○​ Doesn’t account for potential competition.
○​ Ignore firm behavior—two industries with the same CR4 can behave very differently.

2. Price-Cost Margins (Lerner Index)

●​ What it measures: Market power via markup over marginal cost.
●​ Example: A Lerner Index of 0.5 implies significant pricing power.
●​ Limitations:
○​ Requires accurate cost data, which is often unavailable.
○​ High margins may reflect efficiency, not market power.
○​
3. Profitability Measures (ROA, ROE)
●​ What they measure: Financial performance.
●​ Example: High ROE in the pharmaceutical industry.
●​ Limitations:
○​ Can be influenced by accounting practices.
○​ High profits might stem from innovation, not anti-competitive behavior.

4. Conduct Indicators (Advertising-to-Sales Ratio, R&D Intensity)

●​ What they measure: Strategic behavior.
●​ Example: High R&D intensity in tech firms like Apple or Google.
●​ Limitations:
○​ Hard to interpret—high advertising could signal competition or collusion.
○​ Doesn’t capture informal or tacit conduct.

Critique and Modern Perspective

Michael Baye emphasizes that causality may run both ways—performance can influence structure (e.g., successful firms grow and
increase concentration). He also integrates game theory and strategic thinking, which allow for more nuanced analysis of firm behavior
beyond the static SCP model.

Example: Airline Industry

●​ Structure: Few major carriers dominate (e.g., Delta, United, American).
●​ Conduct: Price matching, loyalty programs, route specialization.
●​ Performance: Mixed—high profits on some routes, losses on others.

Alternative Measures:
●​ HHI shows high concentration on specific routes.
●​ High price-cost margins on monopoly routes.
●​ High advertising and loyalty program spending.

Limitations: These measures don’t fully capture dynamic pricing, regulatory constraints, or consumer switching behavior.

Alternative Measures in the SCP Framework

SCP Element Alternative Measure Example Industry Limitation

Structure CR4, HHI Soft Drinks (CR4 ≈ 80%) Ignores potential entrants and product
differentiation

Conduct Advertising-to-Sales Fast Food (McDonald's, High ad spend could signal competition or
Ratio etc.) brand entrenchment

Conduct R&D Intensity Pharmaceuticals Doesn’t reveal whether R&D leads to

innovation or just patent extensions

Performance Lerner Index Tech (e.g., Apple) Requires marginal cost data; high index may
reflect efficiency

Performance ROA, ROE Banking Influenced by leverage and accounting

practices
 ➔​ 1.4.2. Describe examples of vertical, horizontal, and conglomerate mergers, and explain the economic basis for each type of
merger.

[Link] Merger: A horizontal merger occurs between firms that operate in the same industry and are direct competitors.
Economic Basis:
●​ Market Power: Reduces competition, potentially allowing the merged firm to raise prices.
●​ Economies of Scale: Larger production volume can reduce average costs.
●​ Synergies: Shared technology, distribution, or branding.

Example (from Bayes framework):

●​ Standard Oil acquired other oil refiners in the late 1800s.
●​ Facebook acquiring Instagram—both operate in the social media space.
Limitation:
May attract antitrust scrutiny due to potential monopolistic behavior.

2. Vertical Merger-A vertical merger involves firms at different stages of the supply chain (e.g., a manufacturer and a supplier or
distributor).
Economic Basis:
●​ Cost Reduction: Eliminates markup between stages.
●​ Improved Coordination: Better control over inputs and distribution.
●​ Barrier to Entry: Can limit access to key resources for rivals.
Example:
●​ Amazon acquiring Whole Foods—integrating retail with logistics and supply.
●​ A tire manufacturer merging with a rubber producer (backward integration).
Limitation:
May reduce flexibility and lead to inefficiencies if the merged firm becomes too complex to manage.

3. Conglomerate Mergers- A conglomerate merger occurs between firms in unrelated industries.

Economic Basis:
●​ Diversification: Reduces risk by spreading across sectors.
●​ Capital Allocation: Profits from one division can fund growth in another.
●​ Managerial Efficiency: Belief that superior management can improve underperforming firms.
Example:
●​ ITT Corporation in the 1960s acquired firms in telecom, banking, insurance, and hospitality.
●​ Berkshire Hathaway owns businesses in insurance, railroads, and consumer goods.
Limitation:
●​ Lack of Focus: Can dilute strategic direction.
●​ No Synergy: Unlike horizontal or vertical mergers, conglomerates may not benefit from operational integration.

Comparison Chart: Types of Mergers

Merger Type Definition Example Economic Rationale Limitations

Horizontal Merger between Facebook + Increases market power, Antitrust concerns,

firms in the same Instagram reduces competition, potential for price
industry and market achieves economies of increases
level scale

Vertical Merger between Amazon + Whole Reduces transaction costs, Reduced flexibility, risk
firms at different Foods improves coordination, of inefficiencies from
stages of the supply creates entry barriers integration
chain

Conglomerate Merger between Berkshire Diversifies risk, reallocates Lack of synergy,

firms in unrelated Hathaway + capital efficiently, leverages potential for strategic
industries multiple sectors managerial expertise drift
 ➔​ 1.4.3. Relevance of the Herfindahl-Hirschman Index (HHI) for Antitrust Policy
What is HHI?
●​ It measures market concentration by summing the squares of the market shares of all firms in an industry.
●​ For example, if four firms have market shares of 30%, 30%, 20%, and 20%, the HHI = 30² + 30² + 20² + 20² = 2,600.

Bayes Application:
Michael Baye emphasizes that HHI is a quantitative benchmark for assessing whether a merger is likely to reduce competition. It
reflects both the number of firms and their relative sizes.

Antitrust Thresholds:
●​ HHI < 1,500: Unconcentrated market.
●​ 1,500 ≤ HHI < 2,500: Moderately concentrated.
●​ HHI ≥ 2,500: Highly concentrated.
●​ A merger that increases HHI by more than 200 points in a highly concentrated market is presumed to raise antitrust concerns.

➔​ 1.4.4. Structure-Conduct-Performance (SCP) Paradigm, Feedback Critique, and Five Forces

SCP Paradigm:
●​ Developed by Joe Bain and discussed in Bayes book, the SCP model posits a causal chain: Market Structure → Firm Conduct
→ Market Performance
●​ Structure: Number of firms, entry barriers.
●​ Conduct: Pricing, advertising, R&D.
●​ Performance: Efficiency, profitability, consumer welfare.

Feedback Critique:
●​ Baye highlights that causality may be bidirectional.
●​ For example, high profits (performance) may lead to increased concentration (structure) through mergers.
●​ This critique led to the development of modern industrial organization, which incorporates game theory and strategic behavior.

Relation to Porter’s Five Forces:

●​ Michael Porter’s framework expands on SCP by identifying five competitive forces:​

1.​ Threat of new entrants

2.​ Bargaining power of buyers
3.​ Bargaining power of suppliers
4.​ Threat of substitutes
5.​ Industry rivalry

●​ Bayes' book aligns with this by emphasizing strategic interdependence and managerial decision-making in shaping outcomes,
not just market structure.​

➔​ 1.4.5. Identifying Market Structures

Michael Baye outlines four primary market structures, each with distinct characteristics:

Market Structure Key Features Example

Perfect Competition Many firms, identical products, no entry Agricultural markets (e.g., wheat)
barriers, price takers

Monopoly One firm, unique product, high entry Local utilities

barriers, price maker

Monopolistic Competition Many firms, differentiated products, free Restaurants, clothing brands
entry, some pricing power

Oligopoly Few firms, interdependent decisions, Airlines, smartphones

potential for collusion or price leadership
Bayes Strategic Emphasis:
●​ In oligopoly, Baye uses game theory to model firm behavior (e.g., Cournot, Bertrand, Stackelberg models).
●​ In monopolistic competition, he highlights non-price competition like branding and advertising.
1.5 Economic concepts essential to obtaining an understanding of entity's business and industry

➔​ 1.5.1 Macroeconomics (national economic issues and measures of economic performance such as GDP, Business
cycle; unemployment and inflation; fiscal and monetary policies; international trade and foreign exchange rates)

Macroeconomics focuses on the overall economy and its impact on business conditions. Baye integrates macroeconomic indicators
into managerial strategy by showing how they influence demand, costs, and investment decisions.

Concept Explanation

GDP (Gross Domestic Measures the total value of goods and services produced. A growing GDP signals
Product) economic expansion, which boosts consumer demand.

Business Cycle Refers to fluctuations in economic activity—expansion, peak, recession, and

recovery. Firms adjust output and pricing based on the cycle.

Unemployment High unemployment reduces consumer spending; low unemployment may

increase wage costs.

Inflation Rising prices affect input costs and consumer purchasing power. Inflation
expectations also influence pricing strategies.

Fiscal Policy Government spending and taxation influence aggregate demand. For example,
tax cuts can stimulate consumption.

Monetary Policy Central bank actions (e.g., interest rate changes) affect borrowing costs and
investment.

International Trade Trade policies and tariffs affect input costs and market access.

Foreign Exchange Rates Currency fluctuations impact the cost of imports/exports and profitability of
international operations.

Bayes Emphasis: Managers must monitor these indicators to forecast demand, adjust pricing, and plan investments. For instance,
during a recession, firms may delay capital expenditures or reduce inventory.

➔​ 1.5.2 Microeconomics: Firm-Level Behavior and Market Dynamics

Microeconomics examines how individual firms and consumers make decisions. Bayes' book is rooted in microeconomic theory,

🔹
especially in how firms optimize pricing, output, and strategy.

Concept Explanation

Supply The quantity firms are willing to produce at various prices.

Influenced by input costs, technology, and regulation.

Demand The quantity consumers are willing to buy at various prices.

Affected by income, preferences, and substitutes.

Market Equilibrium The price at which quantity supplied equals quantity

demanded. This determines the market-clearing price.

Price Elasticity of Demand Measures how sensitive quantity demanded is to price

changes. Crucial for pricing decisions—elastic demand
means consumers are price-sensitive.

Market Structure Determines pricing power and strategy. Includes perfect

competition, monopoly, monopolistic competition, and
oligopoly.
 Production Functions Show how inputs (labor, capital) are transformed into outputs.
Help firms optimize resource use.

Cost Functions Include fixed, variable, marginal, and average costs.

Understanding cost behavior is essential for profit
maximization.

Bayes Emphasis: He uses marginal analysis and game theory to help managers make optimal decisions. For example,
understanding elasticity helps firms decide whether to raise prices or increase volume.