Managerial Economics
LESSON 1 - INTRODUCTION
MANAGERS, PROFITS AND MARKETS
1-1
Managerial Economics
Managerial Economics & Theory
• Managerial economics applies
microeconomic theory to business
problems
• How to use economic analysis to make
decisions to achieve firm’s goal of
profit maximization
• Microeconomics
• Study of behavior of individual
economic agents
1-2
Managerial Economics
Economic Cost of Resources
• Opportunity cost of using any
resource is:
• What firm owners must give up to use
the resource
• Market-supplied resources
• Owned by others & hired, rented, or
leased
• Owner-supplied resources
• Owned & used by the firm
1-3
Managerial Economics
Total Economic Cost
• Total Economic Cost
• Sum of opportunity costs of both
market-supplied resources & owner-
supplied resources
• Explicit Costs
• Monetary payments to owners of
market-supplied resources
• Implicit Costs
• Nonmonetary opportunity costs of
using owner-supplied resources
1-4
Managerial Economics
Economic Cost of Using
Resources (Figure 1.1)
E
xplic
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os
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o f
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ar
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1-5
Managerial Economics
Types of Implicit Costs
• Opportunity cost of cash provided
by owners
• Equity capital
• Opportunity cost of using land or
capital owned by the firm
• Opportunity cost of owner’s time
spent managing or working for the
firm
1-6
Managerial Economics
Economic Profit versus
Accounting Profit
• Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
• Accounting profit = Total revenue – Explicit costs
• Accounting profit does not subtract
implicit costs from total revenue
• Firm owners must cover all costs of all
resources used by the firm
• Objective is to maximize economic profit
1-7
Managerial Economics
Maximizing the Value of a Firm
• Value of a firm
• Price for which it can be sold
• Equal to net present value of expected
future profit
• Risk premium
• Accounts for risk of not knowing
future profits
• The larger the rise, the higher the
risk premium, & the lower the firm’s
value
1-8
Managerial Economics
Maximizing the Value of a Firm
• Maximize firm’s value by maximizing
profit in each time period
• Cost & revenue conditions must be
independent across time periods
• Value of a firm =
1 2 T T
t
...
(1 r ) (1 r ) 2
(1 r )
T
t 1 (1 r ) t
1-9
Managerial Economics
Separation of Ownership &
Control
• Principal-agent problem
• Conflict that arises when goals of
management (agent) do not match
goals of owner (principal)
• Moral Hazard
• When either party to an agreement
has incentive not to abide by all its
provisions & one party cannot cost
effectively monitor the agreement
1-10
Managerial Economics
Corporate Control Mechanisms
• Require managers to hold
stipulated amount of firm’s equity
• Increase percentage of outsiders
serving on board of directors
• Finance corporate investments
with debt instead of equity
1-11
Managerial Economics
Price-Takers vs. Price-Setters
• Price-taking firm
• Cannot set price of its product
• Price is determined strictly by market
forces of demand & supply
• Price-setting firm
• Can set price of its product
• Has a degree of market power, which
is ability to raise price without losing
all sales
1-12
Managerial Economics
What is a Market?
• A market is any arrangement
through which buyers & sellers
exchange goods & services
• Markets reduce transaction costs
• Costs of making a transaction other
than the price of the good or service
1-13
Managerial Economics
Market Structures
• Market characteristics that determine
the economic environment in which
a firm operates
• Number & size of firms in market
• Degree of product differentiation
• Likelihood of new firms entering market
1-14
Managerial Economics
Perfect Competition
• Large number of relatively small
firms
• Undifferentiated product
• No barriers to entry
1-15
Managerial Economics
Monopoly
• Single firm
• Produces product with no close
substitutes
• Protected by a barrier to entry
1-16
Managerial Economics
Monopolistic Competition
• Large number of relatively small
firms
• Differentiated products
• No barriers to entry
1-17
Managerial Economics
Oligopoly
• Few firms produce all or most of
market output
• Products are perfect substitutes
• Profits are interdependent
• Actions by any one firm will affect
sales & profits of the other firms
1-18
Managerial Economics
Comparison
Market Type Number of Size of Product Ease of
Firms firms Differentiation Entry
Perfect Many small undifferentiated No barrier
Competition
Monopoly Single large No substitute Protected by
barriers
Monopolistic many small differentiated No barrier
Oligopoly few large differentiated barrier
1-19
Managerial Economics
Globalization of Markets
• Economic integration of markets
located in nations around the world
• Provides opportunity to sell more
goods & services to foreign buyers
• Presents threat of increased
competition from foreign producers
1-20