CHAPTER 1
The Fundamentals of Managerial Economics
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Learning Objectives
1. Summarize how goals, constraints, incentives,
and market rivalry affect economic decisions.
2. Distinguish economic versus accounting profits
and costs.
3. Explain the role of profits in a market economy.
4. Apply present value analysis to make decisions
and value assets.
5. Apply marginal analysis to determine the
optimal level of a managerial control variable.
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Introduction
The Manager
• A person who directs resources to achieve a
stated goal.
– Directs the efforts of others.
– Purchases inputs used in the production of the
firm’s output.
– Directs the product price or quality decisions.
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Introduction
Economics
• The science of making decisions in the
presence of scarce resources.
– Resources are anything used to produce a good or
service, or achieve a goal.
– Decisions are important because scarcity implies
trade-offs.
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The Economics of Effective Management
Economics of Effective Management
• Basic principles comprising effective
management:
– Understand incentives
• Identify goals and constraints
– Understand markets
– Recognize the time value of money
– Use marginal analysis
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The Economics of Effective Management
Understand Incentives
• Changes in profits provide an incentive to
how resource holders use their resources.
• Within a firm, incentives impact how
resources are used and how hard workers
work.
– One role of a manager is to construct incentives to
induce maximal effort from employees.
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The Economics of Effective Management
Identify Goals and Constraints
• Well-defined goals
• Example: Firm’s overall goal is to maximize
profits
• Constraints make it difficult to achieve goals
– Available technology
– Prices of inputs used in production
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The Economics of Effective Management
Recognize the Nature and
Importance of Profits
• Accounting profit
– Total amount of money taken in from sales (total
revenue) minus the dollar cost of producing goods
or services.
• Economic profit
– The difference between total revenue and cost
opportunity cost.
– Opportunity cost
• The explicit cost of a resource plus the implicit cost of
giving up its best alternative.
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Example:
• Fred currently works for a corporate law firm. He is considering
opening his own legal practice, where he expects to earn
$200,000 per year once he gets established. To run his own firm,
he would need an office and a law clerk. He has found the
perfect office, which rents for $50,000 per year. A law clerk
could be hired for $35,000 per year.
Office rental: $50,000
Law clerk′s salary: + $35,000
Total explicit costs: $85,000
• Accounting profit = Revenues ($200,000) - Explicit costs
($85,000) = $115,000
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Example:
• To open his own practice, Fred would have to quit his current
job, where he is earning an annual salary of $125,000. This
would be an implicit cost of opening his own firm.
• You need to subtract both the explicit and implicit costs to
determine the true economic profit:
• Economic profit = Total Revenues− Explicit Costs – Implicit Costs
= $200,000 − $85,000 − $125,000 = - $10,000 per year
• Fred would be losing $10,000 per year. That does not mean he
would not want to open his own business, but it does mean he
would be earning $10,000 less than if he worked for the
corporate firm.
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The Economics of Effective Management
Understand Markets
• Two sides to every market transaction: buyer
and seller
• Bargaining position of consumers and
producers is limited by three rivalries in
economic transactions:
– Consumer-producer rivalry
– Consumer-consumer rivalry
– Producer-producer rivalry
• Government and the market
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The Economics of Effective Management
Recognize the Time Value of Money
• Often a gap exists between the time when
costs are borne and benefits received.
– Managers can use present value analysis to
properly account for the timing of receipts and
expenditures.
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The Economics of Effective Management
Present Value Analysis 1
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The Economics of Effective Management
Present Value Analysis II
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The Economics of Effective Management
The Time Value of Money in Action
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The Economics of Effective Management
Net Present Value
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The Economics of Effective Management
The Time Value of Money in Action
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Economics of Effective Management
Present Value and Profit Maximization
• Profit maximization
– Maximizing profits means maximizing the value of
the firm, which is the present value of current and
future profits.
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Economics of Effective Management
Use Marginal Analysis
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Economics of Effective Management
Use Marginal Analysis
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Economics of Effective Management
Use Marginal Analysis
• Marginal principle
– To maximize net benefits, the manager should
increase the managerial control variable up to
the point where marginal benefits equal marginal
costs. This level of the managerial control
variable corresponds to the level at which
marginal net benefits are zero; nothing more can
be gained by further changes in that variable.
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Economics of Effective Management
Marginal Analysis In Action
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Economics of Effective Management
Incremental Decisions
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Learning Managerial Economics
Learning Managerial Economics
• Learn terminology
– Break down complex issues into manageable
components.
– Helps economics practitioners communicate
efficiently.
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