Managerial Economics for Non-Major Chapter 1 PDF

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Polytechnic University of the PhilippinesCollege of Social Sciences and Development Department of EconomicsMANAGERIAL ECONOMICSPrepared byMelcah Pascua Monsura Russel R. Penamante Celso G. Tan Jr.Table of ContentsChapter 1 THE NATURE, SCOPE, AND PRACTICE OF MANAGERIAL ECONOMICS - Overview .............

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Polytechnic University of the Philippines College of Social Sciences and Development Department of Economics

MANAGERIAL ECONOMICS

Prepared by Melcah Pascua Monsura Russel R. Penamante Celso G. Tan Jr.

Table of Contents Overview…………………………………………………………………………………….……..…..…4 Chapter 1

THE NATURE, SCOPE, AND PRACTICE OF MANAGERIAL ECONOMICS 1.1 Definition of Managerial Economics and its Nature…………………...…………………………………..………………..……...5 1.2 Why Managerial Economics is Relevant for Managers………………..………………....6 1.3 Managerial Economics is Applicable to Different Types of Organizations…………......6 1.4 Social Responsibility of Business…………………………………………………..….…...7 1.5 Social Responsibility of Business and Social Contract………………………..………….7 Assessment 1…………………………………………………………………..……..…....….10

Chapter 2 ECONOMIC DECISION MAKING 2.1 Public Decisions: Economic View...……………………………………………..………..13 2.2 Decision within Firms: Profit-Maximization…..……………..…………………………....14 2.3 Optimal Decision using Marginal Analysis………………………..………………..…….15 Assessment 2…………………………………………………..………………..……..…...…17 Chapter 3 DEMAND ANALYSIS: Estimation and Forecasting 3.1 Demand Analysis………...………………………………………………………..……….18 A. Demand Schedule…………………………………………………………..…..….18 B. Demand Curve………………………………………………………..………….…19 C. Demand Function……………………………………………….…………….........20 3.2 Price Elasticity of Demand………………………………………..…………………….…21 3.2.1 Price Elasticity of Demand and Total Revenue Relationship………………..23 3.2.2 Cross Elasticity of Demand………………………………………..……………25 3.2.3 Income Elasticity of Demand…………………………………………..……….25 3.2.4 Price Elasticity and Prediction………………………………………..………...26 3.3 Demand Analysis and Optimal Pricing…...………………………………..…………..…27 3.3.1 Price Elasticity, Revenue, and Marginal Revenue………………….…..........28 3.3.2 Optimal Markup Pricing……………………………..…………………….........29 3.3.3 Price Discrimination……………………………………..……………………....31 3.4 Estimating Demand………..……………………………………………..........................33 3.4.1 Collecting Data……………………………………………………..……………34 3.5 Regression Analysis………………………………………………………….…………….36 3.5.1 Simple Regression……………………………………………………..……..…36 3.5.2 Multiple Regression………………………………………………..………..…..38 Assessment 3…………………………………………………………..……………………...43 Chapter 4 FORECASTING DEMAND 4.1 Qualitative Forecasting Technique………………..………………………..………........46 4.2 Quantitative Forecasting Technique…………………………………………..………….47 4.2.1 Time-Series Models………………………………………..……………………47 4.2.2 Smoothing Technique…………………………………..……………………....48 4.3 Quantitative Forecasting Technique using Econometric Models……………..……..…49 Assessment 4…………………………………..……………………………………………...53 Chapter 5 THE THEORY OF PRODUCTION AND COST 5.1 Production Function…………………………………………………………..……………55 5.2 Returns of Scale………………………………………………………………….………...56 2

5.3 Production Periods…………………………………………………..……………..………56 5.3.1 Short-run Production Relationships………………………………..…….……56 5.4 Three Stages of Production……………………………….……………………………....59 5.5 Costs of Production……………………………………………………..………………….59 5.5.1 Economic Costs…………….…………………………………………………...60 5.5.2 Explicit and Implicit Costs…………………………………..……....................60 5.6 Short Run Production Costs…..………………………………..………………………....60 5.7 Marginal Decisions…….……………………………………………..…………………….63 5.8 Long-Run Production Costs…………………………………………..............................64 5.9 Production and Costs in the Long Run………………………………………..……….…66 Assessment 5………………………………………………………………..………………...70 Chapter 6 OPTIMAL OUTPUT DECISIONS AND PRICING STRATEGIES 6.1 Pure Competition…………………………………………………………………..……….72 a. Demand as Seen by a Purely Competitive Seller…………………………..........72 b. Profit Maximization in the Short Run…………………………………..……..……72 c. Loss Minimizing Case……………………………………………….…………..….75 d. Shutdown Case………………………………………………………………..........76 6.2 Pure Monopoly……………………………………………………..……………………....77 a. Monopoly Demand………………………………………………………..………...77 b. The Monopolist is a Price Maker…………………………………………..……….78 c. Profit Maximizing Position of Pure Monopolist…………………..……………..…79 d. Possibility of Losses by Monopolist………………………..……………………....79 6.3 Monopolistic Competition…………………………………..…….……………………..…80 a. A Firm’s Demand Curve……………………………………………..……………..81 b. Profit Maximization in the Short-Run………………………………….……..........81 6.4 Oligopoly………………………………………..…………………………………………...83 a. Oligopoly Behavior: Game Theory……………………………………..………….83 b. Three Oligopoly Models………………………………………………..…………...85 Assessment 6…………………………………………………………………..…………..….87 Chapter 7 ECONOMIC RISK AND UNCERTAINTY 7.1 Risk versus Uncertainty………………………………………………………..…………..88 7.2 Key Difference Between Risk and Uncertainty…………………………..……………....89 7.3 Application of the Concept of Risk and Uncertainty……………………..……………....89 7.4 Five Sources of Business Risk………………………………….…………………………90 7.5 Risk and Return………………………………………………..…………………………...90 Chapter 8 Capital Budgeting 8.1 Definition of Capital Budgeting…………………………………………….………………91 8.2 Characteristics of Capital Investment Decisions……………………………..……....…91 8.3 Capital Budgeting Process………………………………………………..……………….91 8.4 Types of Capital Investment Projects………………………………..…………………...93 8.5 Capital Budgeting Techniques………………………………………..…………………..95 8.5.1 Present Value and Net Present Value Method……………………..………..96 8.5.2 Payback Period Method………………………..…………………………........97 8.5.3 Discounted Payback Period Method……………………..…………………....98 8.5.4 Profitability Index………………………………………..……………………....98 8.5.5 Internal Rate of Return (IRR) Method…………………………………..……...98 8.6 Importance and Significance of Capital Budgeting……………………………….……..99 Assessment 7………………………………………………………………………..……….100 3

Overview Managerial Economics is the analysis of major management decisions using the tools of economics. Managerial economics applies many familiar concepts from economics—demand and cost, marginal analysis, monopoly and competition, the allocation of resources, and economic trade-offs—to aid managers in making better decisions. This module provides the framework and the economic tools needed to fulfill this goal. Furthermore, the discussions in this module illustrate the central decision problems faced by the managers and to provide the economic analysis they need to guide their decisions. The first three chapters will discuss the introduction of Managerial Economics and how managers of the firms decide based on estimating and forecasting demand using regression analysis. Forecasting demand through trends, business cycles, seasonal variations, and random fluctuations will also discuss. These are crucial for economic decision making of managers. The optimal decision of the managers will be based on demand estimation and marginal analysis. The next three chapters, Chapter 3 to Chapter 6, will discuss how the managers analyze the production and cost of production of the firms. In addition, the optimal output and pricing strategies to realize maximum profit will discuss using the four market structures. Each market type has its own characteristics, demand, and pricing strategies which will be discussed in Chapter 6. The remaining chapters include the concepts of risks, uncertainties, and capital budgeting. Since every firm faces risks and uncertainties in their operations and productions, it is crucial to understand the firm’s reactions and decisions in these situations. Moreover, capital budgeting will also consider in identifying good investment for the firm’s possible expansion and continuous operation.

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CHAPTER 11 THE NATURE, SCOPE AND PRACTICE OF MANAGERIAL ECONOMICS Learning Objectives: This chapter provides introduction of managerial economics and on how the economic concepts, theories, and methodologies help managers to improve their decision-making. This part also stresses the importance of managerial economics to the firms. At the end of this chapter, the readers will be able to define managerial economics, establish the relation of managerial economics to other branches of learning, and demonstrate the use of managerial economics in the real-world managerial decision making. 1.1 Definition of Managerial Economics and its Nature One standard definition for economics is the study of the production, distribution, and consumption of goods and services. Secondly, it the study of choice related to the allocation of scarce resources. The first definition indicates that economics includes any business, nonprofit organization, or administrative unit. The second definition establishes that economics is at the core of what managers of these organizations do. We use economics to examine how managers can design organizations that motivate individuals to make choices that will increase a firm’s value. This module discusses the economic concepts and principles from the perspective of “managerial economics,” which is a subfield of economics that places special emphasis on the choice aspect in the second definition. Managerial economics is a branch of economics that applies microeconomic concepts, methods, and analysis to examine how an organization or business can achieve its aims and objectives most efficiently through decision-making. Thus, the purpose of managerial economics is to provide economic method and scientific reasoning to solve managerial decision problems. These economic theories and methods involved with two different conceptual approaches to the study of economics such as microeconomics and macroeconomics. Microeconomics studies phenomena related to goods and services from the perspective of individual decision-making entities—that is, households and businesses. Macroeconomics approaches the same phenomena at an aggregate level, for example, the total consumption and production of a region. Microeconomics and macroeconomics each have their merits. The microeconomic approach is essential for understanding the behavior of atomic entities in an economy. However, understanding the systematic interaction of the many households and businesses would be too complex to derive from descriptions of the individual units. The macroeconomic approach provides measures and theories to understand the overall systematic behavior of an economy. Since the purpose of managerial economics is to apply economics for the improvement of managerial decisions in an organization, most of the subject material in managerial economics has a microeconomic focus. However, since managers must consider the state of their environment in making decisions and the environment includes the overall economy, an understanding of how to interpret and forecast macroeconomic measures is useful in making managerial decisions. Specifically, managerial economics deals with microeconomic reasoning on real-world problems such as pricing and production decisions in selecting best strategy in difference competitive environments. These business decisions can be analyzed through: 1

Most of the discussions were derived from Principles of Managerial Economics available at Creative CommonsNonCommercial-ShareAlike 4.0 International License (http://creativecommons.org/licenses/by-nc-sa/4.0/).

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1. Risk Analysis – Various uncertainty models, decision rules and risk quantification techniques are used to assess the riskiness of a decision. 2. Production Analysis – Microeconomic techniques are used to analyze production efficiency, optimum resource allocation, costs, economies of scale, and to estimate the firm’s costs of production. 3. Pricing Analysis – Microeconomic techniques are used to examine various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and optimal pricing method. 4. Budgeting – Investment theory is used to examine a firm’s capital purchasing decisions. 1.2 Why Managerial Economics Is Relevant for Managers In a civilized society, we rely on others in the society to produce and distribute nearly all the goods and services we need. However, the sources of those goods and services are usually not other individuals but organizations created for the explicit purpose of producing and distributing goods and services. Nearly every organization in our society—whether it is a business, nonprofit entity, or governmental unit—can be viewed as providing a set of goods, services, or both. The responsibility for overseeing and making decisions for these organizations is the role of executives and managers. Most readers will readily acknowledge that the subject matter of economics applies to their organizations and to their roles as managers. However, some readers may question whether their own understanding of economics is essential, just as they may recognize that physical sciences like chemistry and physics are at work in their lives but have determined they can function successfully without a deep understanding of those subjects. Whether or not the readers are skeptical about the need to study and understand economics per se, most will recognize the value of studying applied business disciplines like marketing, production/operations management, finance, and business strategy. These subjects form the core of the curriculum for most academic business and management programs, and most managers can readily describe their role in their organization in terms of one or more of these applied subjects. A careful examination of the literature for any of these subjects will reveal that economics provides key terminology and a theoretical foundation. Although we can apply techniques from marketing, production/operations management, and finance without understanding the underlying economics, anyone who wants to understand the why and how behind the technique needs to appreciate the economic rationale for the technique. We live in a world with scarce resources, which is why economics is a practical science. We cannot have everything we want. Further, others want the same scarce resources we want. Organizations that provide goods and services will survive and thrive only if they meet the needs for which they were created and do so effectively. Since the organization’s customers also have limited resources, they will not allocate their scarce resources to acquire something of little or no value. And even if the goods or services are of value, when another organization can meet the same need with a more favorable exchange for the customer, the customer will shift to the other supplier. Put another way, the organization must create value for their customers, which is the difference between what they acquire and what they produce. Thus, those managers who understand economics have a competitive advantage in creating value. 1.3 Managerial Economics Is Applicable to Different Types of Organizations The organization providing goods and services will often be called a “business” or a “firm,” terms that connote a for-profit organization. And in some portions in the following discussions, we discuss principles that presume the underlying goal of the organization is to create profit. However, managerial economics is relevant to nonprofit organizations and government agencies 6

as well as conventional, for-profit businesses. Although the underlying objective may change based on the type of organization, all these organizational types exist for the purpose of creating goods or services for persons or other organizations. Managerial economics also addresses another class of manager: the regulator. The economic exchanges that result from organizations and persons trying to achieve their individual objectives may not result in the best overall pattern of exchange unless there is some regulatory guidance. Economics provides a framework for analyzing regulation, both the effect on decision making by the regulated entities and the policy decisions of the regulator. 1.4 Social Responsibility of Business In modern capitalist economies, business firms contribute significantly to economic welfare. Within free markets, firms compete to supply the goods and services that consumers demand. Pursuing the profit motive, they constantly strive to produce goods of higher quality at lower costs. By investing in research and development and pursuing technological innovation, they endeavor to create new and improved goods and services. In most cases, the economic actions of firms (spurred by the profit motive) promote social welfare as well: business production contributes to economic growth, provides widespread employment, and raises standards of living. The objective of value maximization implies that management’s primary responsibility is to the firm’s shareholders. But the firm has other stakeholders as well: its customers, its workers, even the local community to which it might pay taxes. This observation raises an important question: To what extent might management decisions be influenced by the likely effects of its actions on these parties? For instance, suppose management believes that downsizing its workforce is necessary to increase profitability. Should it uncompromisingly pursue maximum profits even if this significantly increases unemployment? Alternatively, suppose that because of weakened international competition, the firm has the opportunity to profit by significantly raising prices. Should it do so? Finally, suppose that the firm could dramatically cut its production costs with the side effect of generating a modest amount of pollution. Should it ignore such adverse environmental side effects? All these examples suggest potential trade-offs between value maximization and other possible objectives and social values. Although the customary goal of management is value maximization, there are circumstances in which business leaders choose to pursue other objectives at the expense of some foregone profits. For instance, management might decide that retaining 100 jobs at a regional factory is worth a modest reduction in profit. Value maximization is not the only model of managerial behavior. Nonetheless, the available evidence suggests that it offers the best description of a private firm’s ultimate objectives and actions. 1.5 Social Responsibility of Business and Social Contract 2 It is evident from above, the social responsibility of business implies that a corporate enterprise has to serve interests other than that of common shareholders who, of course, expect that their rate of return, value or wealth should be maximized. But in today’s world the interest of other stakeholders, community and environment must be protected and promoted. Social responsibility of business enterprises to the various stakeholders and society in general is the result of a Social Responsibility of Business Enterprises towards Stakeholders and Society in General contract as shown in the figure below.

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https://www.economicsdiscussion.net/business/social-responsibility/social-responsibility-of-business/10141

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Environment Employees Business Enterprise

Shareholders

Figure: Responsibilities of Business Enterprises towards Stakeholders to Society in General

Consumers Society

Social contract is a set of rules that defines the agreed interrelationship between various elements of a society. The social contract often involves a quid pro quo (i.e. something given in exchange for another). In the social contract, one party to the contract gives something and expects a certain thing or behavior pattern from the other. In the present context the social contract is concerned with the relationship of a business enterprise with various stakeholders such as shareholders, employees, consumers, government, and society in general. The business enterprises happen to have resources because society consisting of various stakeholders has given them this right and therefore it expects from them to use them to for serving the interests of all of them. Though all stakeholders including the society in general are affected by the business activities of a corporate enterprise, managers may not acknowledge responsibility to them. Social responsibility of business implies that corporate managers must promote the interests of all stakeholders not merely of shareholders who happen to be the so-called owners of the business ente...