Week 1 Introduction to managerial economics PDF

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Week 1 Introduction to managerial economics tutorial questions...

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6/9/21

ECF2731/ECF5927 Managerial Economics Week 1, Semester 2, 2021 Dr. Wenli Cheng

Monash University CRICOS Provider Number: 00008C

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Introduction to managerial economics § What is managerial economics? § How does it help managers making decisions? § What is the primary goal of a firm? § What determines the value of a firm? § What is the role of business in society?

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“Where” is managerial economics in the curriculum?

Principles of microeconomics Managerial economics

Microeconoimcs

...... Economics Principles of macroeconomics

Macroeconmoics

Macroeconomic policy

......

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What is economics? § Economics is “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” -- Lionel Robbins (1932), An Essay on the Nature and Significance of Economic Science

§ It is a theory of decisions ... – how to make the most out of limited resources.

§ ... with given means and ends. – It can, in principle, be solved mathematically.

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What is economics? A different perspective § Ludwig von Mises – Economics is a general theory of human action – Action is purposeful behaviour – ends and means. – People cannot have everything they desire (scarcity), so they need to make choices (economise) – know what they want (ends), identify what they believe the available means are, and figure out how to achieve for the relevant ends. Economics is a theory of action under uncertainty. It has an entrepreneurial element and cannot be solved mathematically.

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What is managerial economics? § Managerial economics – studies how to manage scarce resources from the perspective of the firm § effective: do the right thing § efficient: do the thing right

– helps you make better management decisions

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Managerial economics is a problem-solving tool

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Two types of decisions • Participation (inframarginal decision): What? – Make or buy? • Total benefit vs. total cost

• Extent (marginal decision): How much? – How much to produce? How much to buy? • Marginal benefit vs marginal cost

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Decision-making process • Problem formulation – State the problem – Construct a model: abstract representation of the problem • Assumptions, variables and their relationships – controllable vs. uncontrollable variables – Input data • Relevant, accurate – “Garbage in garbage out”

• Solution – Find a solution – Test the solution, and modify the model if necessary.

• Interpretation – What does the solution imply? – Sensitivity analysis – Implementation

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How to “model” a business enterprise? § A firm as a set of contractual relationships connecting stakeholders

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What constraints do firms face? § Resource constraints – – – – –

Labour Space Raw materials Energy Capital goods...

§ Social constraints – – – –

Laws Regulations Standards Norms

§ Self-imposed constraints

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What is a firm’s primary goal? § A firm’s primary goal (in our model) is to – maximise long-term expected value... – ...which equals the present value of its expected future profits

Why present value? – $1 today ≠ $1 tomorrow – To compare today’s dollars and tomorrow’s dollars, we need to apply discounting: converting tomorrow’s dollars into today’s dollar

Value of the firm = ∑$!"#

%&! '%(! (#*+)!

where r is the discount rate

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Business profit vs. economic profit § Business (accounting) profit = revenue – explicit accounting costs § Economic profit = business profit – implicit costs – Implicit costs include: cost of owner’s capital and other owner provided inputs

Revenue

Economist view of profit

Business (accountant view of profit)

Economic profit

Business profit

Implicit Cost

Revenue Explicit Cost

Explicit Cost

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Quiz: Business profit vs. economic profit Stephanie invests $500,000 of her savings in her cafe. If she put the money in a bank, she would earn a 2% interest per year. § What is the implicit cost of capital? § Suppose the cafe’s total revenue is $50,000 and total other cost is $40,000. How much is its business profit? How much is its economic profit?

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What is the social function of profit and loss? § The prospect of earning above normal rate of return (i.e., positive economic profit) provides incentives for excellence and innovation. – Normal rate of return on capital § Is the minimum return necessary to attract and retain investment. § Is considered by economists as part of the cost of doing business

§ The profit and loss mechanism promotes the efficient allocation of resources – Economic profits encourages entry and expansion, attracting more resources. – Economic losses encourages exit and downsizing, releasing resources.

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Do managers optimise or satisfice? § Optimise: seek the best solution § Satisfice: seek a satisfactory solution § Q: Is it reasonable to assume profit maximising in our model? § Response: – Competition forces optimisation – Apparent satisficing behaviour may be in fact by optimising when complex factors (e.g., information, uncertainty) are taken into account. What do YOU think?

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Role of Business in Society § Firms create value • Value added = buyer benefit – seller cost • Valued added is shared: § Value added = buyer surplus + seller surplus

• e.g., Computers § Demand/Buyers: all of us v pay a price, get benefit v surplus = benefit - price § Supply/Sellers: Dell, HP v incur a cost to produce, receive revenue v profit = revenue - cost § Value added = ?

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References Hirshey, M., Bentzen, E., & Scheibye, C. (2019). Managerial Economics, 15th Edition, Cengage. Chapter 1. Png, Ivan (2016). Managerial Economics, 5e, Routledge. Chapter 1. von Mises, Ludwig (1949). Human Action. https://mises.org/library/humanaction-0

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