Managerial Economics Notes: Chapter 1

[Jeevan]

This is the Notes of M.E , provided by Umesh sir for all the 7th semester students of GCES

Why study economics?
a) Growing complexity of business decision making
b) Increasing use of economic, logical concepts, theories
c) The need of professionally trained manpower

- Traditionally Family run business
- Now mergers and takeovers
- National and international competition
- Risk and uncertainty involved
- The family training and experience is not enough
- Complexity of business decision making has inevitable
- Market condition
- Market fundamentals
- Intensive market analysis, product input
- Theory, logic to predict behavior

Economic theories and Analytical tools that are widely applied business decision making crystallized
New branch of management studies- Managerial Economics

WHAT IS MANAGERIAL ECONOMICS?

Economic theories and logic- applied to business decision making
Economics: Social Science. Its basic function to study how people, individual, household, firms, nation maximize their gains from their limited resources and opportunities.
- Optimizing behavior from given resource.
- Household allocate resource to get maximum satisfaction
- Producer- which commodity, location of firm, price of product, Amount of advertisement
- Nation- how to allocate their resources to economic welfare of society can be maximized

Economics is choice making behavior of people in complex situation and in complex affair.
- Tools and techniques(Analytical)
- Economic theories
- Economic laws
- Optimization techniques

Managerial Economics- theories, techniques to apply, analyze problems- evaluate options, reach a decision.

- Application of concept to decision making
- Use theories to attain economic goals
- Analyze problems faced by managers

WHY MANAGERS NEED TO KNOW ECONOMICS?
- Economics contributes managerial duties and responsibilities
- Just like Biology contributes medical contribution
- Managers can work more efficiently
- To achieve objective by limited resource
- Sunshine/ Air/ Water – but limited


HOW DOES ECONOMICS CONTRIBUTE TO MANAGERIAL FUNCTION?
- Managers are practicing economists
- Decisions are taken under the condition of UNCERTAINTY and RISK
- Market forces creates uncertainty and risk
- Changing environment
- Government policies
- Social/ Political changes
- Domestic market
- Emergence of competition

- UNCERTAINTY can be reduced if it can be predicted with reliability
- Appropriate decision making
- Economic theories explain and analyze

Contributions (Baumol)
1. Analytical model helps to concentrate on main issues
2. A set of analytical methods enhance capabilities
3. Clarity of the concepts help to avoid pitfalls.

THE SCOPE OF MANAGERIAL ECONOMICS

1 Microeconomics
2 Macroeconomics

Microeconomics – applied to operational issues
1 Choice of business and nature of product: what to produce?
2 Choice of size of firm: how much to produce?
3 Choice of technology: Choosing the factor combination.
4 Choice of price: how to price a commodity?
5 How to promote sales?
6 How to face price competition?
7 How to decide on new investment?
8 How to manage profit and capital?
9 How to manage inventory?

Micro economics deals with questions
1 Theory of demand
How do consumers decide to buy?
When they stop consuming?
Change in taste
Change in price revenue relation

2 Theory of production and production decision
Relation between input and output
One factor increased and other factors constant
Maximizing output within resources (Capital and labor employment)

3 Analysis of Market structure and pricing theory
How prices are determined in different condition?
Advertising- when to decide?
Optimum size of the firm

4 Profit analysis and profit management
Main objective
Conditions of uncertainty
Competition
Market forces
5 Theory of capital and investment decision
Efficient allocation of resources
Choice of project
Efficiency of capital

MACROECONOMICS APPLIED TO BUSINESS ENVIRONMENT
1. The type of economic system
2. Trend in production, employment, income, price, saving etc.
3. Foreign Trade
4. Government- industrial policy, Fiscal policy, Monetary policy
5. Degree of openness – MNCs
6. Political social environment

Single can’t affect but industry or joint effort or giants can
Environmental Factors- Cigarette factory
Monopoly- Restrictions
State activities and policies- Hitler

MACRO VARIABLES
Forward planning and future strategy- Issue related to
1. Macro variables
- Economic activities to the country
- Investment climate
- Trends in output and employment
- Consumption level

2. Foreign Trade:
- Trade relation with other countries
- Fluctuations
- Exchange rate
- International trend

3. Government policies: Regulatory measures, Laws

Wider understanding of economic behavior.

DIFFERENCE BETWEEN MICRO AND MACRO ECONOMICS

Microeconomics- study of how individual work in economy
Family, club, corporation

Micro- Smaller Social situation
Micro – e.g. Chimney from one factory and effect on nearly area

Macro- Keynes- “The General Theory”- 1930s
- Big ideas of economic system
- Overall Interaction and changes
- Measuring inflation and unemployment are examples
Macro- large social situation (5,00,000 people)
Macro- e.g. Chimneys in country’s affect in population, their health, oxygen, structure of building

Macro- Focus on price level, employment level, economic output, quantity of money in economy, will economy take care itself?

PROFIT MAXIMIZING OBJECTIVE
- Most important for price and production theory
- Conventional theory assumes only objective
- Most reasonable and analytically most productive
- Price and output under different market condition

CONDITIONS
Π = TR-TC

I) Necessary Condition
II) Secondary or supplementary condition

1. Necessary condition
MR= MC

If MR is greater than MC, that means the business could increase total profit by MR-MC by producing an extra unit. It should continue increasing production until MR=MC, which is where total profit maximized.

2. Secondary Condition
- Fulfill decreasing MR and Rising MC
Π = TR-TC
TR = f(Q)
TC= f (Q)
Q= quantity produced and sold

Π = f(Q)TR-f(Q)TC

Now,
1st order condition
dΠ = dTR - dTC = 0
dQ dQ dQ

•dTR - dTC
dQ dQ

• MR = MC

2nd order condition


Fig: Marginal conditions of profit maximization

2nd order derivative condition is negative

d2Π = d2TR - d2TC = 0
dQ2 dQ2 dQ2

Second order requires that,
d2TR - d2TC < 0
dQ2 dQ2

d2TR < d2TC
dQ2 dQ2

slope of MR< slope of MC
- Profit is maximized at both points.

Example:
Profit P= 100 – 2Q
Cost TC= 10+ 0.5Q2

P.Q = TR=(100-2Q)Q
TR = 100Q- 2Q2

First order condition,

MR=MC
dTR = dTC
dQ dQ


Here, MR = dTR = 100- 4Q
dQ
and MC = dTC = Q
dQ
Thus profit maximize, where

MR=MC
100 – 4Q = Q
Q = 20

The output 20 also satisfies 2nd order condition. 2nd order condition requires that

d2TR - d2TC < 0
dQ2 dQ2

dMR – dMC < 0
dQ dQ

d(100-4Q) – d(Q) < 0
dQ dQ

-4-1<0

Thus second order condition is also satisfied at output 20.


CONTROVERSY OVER PROFIT MAXIMIZATION
- Sole objective
- Large function - Sales maximization
• Maximization of managerial utility
• Making target profits
• Retaining market share

Traditionally- Full and complete knowledge
- Demand and cost function in short or long run
- Based on Probability

Finally, Average cost principle
AC= AVC + AFC
+10% margin
Different from marginal pricing
Ever changing condition and extreme changes

DEFENCE OF PROFIT MAXIMIZATION
1. Profit for survival: become large: only feasible goal (survival)
2. Other objective can be achieved: only after profit
3. Evidence against- not conclusive- time honoured
4. Profit maximization objective has greater predicting power
5. Profit- more reliable measures of firms efficiency


MR>MC
MR<MC- profit shrinks
MR=MC- This point maximize profit


Reasons for aiming at Reasonable Profits

1 Preventing entry of competitors
- High profit attracts
- Reasonable profit maintains barrier

2 Projecting a favorable public image
- Bad public opinion
- Government officials eyebrows
3 Restraining trade union demands
- wage hike
- weapons against trade union activities
4 Maintaining customer goodwill
- quality of price with fair price
5 Other Factors
- internal management control by restricting firms size and profit
- manager utility function being preferable to profit maximization for executives


Standards of Reasonable Profits

-What form of standard should be used?
-How should reasonable profits be determined?

1 Forms of profit standard
- Aggregate money term
- Percentage of sales
- Percentage return on investment
- Net profit is more common
- ROI is preferable to discourage competitors

2 Setting profit standard
a) Capital attracting standard- high enough to attract debt and equity
Criteria
- Capital structure – debt, stock, bond, Preference share determines rate of profit
b) ‘Plough-back’ standard
- maintaining liquidity and avoiding debt
- socially not valid- profit should distribute to shareholders
- R/E can be invested in low earning projects by management

c) Normal earning standard: Over a normal period group of firms
- Attracting external capital
- Discouraging growth of competition
- Keeping stockholder satisfied
- Due condition and market condition determine


Profit as control measure:

Measuring and controlling performance of the executives often deviate to their own utility function
- Job security
- Promotion
- Large perks

1 More energy is spent on sales volume and product lines than to raise profitability
2 Subordinate spend too much time and money doing jobs regardless of its cost and usefulness
3 More concerned about job security

- Top management uses decentralization and profit objective techniques
- Division
- Autonomy budget - Profit to be achieved/ not sales or quality
- Useful guide in reorganization of the product lines
- Problems
1 Total net profit for division or share of profit by divisions
2 How should divisional profits be determined when there is long ladder of vertical integration
- Easy to handle

Alternative objectives of Business Firms

- Traditional theory – owner’s and manager’s interest
- Today- owner and manager- separate entities.

Berl- Means- Galbraith
1 Owner controlled firm- higher profit
2 The manager have no incentive for profit maximization
In large firm profit to keep quit the owners and utility function of manager is high


Baumol’s Hypothesis of Sales Revenue Maximization
Maximization of sales revenue- Alternative to profit maximization

In big firms, managers choose to maximize utility function, so try to maximize sales.

Reasons:
1 Salary and earning of managers are more closely related to sales
2 Bank and Financial institution looks at sales rather than profit
3 Trend in sales revenue is performance indicator helps in handling personal problem
4 Sales related to prestige of manager, while profit goes to owners
5 Profit maximization is difficult objective, change as per environment
6 Strength competitive strength

Factual evidences are inconclusive- inadequate data but in long run, both are same- under perfect condition normal profit as sales maximization.




MARRIS’S HYPOTHESIS OF MAXIMIZATION OF FIRM’S GROWTH
Managers maximize firms balanced growth rate, Firms balanced growth rate(G) as:
G= Gd= Gc

Gd- growth rate of demand for firms product
Gc- growth rate of capital supply to the firm

Growth rate is balanced when demand for product and supply for capital of the firm increases at same rate.

Utility Functions
Manager’s Utility (Um)= f(salary, power, job security, prestige, status)
Owner’s Utility (Uo) = f(Output, capital, market- share, profit, public esteem)

Uo= growth of demand of product and growth of capital supply

By maximizing these variables managers maximize both their utility function and that of owners
(Salary, status, power) are closely correlated to profit, capital market share etc.

Growth of these variables depends upon the growth of the firms. So, managers seek steady growth rate

More rigorous than Baumol’s but still weakness
- fails to deal with oligopolistic interdependence
- it ignores price determination- main concern for profit maximization
- does not seriously challenge profit maximization hypothesis


WILLIAMSON’S HYPOTHESIS OF MAXIMIZATION OF MANAGERIAL UTILITY FUNCTION

- Utility maximize subject to minimum profit
- Manager’s utility function (U) is expressed as

U= f(S, M, ID)

Where,
S = additional expenditure on staff
M = Managerial emoluments (remuneration for large earnings)
ID = Discretionary (personal judgments not by rules) investments

Satisfactory profit- minimum profit- manager’s job security is endangered
Utility function includes both quantifiable variable- salary, slack earning, non-quantifiable variables- prestige, power, status, job security

Non quantifiable- derived in terms of satisfaction derived out of certain type of expenditure(such as slack payment), and ready availability of funds for discretionary investment.

Problems:
- Oligopolistic interdependence
- Rivalry between firms is not strong where strong profit maximization is appropriate


CYERT- MARCH HYPOTHESIS OF SATISFICCING BEHAVIOUR
Extension of Simon’s hypothesis of firms’ satisfying behavior

Simon:
- Real business world is full of uncertainty
- Accurate and adequate data are not readily available
- Where available managers have little time and ability to process them
- In such condition- neither profit maximization, not maximize sales, growth or anything else
- They seek satisfactory profit, satisfactory growth etc.
- This behavior is satisfying behavior

Cyert- March:
- Apart from dealing with uncertain business world. Manager’s have to satisfy variety of group.
- Managerial staff
- Labour
- Shareholder
- Customer
- Financiers
- Suppliers
- Accountant
- Lawyers

All have interest in fir even conflicting. Manager’s responsibility is to satisfy them all.
Satisfying behavior means satisfying various interest group by sacrificing firm’s interest or objective.

Underlying assumption:
-Coalition of different groups
- Involve in different activities
- High and low expectation
- Sacrificing firm’s own interest and objective

In order to satisfy managers’ combine the following goals.

a) Production goal
b) Sales and market share goals
c) Inventory goal
d) Profit goal

Based on past experience, and their assessment of future market condition
- modified and revised as per condition

Problems:
1. Though realistic activity, it does not explain firm’s behavior under dynamic condition in the long run.
2. Can not predict future course of activities
3. Does not deal with equilibrium of industry.

ROTHCHILD’S HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKET SHARE GOAL

- Primary goal- Long run survival
- Some other economist – retention of constant market share is additional objective.
- The manager seek market share and long run survival
- The firm maximize profit in long run though not certain.

Entry prevention and risk avoidance:
Prevent Entry:
a) Profit maximization in long run
b) Securing constant market share
c) Avoidance of risk caused by unpredictable behavior of new firms

Evidence is not conclusive, Management is divorced from the ownership is profit maximization is reduced.

Advocates:
Only profit maximization can survive in long run. Firm can survive in long run if maximization of profit.
- Prevention is major objective of pricing policy (Limit pricing) motive of barriers is to secure constant market share. It is compatible with profit maximization.