Minglana, Mitch T.

BSA 201

A REVIEW PAPER ABOUT THE TOPICS IN MANAGERIAL ECONOMICS

Managerial economics is a discipline which deals with the application of economic theory to
business management. It deals with the use of economic concepts and principles of business decision
making. Formerly it was known as “Business Economics” but the term has now been discarded in
favor of Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic and methodology
which are generally applied to seek solution to the practical problems of business. Managerial
Economics is thus constituted of that part of economic knowledge or economic theories which is
used as a tool of analyzing business problems for rational business decisions. Managerial Economics
is often called as Business Economics or Economic for Firms.

The primary function of management executive in a business organization is decision making and

forward planning.

 Decision making and forward planning go hand in hand with each other. Decision making
means the process of selecting one action from two or more alternative courses of action.
Forward planning means establishing plans for the future to carry out the decision so taken.
 The problem of choice arises because resources at the disposal of a business unit (land, labor,
capital, and managerial capacity) are limited and the firm has to make the most profitable use
of these resources.
 The decision making function is that of the business executive, he takes the decision which
will ensure the most efficient means of attaining a desired objective, say profit maximization.
After taking the decision about the particular output, pricing, capital, raw-materials and
power etc., are prepared. Forward planning and decision-making thus go on at the same time.
 A business manager’s task is made difficult by the uncertainty which surrounds business
decision-making. Nobody can predict the future course of business conditions. He prepares
the best possible plans for the future depending on past experience and future outlook and yet
he has to go on revising his plans in the light of new experience to minimize the failure.
 Managers are thus engaged in a continuous process of decision-making through an uncertain
future and the overall problem confronting them is one of adjusting to uncertainty.
 In fulfilling the function of decision-making in an uncertainty framework, economic theory
can be, pressed into service with considerable advantage as it deals with a number of
concepts and principles which can be used to solve or at least throw some light upon the
problems of business management. E.g. are profit, demand, cost, pricing, production,
competition, business cycles, national income etc. The way economic analysis can be used
towards solving business problems, constitutes the subject-matter of Managerial Economics.

Thus, in brief we can say that Managerial Economics is both a science and an art

The scope of managerial economics is not yet clearly laid out because it is a developing science.
Even then the following fields may be said to generally fall under Managerial Economics:

1. Demand Analysis and Forecasting

2. Cost and Production Analysis
3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management

Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc.,
have also come to be regarded as part of Managerial Economics.

1. Demand Analysis and Forecasting: A business firm is an economic organization which

is engaged in transforming productive resources into goods that are to be sold in the
market. A major part of managerial decision making depends on accurate estimates of
demand. A forecast of future sales serves as a guide to management for preparing
production schedules and employing resources. It will help management to maintain or
strengthen its market position and profit base. Demand analysis also identifies a number
of other factors influencing the demand for a product. Demand analysis and forecasting
occupies a strategic place in Managerial Economics.
 2. Cost and production analysis: A firm’s profitability depends much on its cost of
production. A wise manager would prepare cost estimates of a range of output, identify
the factors causing are cause variations in cost estimates and choose the cost-minimizing
output level, taking also into consideration the degree of   uncertainty in production and
cost calculations. Production processes are under the charge of engineers but the business
manager is supposed to carry out the production function analysis in order to avoid
wastage’s of materials and time. Sound pricing practices depend much on cost control.
The main topics discussed under cost and production analysis are: Cost concepts, cost-
output relationships, Economies and Diseconomies of scale and cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of
a business firm largely depends on the correctness of the price decisions taken by it. The
important aspects dealt with this area are: Price determination in various market
forms, pricing methods, differential pricing, product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the
long period, it is profit which provides the chief measure of success of a firm. Economics
tells us that profits are the reward for uncertainty bearing and risk taking. A successful
business manager is one who can form more or less correct estimates of costs and
revenues likely to accrue to the firm at different levels of output. The more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. In fact,
profit-planning and profit measurement constitute the most challenging area of
Managerial Economics.
5. Capital management: The problems relating to firm’s capital investments are perhaps
the most complex and troublesome. Capital management implies planning and control of
capital expenditure because it involves a large sum and moreover the problems in
disposing the capital assets off are so complex that they require considerable time and
labour. The main topics dealt with under capital management are cost of capital, rate of
return and selection of projects.

What is Supply
Supply is a fundamental economic concept that describes the total amount of a specific good or
service that is available to consumers. Supply can relate to the amount available at a specific price
or the amount available across a range of prices if displayed on a graph. This relates closely to
the demand for a good or service at a specific price; all else being equal, the supply provided by
producers will rise if the price rises because all firms look to maximize profits.

Demand

is the quantity of good and services that customers are willing and able to purchase during a
specified period under a given set of economic conditions. The period here could be an hour, a
day, a month, or a year. The conditions to be considered include the price of good, consumer’s
income, the price of the related goods, consumer’s preferences, advertising expenditures and so
on. The amount of the product that the customers are willing to buy, or the demand, depends on
these factors. There are two types of demand. The first of these is called direct demand. This
model of demand analysis individual demand for goods and services that directly satisfy
consumers desires. The prime determinant of direct demand is the utility gained by consumption
of goods and services. Consumers budget, product characteristics, individuals preferences are all
important determinants of direct demand. The other type of demand is called derived demand.
Derived demand is the demand resulting from the need to provide the final goods and services to
the consumers. Intermediate goods, office machines are examples of derived demand. An other
good example is mortgage credit. Mortgage credit demand is not demanded directly, but derived
from the demand for housing.

Market demand function The market demand function for a product is a function showing the
relation between the quantity demanded and the factors affecting the quantity of demand. A
demand function for the good X can be expressed as follows: Quantity of product X demanded =
Qx = f (the price of X, prices of related goods, expectations of price changes, income,
preferences, advertising expenditures and so on. ) For use in managerial decision making, the
relation between quantity of demand and each demand determining variable must be specified.

Demand Curve The demand function specifies the relation between the quantity demanded and
all factors that determine demand. But the demand curve expresses the relation between the price
of a product and the quantity demanded, holding constant all the other factors affecting demand.
Understanding the Law of Supply and Demand

The law of supply and demand, one of the most basic economic laws, ties into almost all
economic principles in some way. In practice, supply and demand pull against each other until
the market finds an equilibrium price. However, multiple factors can affect both supply and
demand, causing them to increase or decrease in various ways. It was extensively studied
by Murray N. Rothbard.

Law of Demand vs. Law of Supply

The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher price is less because as the
price of a good goes up, so does the opportunity cost of buying that good. As a result, people will
naturally avoid buying a product that will force them to forgo the consumption of something else
they value more. The chart below shows that the curve is a downward slope.

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope. This
means that the higher the price, the higher the quantity supplied. Producers supply more at a
higher price because selling a higher quantity at a higher price increases revenue.

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in
demand or price. So it is important to try and determine whether a price change that is caused by
demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas year-
round, the change in demand and price will be expected to be long term; suppliers will have to
change their equipment and production facilities in order to meet the long-term levels of demand.
Market

A market is the area where buyers and sellers contact each other and exchange goods and services.
Market structure is said to be the characteristics of the market. Market structures are basically the
number of firms in the market that produce identical goods and services. Market structure influences
the behavior of firms to a great extent. The market structure affects the supply of different
commodities in the market.

When the competition is high there is a high supply of commodity as different companies try to
dominate the markets and it also creates barriers to entry for the companies that intend to join that
market. A monopoly market has the biggest level of barriers to entry while the perfectly competitive
market has zero percent level of barriers to entry. Firms are more efficient in a competitive market
than in a monopoly structure.

Perfect Competition

Perfect competition is a situation prevailing in a market in which buyers and sellers are so numerous
and well informed that all elements of monopoly are absent and the market price of a commodity is
beyond the control of individual buyers and sellers

With many firms and a homogeneous product under perfect competition no individual firm is in a
position to influence the price of the product that means price elasticity of demand for a single firm
will be infinite.

Pricing Decisions

Determinants of Price Under Perfect Competition

Market price is determined by the equilibrium between demand and supply in a market period or
very short run. The market period is a period in which the maximum that can be supplied is limited
by the existing stock. The market period is so short that more cannot be produced in response to
increased demand. The firms can sell only what they have already produced. This market period
may be an hour, a day or a few days or even a few weeks depending upon the nature of the product.

Market Price of a Perishable Commodity

In the case of perishable commodity like fish, the supply is limited by the available quantity on that
day. It cannot be stored for the next market period and therefore the whole of it must be sold away
on the same day whatever the price may be.

Market Price of Non-Perishable and Reproducible Goods

In case of non-perishable but reproducible goods, some of the goods can be preserved or kept back
from the market and carried over to the next market period. There will then be two critical price
levels.

The first, if price is very high the seller will be prepared to sell the whole stock. The second level is
set by a low price at which the seller would not sell any amount in the present market period, but
will hold back the whole stock for some better time. The price below which the seller will refuse to
sell is called the Reserve Price.

Technology summarizes the feasible means of converting raw inputs into an output. Most production
processes involve capital (machinery) and labor (people).

Increasing marginal returns – Range of input usage over which marginal product increases. E.g. in
the first hours you study for an exam you can concentrate very well and you increase your
knowledge rapidly.

Decreasing (diminishing) marginal returns – Range of input usage over which marginal product
declines. E.g. the longer you study the less you remember but still you gain more knowledge. You
increase total knowledge, but at a decreasing rate. Marginal product declines but it is still positive.

Negative marginal returns – Range of input usage over which marginal product is negative. E.g. if
you study too long you get tired and too much information is in your head in too little time. You get
confused and reduce the total knowledge.
 Phases of Marginal Returns – When there is an increase in the use of input, Marginal product
changes from increasing to decreasing and further to negative.

The manager’s role in the production process:

1. Produce on the production function

It describes the maximum possible output that can be produced with given inputs. In case of labor,
the manager has to think of an incentive system to ensure that employees are working at full
potential.

2. Use the Right level of inputs

The manager has to determine how many units of input are needed to maximize total output. When a
manager decides on how many employees that his/her firm needs to employ, he/she has to consider
marginal returns. The value marginal product describes the value of the output produced by the last
unit of an input.

Profit-Maximizing Input Usage – To maximize profits, a manager should use inputs at levels at
which the marginal benefit equals the marginal cost. More specifically, when the cost of each
additional unit of labor is w, the manager should continue to employ labor up to the point where in
the range of the diminishing marginal product. E.g. it is profitable to hire additional units of labor as
long as his/her contribution (value marginal product) is greater than his/her hiring costs.

Algebraic Forms of Production Functions

Optimal Input Substitution – To minimize the cost of producing a given level of output, the firm
should use less of an input and more of other inputs when that input’s price rises.
For given input prices, different isoquants will entail different production costs, even allowing for
optimal substitution between capital and labor. The higher isoquants will imply higher costs of
production, even assuming the firm uses the cost-minimizing input mix.

The Cost Function

Fixed costs (FC) – Costs that do not change with changes in output; include the costs of fixed inputs
used in production.

Variable costs (VC) – Costs that change with changes in output; include the costs of inputs that vary
with output.

Short-run cost function – A function that defines the minimum possible cost of producing each
level of output when variable factors are employed in the cost-minimizing fashion. Mathematically it
is the sum of fixed and variable costs. TC = FC+VC

Average fixed cost (AFC) – Fixed costs divided by the number of units of output. Average fixed
cost decrease as output increases.

Long-run average cost curve (LRAC) – A curve that defines the minimum average cost of
producing alternative levels of output, allowing for optimal selection of both fixed and variable
factors of production. The long-run average cost curve lies below every point on the short-run
average cost curves.

 
Economies of scale – Exist whenever long-run average costs decline as output is increased.
Diagrammatically, it is in the section of LRAC with negative slope.

Diseconomies of scale – After a certain point, the optimal production quantity Q*, further increases
in output lead to an increase in average costs. Long run average costs rise as output is increased.
Diagrammatically, it is in the section of LRAC with positive slope

Constant returns to scale – Exist when long-run average costs remain constant as output is
increased. A firm produces at different levels of output at the same minimum average cost.

Accounting costs – Costs that appear on the income statements of firms.

Economic costs – The costs perceived of producing a certain product, while the opportunity to
produce another product is forgone.

Multi-product cost function – A function that defines the cost of producing given levels of two
or more types of outputs assuming all inputs are used efficiently

Successful management brings about competitors.

Limit pricing to prevent entry
Manager may consider strategy such as limit pricing to prevent entry.
Limit Pricing – Strategy where an incumbent maintains a price below the monopoly in order to
prevent entry.
Theoretical basis for limit pricing: by limiting the price in level that is below the monopoly price,
the incumbent firm can force the potential entrance to get only the residual demand. In the event
where this residual demand is less than the average cost, the potential entrance will stay away from
the market.
Due to this reason, it is better if the incumbent can threaten to limit price without really do so. The
profit it gets will be monopoly profit and no companies will try to enter if they believe the threat.
Effective limit pricing: for limit pricing to effectively prevent entry by rational competitors, the pre-
entry price must be linked to the post-entry profits of potential entrants.
Linking the pre-entry price to post-entry profits > some conditions need to be meet to ensure that
deterring entry is actually the best strategy.
Commitment Mechanisms - the incumbent can commit to produce at least the post-entry output.
This way the incumbent will actually earn more profit since if it does not commit and let the
competitor to enter, the profit will be divided among the firms in the market.
Learning curve effects - when a firm enjoys lower costs due to knowledge gained from its past
production decisions. Having learning better method of production, the incumbent can lower its
cost and then limits the price of the goods or services.
Incomplete information - due to lack of complete information, the incumbent can purposefully limit
price to make the potential entrants to reconsider their plan to enter the market.
Reputation effects - if the incumbent has the reputation on being tough, it may prevent entry
 
Dynamic consideration
If the firm manage to maintain its monopoly, then the profit will be π = [(1+i)/i] πm
If entry occurs, then the profit will be π = πm + πd/i
If the incumbent uses limit pricing, the profit will be π = [(1+i)/i] πl
Limit pricing is profitable if
 
Predatory Pricing to Lessen Competition
Predatory pricing  – strategy where a firm temporarily prices below its marginal costs to drive
competitors out of the market.
It arises when a firm charges price below its marginal cost. In order to engage in predatory pricing,
the ‘predator’ needs to be healthier than the ‘prey’.
Some counter strategies:
1. Since the predator is selling the product below cost, the prey might stop production or
2. Purchase the product from the predator and stockpile them.
Predatory pricing cannot be used if the prey is of similar size and situations
Predatory pricing can also be used to enter the market, by giving the product for free.
 
Raising Rivals’ Costs to Lessen Competition
Raising Rivals’ Costs – strategy in which a firm gains advantage over competitors by increasing
their costs.
Strategies involving MC - by raising its rival’s MC, one firm shifts its rival’s reaction function
down. The result is that the firm will have more market share and higher profit.
Strategies involving fixed costs - if the incumbent raises the fixed cost by asking for government to
regulate the market, then it makes potential entrants to recalculate the profitability of entering the
market.
Strategies for vertically integrated firms
Vertical foreclosure – strategy wherein a vertically integrated firm charges downstream rivals a
prohibitive price for an essential input, thus forcing rival to use more costly substitutes or go out of
business.
Price-cost squeeze – Tactic used by a vertically integrated firm to squeeze the margins of its
competitors.
 
Price Discrimination as a Strategic Tool
The profitability of such measures mention above will increase if the firm can actually price
discriminate by charging different customers different prices and also for the vertically integrated
firm, it can charge different downstream rival differently.
 
Changing the Timing of Decisions or the Order of Moves
First mover advantages - it permits a firm to earn higher profit by committing itself before other
firms. This is partly due to learning effect that reduces cost.
Second mover advantages - sometimes it is more beneficial to be the second mover as firm can
learn from the mistakes of the first mover, hence producing better product at lower cost.