Managerial Economics Sees1

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Introduction

Economics

Macro Economics Micro Economics

The study of the economicsystem as a whole

The study of the behaviour ofthe individual/s and firm/s and

their interaction in the market.

Applied micro economic isManagerial Economics.


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Managerial Economics

Focuses on the topics like:- Demand, production, cost, pricing,

market structure and govt. regulation etc.

The better understanding of the economic behaviour of the firms and

individuals results in better managerial talent, decisions, higher

profits, allocation efficiency and an increase in the value of the firm

etc.

Development of Managerial Economic skill attributed to the

followings

1. Circular flow of Economic Activities.

2. Nature and Objective of the Firm

3.Importance of Profit: Accounting & Economic Profit

4. Principal-Agent Problems

5. role of Economics in Decision Making


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1. Circular flow of Economic Activities.

Interrelationship among consumers, firms and resource ownersin a market economy-

Circular flow of income, output, resources and factorpayment-

Interdependent relationship between product and factormarkets.


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Product MarketGoods & services

Household

Economic

Resources

Income

Goods & services

Firms

Factor Market Factor payments

Economic

Resources

Fig. Circular flow of income, output, resources & factor payment.


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2. Nature and objective of the Firm

The very nature of the firm is to organize the factors of production

to produce goods and services that will meet the demands of

individual consumers and other firms in such a way that profit can beearned. Thus, the concept of firm and the theory of firms plays

central role in Managerial Economics.

Rationale for the firm

1. Dichotomy:- Dichotomy in organizing production in a market

economy i.e. Absence of external (govt./other) central control/direction but existence of internal control and direction (performed

by managers).

In a free market economy, the organization and interaction ofproducers (i.e. firms) and customers is accomplished through theprice system. But due to the dichotomous relation as mentioned

above, the price system guides the decentralized interaction among

consumers and firms, whereas central planning and control tend toguide the interaction within the firms.


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This raises the question, why is the production system not guided by

price signals ? That is, why do firms exist in a market economy?

Essentially firms exist as organisations because the total cost of

producing any rate of output is lower than if the firm did not exist.

There are several reasons why these cost are low as follows :-

1- saving of transaction cost (associated with obtaining information,

negotiation and contracts. )

2- Saving cost (transaction cost while transacting among firms) by

internalising certain things in production process.

Given that production cost are reduced by organising production factors

into firms, why wouldnt the process continue until there is just onelarge firm, such a giant that produces all goods and services for the

entire economy? There are at least two reasons.


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1- Higher Transaction cost

The larger the size of firm the Higher the transaction cost.

2- Limited managerial ability :-

The larger the size of firm the limited the managerial ability. Thus it

leads to allocative inefficiency & hence production costs per unit of

output will tend to rise as firm goes larger. This can be termed as

diminishing returns to management.

To overcome this problems many large firms are organised in to groups

of divisions (i.e. decentralised by establishing a number of separate

divisions) referred to as profit centers that act as individual firms. The

management of each of these seeks to maximise divisions profit.

The objective of the firm

to maximise the present value of all future profits, subject to various

constraints like moral, contractual, financial and technological

constraints etc..


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Traditionally, economists have assumed that the objective at the firm is

to maximise profit. But profit in which period? This year? The next five

year? Often, managers are observed making decisions that reduce current

year profits in an effort to increase profits in future years. Expenditure

for R&d, New capital equipment, and major marketing programmes are afew examples of activities that reduce profits initially but will

significantly increase profits in later years.

As both current and future profits are important it is assumed that the

goal is to maximise the present or discounted value of all future profits.

Symbolically.

Maximise PV ( ) = 1 + 2 + -------- + n

1+r (1+r)2 (1+r)n

Where, PV= present value, -profit, r = discount rate, t = time period or

max. PV ( ) = n t

i = 1(1 + r)t


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Example : An Annuity of three, Rs. 100- payments at the end of each of

the next three years at 10% interest rate. PV = 100 [ PVAF10%, 3years ] =

100 [2.4868]= 248.68

or, PV = 100 [ 3 1 ] = 100 (2.4868) = 248.68i = 1

(1+r)3

Or, PV = 100 1 + 100 1 + 100 11.10 (1.10)2 (1.10)3

= 100 (PV1F 10% ,1) + 100 (PV1F 10%, 2) + 100 (PV1F 10%, 3)

= 100 (0.9091 + 0.8264 + 0.7513) = 100 (2.4868) = 248.68

= 100 (PVAF10%, 3yrs

) = 100 (2.4868) = 248.68

PVAF = Present Value Annuity Factor.

PVIF = Present Value Interest Factor


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Principal Agent Problem

The principal (owner or, stockholders) Agent (Manager) problem refers

to the possibility that owners and their managers may have different

objectives. These interests can be aligned through the use of managerialcompensation arrangements that tie individual compensation to the

overall performance of the firm.

Example : smith is hired as the president of a firm at an annual salary of

Rs. 5,00,000 plus a five year option to by 1,00, 000 shares of stock at thecurrent market price of Rs. 50% per share. Assume that within five years

the price of the stock has increased to Rs. 75 per share. Smith exercises

the option by buying 1,00,000 share for Rs. 50,00,000 which have a

market value of Rs. 75,00,000. In the year the option are exercised, smith

has a gain (i.e. additional compensation) of Rs. 25,00,000. However if

the price of stock had remained unchanged or had declined, this option

would have no value and smith would have received no additional

compensation.


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The Present Value of all future profits can also be interpreted as the value

of the firm, that is, what a willing buyer would pay for the business.

Thus, to maximise the discounted value at all future profits is equivalent

to maximising the value of the firm.Examples of PV method.

PV of an Amount :- (S = Amount).

PV = S [ 1 ] = S [PVIF i, n](1+i)n

Where, PVIF i, n = Present value Interest Factor at i rate in n period

present value of Rs. 1 in n period if the interest rate is i .

Example:- 1)What is the PV of Rs. 1080 in 1 year if the interest rate is

8% per year.

2) What is the PV of Rs.1,00,000 to be received at the end of 10 years if

the interest rate is 10 % ?.


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Ans:- 1)

PV = 1080 [ 1 ] = 1080 [ 1 ] = Rs. 1000

Or, PV = 1080 [0.9259] = Rs. 1000 ( Where, PVIF 8%, 1 yr. = 0.9259

as given in PVIF Table)

2) PV = 100, 000 [ 1 ] = 100,000 [ 1 ] = 38,550.

Or PV = 100,000 [0.3855] = 38,550 [ PVIF 10%, 10 yrs = 0.3855 ]

PV of an Annuity

PV = A 1 + A 1 + -------- + A 1

1+0.08 1.08

(1+0.10)10 (1.10)10

(1+i) (1+i)2 (1+i)n

Or, PV = A[ n 1 ] = A [ PVAF i, n ](1+i)t

i = 1


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Example:-

Consider an individual who has an MBA degree and is considering

investing Rs. 2,00,000 in a retail store that he would manage. Further, the

best alternative use for this money (i.e. Rs. 2,00,000) might be in a bankaccount paying a 5% interest rate per annum. Also it is learnt that the

annual wage return on an MBA degree from a reasonably good business

school may be Rs. 60,000 per year. Given this information stated above,

the projected income statement for the year as prepared by an accountant

is shown as follows. Find out the Economicprofit and show how it is

different from Accounting profit.

Sales 90,000

Less: Cost of goods sold 40,000Gross profit --------------------------

50,000


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Less Advertising 10,000

Depreciation 10,000

Utilities 3,000

Property tax 2,000

Misc. expenses 5,000 30,000-----------20,000

Net Accounting profit

Less : implicit cost

Return on 2,00,000 of invested capital 10,000

Foregone wages 60,000 70,000

------------- ----------

Net Economic Profit - 50,000


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From, this broader perspective, the business is projected to lose Rs.

50,000 in the first year. The 20,000 accounting profits disappears when

all relevant costs are included. Obviously with the financial

information reported in this way, an entirely different decision might be

made on whether to start this business. Another way of looking at theproblem is to assume that Rs. 2,00,000 had to be borrowed at 5% interest

per annum and an MBA graduate hired at Rs. 60,000 per year to run the

store. In this case, Implicit costs become explicit and the accounting

profit is the same as the economic profit (i.e.50,000) because all costsboth explicit and implicit, have been considered.

PROBLEMS

1-1, A recent engineering graduate turns down a job offer at Rs.

3,00,000 per year to start his own business. He will invest Rs. 5,00,000

of his own money, which has been in a bank account earning 7% interest

per year. He also plans to use a building he owns that has been rented for

Rs. 15,000 per month.Revenue in the new business during the first year

was Rs. 10,70,000 while other expenses were:-

d i i


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Advertising Rs. 50,000

Rent 1,00,000

Taxes 50,000

Employees' Salaries 4,00,000

Supplies 50,000

Prepare Two income statements, one using the traditional accounting

approach and one using the opportunity cost approach to determine

profit.

Ans:-

Revenue Rs. 10,70,000

Less: Explicit costs

Advertising 50,000Rent 1,00,000

Taxes 50,000

Employees Salaries 4,00,000

Supplies 50,000 65,0000


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Accounting Profit 4,20,000

Less implicit Cost

Return of Rs. 5,00,000 35,000

Invested Capital

Rent foregone 1,80,000

Foregone Salary 3,00,000 5,15,000

Economic Profit -95,000

The business is projected to lose 95,000 in the first year


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Managerial Economics Sees1