ARBA MINCH UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

FACULTY OF MANAGEMENT
Master of Business Administration (Regular)
Course Title: Managerial Economics
Semester - II
Course Code: MBA – 651
Sawla Campus
MANAGERIAL ECONOMICS Assignment
TOPIC:- BASIC ECONOMIC RELATIONS
GROUP ONE MUMBERS
S.No. Student’s Name ID No.
1 Afwork Asrat Atsa PWBE/024/15
2 Andualem Eshetu Mohammed PWBE/027/15
3 Yehualashet Tekleariam Bezu PWBE/035/15

Submitted to Prof. Antony Dhason, Ph.D

Department of Management College of Business and Economics
Arbaminch University
Arbaminch
Ethiopia
Cell: +251-946729221
+251-946729222
Email: dr.dhasonantony@gmail.com
prof.antonydhason@gmail.com
SUBMITION DATE MAY 20/2023 G.C
Arbaminch, Ethiopian
BASIC ECONOMIC RELATIONS

1. INTROPDUCTION
Managers have to make tough choices that involve benefits and costs. Until recently,
however, it was simply impractical to compare the relative pluses and minuses of a large
number of managerial decisions under a wide variety of operating conditions. For many
large and small organizations, economic optimization remained an elusive goal. It is easy to
understand why early users of personal computers were delighted when they learned how
easy it was to enter and manipulate operating information within spreadsheets.
Spreadsheets were a pivotal innovation because they put the tools for insightful demand,
cost, and profit analysis at the fingertips of managers and other decision makers. Effective
managers in the twenty-first century must be able to collect, organize, and process a vast
assortment of relevant operating information. However, efficient information processing
requires more than electronic computing capability; it requires a fundamental
understanding of basic economic relations. The fundamental principles of economic
analysis. These ideas form the basis for describing all demand, cost, and profit relations.
Once the basics of economic relations are understood, the tools and techniques of
optimization can be applied to find the best course of action.

2. ECONOMIC OPTIMIZATION PROCESS

Effective managerial decision making is the process of arriving at the best solution to a
problem. If only one solution is possible, then no decision problem exists. When alternative
courses of action are available, the best decision is the one that produces a result most
consistent with managerial objectives. The process of arriving at the best managerial
decision is the goal of economic optimization and the focus of managerial economics.

2.1 Optimal Decisions

When alternative courses of action are available, the decision that produces a result most
consistent with managerial objectives is called the optimal decision. This decision-making
process is characterizing the desirability of decision alternatives in terms of the objectives
of the organization. Decision makers must recognize all available choices and portray them
in terms of appropriate costs and benefits. The description of decision alternatives is
greatly enhanced through application of the principles of managerial economics.
Managerial economics also provides tools for analyzing and evaluating decision
alternatives. Economic concepts and methodology are used to select the optimal course of
action in light of available options and objectives. Principles of economic analysis form the
basis for describing demand, cost, and profit relations. Once basic economic relations are
understood, the tools and techniques of optimization can be applied to find the best course
of action. Most important, the theory and process of optimization gives practical insight
concerning the value maximization theory of the firm. Optimization techniques are helpful
because they offer a realistic means for dealing with the complexities of goal-oriented
managerial activities.

2.2 Maximizing the Value of the Firm

In managerial economics, the primary objective of management is assumed to be
maximization of the value of the firm. Value maximization is a complex process that
involves an ongoing sequence of successful management decisions. This complex task that
involves consideration of future revenues, costs, and discount rates. Total revenues are
directly determined by the quantity sold and the prices received. Factors that affect prices
and the quantity sold include the choice of products made available for sale, marketing
strategies, pricing and distribution policies, competition, and the general state of the
economy. Cost analysis includes a detailed examination of the prices and availability of
various input factors, alternative production schedules, production methods, and so on.
Finally, the relation between an appropriate discount rate and the company’s mix of
products and both operating and financial leverage must be determined.
To determine the optimal course of action, marketing, production, and financial decisions
must be integrated within a decision analysis framework. Similarly, decisions related to
personnel retention and development, organization structure, and long-term business
strategy must be combined into a single integrated system that shows how managerial
initiatives affect all parts of the firm. The value maximization model provides an attractive
basis for such as integration. Using the principles of economic analysis, it is also possible to
analyze and compare the higher costs or lower benefits of alternative, suboptimal courses
of action. The complexity of completely integrated decision analysis or global optimization
confines its use to major planning decisions.
 For many day-to-day operating decisions
 Managers typically use less complicated
 Partial optimization techniques

3. BASIC ECONOMIC RELATIONS

Tables are the simplest and most direct form for presenting economic data. When these
data are displayed electronically in the format of an accounting income statement or
balance sheet, the tables are referred to as spreadsheets. When the underlying relation
between economic data is simple, tables and spreadsheets may be sufficient for analytical
purposes. In such instances, a simple graph or visual representation of the data can provide
valuable insight. Complex economic relations require more sophisticated methods of
expression. An equation is an expression of the functional relationship or connection
among economic variables. When the underlying relation among economic variables is
uncomplicated, equations offer a compact means for data description; when underlying
relations are complex, equations are helpful because they permit the powerful tools of
mathematical and statistical analysis to be used.

3.1 Functional Relations: Equations

The easiest way to examine basic economic concepts is to consider the functional relations
incorporated in the basic valuation model. Consider the relation between output, Q, and
total revenue, TR. Using functional notation, total revenue is
TR = PQ
“Total revenue is a function of output.” The value of the dependent variable (total revenue)
is determined by the independent variable (output). The variable to the left of the equal
sign is called the dependent variable. Its value depends on the size of the variable or
variables to the right of the equal sign. Variables on the right-hand side of the equal sign are
called independent variables.
3.2 Total, Average, and Marginal Relations
Total, average, and marginal relations are very useful in optimization analysis. Where as
the definitions of totals and averages are well known, the meaning of marginal needs
further explanation. A marginal relation is the change in the dependent variable caused by
a one-unit change in an independent variable.
 Marginal revenue is the change in total revenue associated with a one-unit change
in output
 Marginal cost is the change in total cost following a one-unit change in output
 Marginal profit is the change in total profit due to a one-unit change in output

3.3 Graphing Total, Marginal, and Average Relations

Knowledge of the geometric relations among totals, marginal, and averages can prove
useful in managerial decision making. Just as there is an arithmetic relation among totals,
marginal, and averages in the table, so too there is a corresponding geometric relation. Just
as there is an arithmetic relation among totals, marginal, and averages in the table, so too
there is a corresponding geometric relation.
 At any point along a total curve, the corresponding average figure is given by the
slope of a straight line from the origin to that point.
 At any point along a total curve, the corresponding marginal figure is given by the
slope of a line drawn tangent to the total curve at that point.

4. MARGINAL ANALYSIS IN DECISION MAKING

Marginal analysis gives clear rules to follow for optimal resource allocation. As a result,
geometric relations between totals and marginal offer a fruitful basis for examining the role
of marginal analysis in managerial decision making. This are:-

4.1 Use of Marginal in Resource Allocation

Use of Marginal in Resource Allocation is a perfective competitive market economy
resources are efficiently or optimally allocated and used

4.2 Total and Marginal Functional Relationships

Geometric relations between totals and marginal offer a fruitful basis for examining the
role of marginal analysis in economic decision making. Managerial decisions frequently
require finding the maximum value of a function. For a function to be at a maximum, its
marginal value (slope) must be zero. Evaluating the slope, or marginal value, of a function,
therefore, enables one to determine the point at which the function is maximized.
Profit maximization
Activity level that generates the highest profit,
MR = MC and Mπ = 0
The relations among marginal revenue, marginal cost, and profit maximization can also be
demonstrated by considering the general profit expression, π = TR – TC. Because total
profit is total revenue minus total cost, marginal profit (Mπ) is marginal revenue (MR)
minus marginal cost (MC):
Mπ = MR – MC
Because maximization of any function requires that the marginal of the function be set
equal to zero, profit maximization occurs when
Mπ = MR – MC = 0
Therefore, in determining the optimal activity level for a firm, the marginal relation tells us
that so long as the increase in revenues associated with expanding output exceeds the
increase in costs, continued expansion will be profitable. The optimal output level is
determined when marginal revenue is equal to marginal cost, marginal profit is zero, and
total profit is maximized.

5. PRACTICAL APPLICATIONS OF MARGINAL ANALYSIS

The practical usefulness of marginal analysis is easily demonstrated with simple examples
that show how managers actually use the technique. Common applications are to maximize
profits or revenue, or to identify the average-cost minimizing level of output.

5.1 Profit Maximization

The most common use of marginal analysis is to find the profit-maximizing activity level.
These relations can be used to determine the optimal activity level for the firm. Profit will
be maximized where MR = MC.
5.2 Revenue Maximization
Although marginal analysis is commonly employed to find the profit-maximizing activity
level, managers can use the technique to achieve a variety of operating objectives. To limit
an increase in current and future competition, Storrs may decide to lower prices to rapidly
penetrate the market and preclude entry by new rivals.
Revenue maximization
Activity level that generates the highest revenue,
MR = 0
Notice that revenue maximization involves a consideration of revenue or “demand-side”
influences only. Unlike profit maximization, cost relations are not considered at all. Relative
to profit maximization, revenue maximization increases both unit sales and total revenue
but substantially decreases short-run profitability. These effects are typical and a direct
result of the lower prices that accompany a revenue maximization strategy. Because
revenue maximization involves setting MR = 0, whereas profit maximization involves
setting MR = MC, the two strategies will only lead to identical activity levels in the unlikely
event that MC = 0. Although marginal cost sometimes equals zero when services are
provided, such as allowing a few more fans to watch a scarcely attended baseball game,
such instances are rare. Most goods and services involve at least some variable production
and distribution costs, and hence marginal costs typically will be positive. Thus, revenue
maximization typically involves moving down along the demand and marginal revenue
curves to lower prices and greater unit sales levels than would be indicated for profit
maximization. Of course, for this strategy to be optimal the long run benefits derived from
greater market penetration and scale advantages must be sufficient to overcome the short-
run disadvantage of lost profits.

5.3 Average Cost Minimization

Profit and revenue maximization may be the most common uses of marginal analysis, but
other useful applications are also prevalent. Consider the implications of still another
possible short run strategy for Storrs. Suppose that instead of short-run profit or revenue
maximization, the company decides on an intermediate strategy of expanding sales beyond
the short-run profit maximizing activity level but to a lesser extent than that suggested by
revenue maximization. This might be appropriate if, for example, Storrs is unable to finance
the very high rate of growth necessary for short-run revenue maximization. Given the
specific nature of Storrs’ total cost and profit relations, the company might decide on a
short-run operating strategy of average cost minimization. To find this activity level,
remember that average cost is falling when MC < AC, rising when MC > AC, and at a
minimum when MC = AC. Therefore, the average cost minimizing activity level for Storrs is
Activity level that generates the lowest average cost,
MC = AC
For Storrs, average cost minimization involves operation at an activity level that lies
between those indicated by profit maximization and revenue maximization strategies.
Because average cost minimization reflects a consideration of cost relations or “supply-
side” influences only, however, either greater or lesser activity levels than those indicated
by profit maximization and revenue maximization strategies might result. In Storrs’ case,
average cost minimization leads to some of the market penetration advantages of revenue
maximization but achieves some of the greater profits associated with lower activity levels.
As such, it might be an attractive short-run strategy for the company. In general, revenue
and cost relations as well as entry conditions must be considered before settling on an
appropriate short-run operating strategy. Once such a strategy is identified, a study of the
specific revenue and cost relations and other influences facing the firm will suggest an
appropriate activity level.