MANAGERIAL ECONOMICS - Material No.

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Chapter 2 – Economic Optimization
Reference:
MANAGERIAL ECONOMICS 14TH EDITION BY: HIRSCHEY AND BENTZEN (2016)

Introductory Discussion

Managers make tough choices that involve benefits and costs. It is easy understand why
early users of personal computers were delighted when learned how easy it was to
enter and manipulate operating information in spreadsheets. Spreadsheets were pivotal
innovation because they put the tools for insightful demand, cost, profit analysis at the
fingertips of decision-makers. Today’s low cost but po9werful PCs and user-friendly
software make it possible to efficiently analyze computer-specific data and broader
information from the Internet. It has never been easier or more vital to consider the
implications of managerial decisions under an assortment of operating scenarios.

Effective managers must collect, organize and process relevant operating information.
However, efficient information processing requires more than electronic computing
capability; it requires a fundamental understanding of basic economic relations. Within
such a framework, powerful PCs and a wealth operating and market information became
an awesome aid to effective managerial decision-making.

ECONOMIC OPTIMIZATION PROCESS

Effective managerial decision-making is the process of arriving at the best solutions to

a problem.

Optimal Decisions

Should the quality of inputs be enhanced to better meet-low-cost import competition?

Is a necessary reduction in labor costs efficiently achieved through an across-the-board
decrease in staffing, or is it better to make targeted cutbacks? Following an increase in
product demand, is it preferable to increase managerial staff, line personnel, or both?

These are the types of questions facing managers on a regular basis that require a
careful consideration of basic economic relations. Answers to these questions depend
on the objectives and preferences of management. Just as there is no single ‘best’
decision for all customers at all times, there is no single ‘best’ investment decision for
all mangers at all times. When alternative courses of actions are available, the decision
that produces a result most consistent with managerial objectives is the optimal
decision.

A challenge that must be met in the decision-making process is characterizing the

desirability of decision alternatives in terms of the objectives of the organization.

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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 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, then 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 complexities of goal-oriented managerial activities.

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. Maximizing value of the firm is a complex task that
involves consideration of future revenues, costs and discount rates.

Total revenues are directly determined by the quantity sold and the prices obtained.
Factors that affect prices and the quantity sold include:
• choice of products made available for sale
• marketing strategies
• pricing and distribution policies
• competition, and
• general sate 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.

The relation between an appropriate discount rate and the company’s mix products and
both operating and financial leverage must be determined.

All these factors affect the value of the firm.

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 integration. Using
the principles of economic analysis, it is also possible to analyze and compare the higher
costs or lower benefits of alternatives, suboptimal courses of actions.

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Demand and Total Revenue

Concepts of Demand, Price and Revenue

Demand is the quantity of consumers who are willing and able to buy products at various
prices during a given period of time. Demand for any commodity implies the consumers’
desire to acquire the good, the willingness and ability to pay for it. An effective demand
has three characteristics namely: desire, willingness, and ability to pay for a product.
The demand for a product is always defined in reference to the three key factors: price,
point in time, and market place.

Price is the amount of money that has to be paid to acquire a given product. Insofar as
the amount people are prepared to pay for a product if it represents its value. Price is
also a measure of value.

The Law of Demand states that a higher price leads to a lower quantity demanded and
that a lower price leads to a higher quantity demanded. The relationship between price
and quantity demanded is inversely proportional.

The Law of Supply states that a higher price leads to a higher quantity supplied and that
a lower price leads to a lower quantity supplied. The relationship between price and
quantity supplied is directly proportional.

The Theory of Price is an economic theory that states that the price of a specific good or
service is determined by the relationship between its supply and demand at any given
point in time. Prices should rise if demand exceeds supply and fall if supply exceeds
demand.

Revenue is the total amount of income generated by the sale of goods or services related
to the company’s primary operations. In accounting, revenue is also known as gross
sales, and is often referred to as the ‘top line’ because it sits at the top of the income
statement. Technically, revenue is calculated by multiplying the price (p) of the good by
the quantity produced and sold (q) or in algebraic form revenue is defined as R = p x q.

Total revenue is the sum of revenues from all products and services that a company
brings from selling its goods and services. It determines how well a company is bringing
money from its core operations based on the demand and price. The total revenue figure
is very important a business must bring in money to turn a profit.

Precise information about the effect of a change in output on total revenue is given by
the marginal relation between revenue and output. Total, average and marginal relations
are very useful in optimization analysis.

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Marginal revenue is the increase in revenue that results from the sale of one additional
unit of output. While marginal revenue can remain constant over a certain level of output,
it follows from the law of diminishing returns and will eventually slow as the output level
increases. Marginal revenue (MR) is the rate of change in total revenue associated with
a change in quantity; in other words, marginal revenue is the first derivative of the total
revenue relative to quantity.

The Law of Diminishing Returns is an economic principle stating that as investment in a

particular area increases, the rate of profit from that investment, after a certain point,
cannot continue to increase if other variables remain constant. As investment continues
to past that point, the return diminished progressively. For example, if a factory employs
workers to a manufacture its products, at some point, the company will operate optimal
level; with all other production factors constant, adding additional worker beyond this
optimal level will result in less efficient operations.

Tables, Spreadsheets, Graphs, Charts and Equations

Tables, graphs, charts and equations are visual representations of data. They are
important and useful because they are powerful tools that can be used for things like
analyzing data, emphasizing a point, or comparing multiple sets of data in a way that is
easy to understand and remember.

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 statements or
balance sheet, the tables are referred to as spreadsheets.

A table is an arrangement of information or data, typically in rows and columns, or

possibly in a more complex structure. Below is an example of a table:

A spreadsheet is an electronic document in which data is arranged in rows and columns

of a grid and can be manipulated and used in calculation. Spreadsheets are one of the
most popular tools available with personal computers. A spreadsheet is generally
designed to hold numerical data and short text strings. An example is the color-coded
Excel spreadsheet is a computer program used to create and manipulate spreadsheet.
The most common reason to use spreadsheet is to store and organize data, like revenue,

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payroll and accounting information. Spreadsheets allow the user to make calculations
with this data and to produce graphs and charts.

Example of spreadsheet:

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 data can provide valuable insights.

A graph in economics is a visual illustration of numerical data in economics. Economists

plot graphs on two axes: the vertical axis, also known as the y-axis; and the horizontal
axis, also known as the x-axis. Economics can be very wordy, and it is essential for
graphs in economics to show the things in visual format. While simple numbers may be
easy to present in numerical format, numbers that are relative to other numbers may
be confusing, and graphs help us visualize these relationships.

Graphs in economics serve this purpose. The importance of graphs in economics is they
simplify numerical data to improve readability and understanding. Likewise, economic
graphs are important because they illustrate the relationships and connections between
different variables or concepts in economics.

For instance, the graphs are important in visualizing the relationship between the price
and the quantity of good, to illustrate:

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A chart is a graphical representation for data visualization, in which the data is
represented by symbols, such as bars in a bar chart, lines in a line chart, or slices in a
pie chart. A chart can represent tabular numeric data, functions or some kind of quality
structure and provide information. Charts enable us to visually compare multiple sets
of data. Charts help us better understand and remember information. Examples of chart:

Complex economic relations require more sophisticated methods of expression. An

equation is an expression of the functional relationship or connection among economic
variables. The easiest way to examine basic economic concepts is to consider the
functional relations incorporated in a basic valuation model. As an illustration demand
function:

By Q(p) we denote the demand function for a single product, where Q is the quantity
demanded and the p is the unit price. A linear demand function is given by:

Q = a + bP

Where the value of a represents the maximum quantity sold if the price is equal to zero,
and the value of b represents the marginal effect of quantity on changing the price.

An important reason for examining demand relationship lies in the use of revenue
received by the company. To illustrate:

TR = P x Q

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Where TR represents total revenue, P is the price and Q represents the Quantity of the
goods sold. In the equation, the variable to the left of the equal sign is called the
dependent variable. Its value depends on the size of the variables to the right of the
equal sign. Variables on the right side of the equal sign are called as independent
variables. Their values are determined independently of the functional relation
expressed in the equation.

The relationship between demand and revenue is that a business generates revenue by
satisfying demand from customers, in other words, revenue flows from customer
demand – but only if a business has a product that meets the customer needs and
expectations.

COSTS RELATIONS

Meeting customer demand efficiently depends upon a careful understanding of cost

relations.

Total Costs

Proper use of relevant cost concepts requires an understanding of various relations

between costs and output, or cost functions. Two basic cost functions are used in
managerial decision-making, namely:

1. Short-run cost functions are cost relations when fixed costs are present and
used for day-to-day operating decisions.
2. Long-run cost functions are cost relations when all costs are variable and used
for long term planning.

Total costs comprise fixed and variable expenses. Fixed costs do not vary with output.
These costs include interest expense, rent on leased plant and equipment, depreciation
charges associated with the passage of time, property taxes, and salaries for employees
not laid off during periods of reduced activity. Because all costs are variable in the long-
run, long-run fixed costs always equal to zero.

In economic analysis:
• The short-run -
o is the operating period during which the availability of at least one input is
fixed;
o operating decisions are typically constrained by prior capital expenditures.
• In the long-run –
o the firm has complete flexibility with respect to input use
o no such restrictions exist.

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For example, a management consulting firm operating out of rented office space might
have a short-run period as brief as a few weeks, the time remaining on the office lease.

Variable costs fluctuate with output. Expenses for raw materials, depreciation
associated with the use of equipment, the variable portion of utility charges, some labor
costs, and sales commissions are examples of variable expenses. In the short-run, both
variable and fixed costs are often incurred. In the long-run, all costs are variables.

A sharp distinction between fixed and variable costs is neither always possible nor
realistic. For example, CEO and staff salaries may be largely fixed, but during severe
business downturns, even CEOs take a pay cut. Similarly, salaries for line managers and
supervisors are fixed only within certain output ranges. Below a lower limit, supervisors
and managers get laid off. Above an upper limit, additional supervisors and managers
get hired. The longer the duration of abnormal demand, the greater the likelihood that
some fixed costs will actually vary.

In equation form, total cost can be expressed as the sum of fixed and variable costs.

TC = FC + VC

Marginal and Average Cost

Marginal cost (MC) is the rate of change in total costs associated with a change in
quantity. Marginal cost is almost always positive because almost all goods and services
entail least some labor and/or material. It is also common for marginal costs to rise as
output expands, but this is not universally true.

MC = ǝTC/ǝQ

Average cost (AC) is simply total cost divided by the number of units produced.

AC – TC/Q

At every output level, the relationship between marginal cost and output indicates the
change in total cost that will occur with a 1-unit change in the number of units produced.
Similarly, the relationship between marginal cost and average cost can be studied to
determine the change in average cost that will occur with a change in the number of
units produced.

Important points to remember:

• Average cost is falling when MC < AC (whenever the marginal is less than the
average, the average will fall)

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 • Average cost is rising when MC > AC (whenever the marginal is greater than the
average, the average will rise)
• If the marginal is equal to the average, the average is at either a minimum or
maximum.
• Average cost minimization is activity level that generates the lowest average
cost, MC = AC

PROFIT RELATIONS

Profit maximization involves a careful comparison of revenue and cost relations.

Total and Marginal Profit

Total profit (TP) is the difference between total revenue and cost.

TP = TR - TC

Marginal profit is the rate of change in quantity. In mathematical terms, marginal profit
is the first derivative of the total profit caused by a change in quantity. Equivalently,
marginal profit can be thought of as a difference between marginal revenue and
marginal cost.

MP = MR – MC

The profit maximization rule states that the total profit will be maximized when marginal
profit equals zero, provided that profit declines with further expansion in output. In
functional form, profit is maximized only if MP = 0 and profit falls with a further increase
in output. At then profit maximizing activity level, MR = MC.

INCREMENTAL CONCEPTS IN ECONOMIC ANALYSIS

When economic decisions have a lumpy rather than continuous impact on output, use of
incremental concept is appropriate.

Marginal vs. Incremental Concept

It is important to recognize that marginal relations measure the effect associated with
unitary changes in output. Many managerial decisions involve a consideration of
changes that are broader in scope. For example, a manager might be interested in
analyzing the potential effects on revenues, costs and profits of a 25% increase in the
firm’s production level. Alternatively, a manager might want to analyze the profit impact
of introducing an entirely new product line, or assess the cost impact of changing an
entire production system.

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In all managerial decision, the study of differences or changes is the key element in the
selection of an optimal course of action. The marginal concept, although correct for
analyzing unitary changes in output, it too narrow to provide a general methodology for
evaluating all alternative course of action.

The incremental concept is the economist’s generalization of the marginal concept.

Incremental analysis involves examining the impact of alternative managerial decisions
or courses of action on revenues, costs, and profit. It focuses in changes or differences
among alternatives. The incremental change is the change resulting from a given
managerial decision. For example, the incremental revenue of a new item in a firm’s
product line is measured as difference between the firm’s total revenue before and after
the new product is introduced.

The incremental profit is the profit gain or loss associated with a given managerial
decisions. Total profit increases so long incremental profit is positive. When incremental
profit is negative, total profit declines. Similarly, incremental profit is positive (and total
profit increases) if the incremental revenue associated with decision exceeds the
incremental cost.

The incremental concept is so intuitively obvious that is easy to overlook both its
significance in managerial decision-making and the potential for difficulty in correctly
applying it.

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