M.A.

third semester

MANAGERIAL ECONOMICS
UNIT I: FUNDAMENTALS OF MANAGERIAL
ECONOMICS

1. Nature and Scope of Managerial Economics

2. Managerial Decision and Principles in Today's
Economy
3. Firms, Managers and their Goals
4. The Nature and Function of Profit
5. The International Framework of Managerial
Economics
6. Economists and the Application of Managerial
Economics
Numerical Assignments and Case Studies
CONCEPT OF MANAGERIAL ECONOMICS,

 The contribution of Prof. Joel Dean introduced

managerial economics in1951.
 Application of economic theory, concept and tools
to solve the business (managerial) problems.
 Integration of economic analysis with business
practices to solve the business problems
 Helps for the further business planning
 Prescribes rules for improving managerial
decision
 Teach manager how to take decisions to achieve
the goal of organization efficiently.
 Joel Dean: use of economic analysis in
formulating policies is known as
managerial economics.
 Spencer and Seiglemen: Managerial
economics is the integration of economic
theory and business practice for the
purpose of facilitating decision making and
forward planning by the management.
 Pappas and Brigham: Managerial
economics is the application of economic
theory and methodology to business
administration practice
CHARACTERISTICS OF MANAGERIAL
ECONOMICS

1. Microeconomics in character
2. Normative
3. Pragmatic
4. Use macroeconomics
5. Profit maximization objective
6. Conceptual and metrical
7. Theory of firm
8. Integration of economic theories with
business practice
SCOPE OF MANAGERIAL ECONOMICS

 Demand analysis and forecasting

 Production and cost analysis
 Pricing theories and practices
 Profit management
 Capital and investment
 Inventory analysis
 Environmental analysis
domestic business environment
international business environment
nature and impact of government policy
NATURE AND SCOPE OF MANAGERIAL
ECONOMICS:

What to Sales How

produce? promotio much to
n? invest?

How to Profit
produce? margin?

Govern
Pricing? ment
How
policy?
much to
produce? Nature of
business
environment?
OPERATIONAL ISSUES

 What to produce?
 How to produce?
 How much to produce?
 How much to invest?
 What should be the reasonable profit
margin and price?
 What should be the reasonable sales
expenditure?
SOLVING OPERATIONAL ISSUES

 Forecasting
 Optimization Decision science
 Pricing and profit tools

Example:
 Demand forecasting

- General sales trend – Time series

- Response to price, sales expenditure –
Regression 
Qd = a – bP, Qd = a + bA, Qd = a – b1P + b2A
ENVIRONMENTAL ISSUES:

 What is the nature and trend of domestic

business environment?
 What is the nature and trend of
international business environment?
 What is the orientation of government
policies towards private sector business
growth?
 What is the impact of social cost?
MEASUREMENT FACTORS FOR ECONOMIC
ENVIRONMENT

 Economic system
 Macroeconomic indicators
 Growth and magnitude of foreign trade
 Growth of financial market
 Economic policies
 Growth of infrastructure/ technology
THE NATURE OF MANAGERIAL ECONOMICS
MANAGERIAL ECONOMICS AND BUSINESS
DECISION MAKING

 Efficient Utilization of resource

allocation
 Basis for prediction
 Price determination
 Setting goals
 Business environment
NATURE AND FUNCTION OF PROFIT:

 Meaning of profit: Profit means the

difference between cost and revenue
 It is differs from persons like economist,
businessman, accountant
 Profit is the excess of income over
expenditure.
 Profit includes various economic concepts
like opportunity cost, fixed cost, variable
cost implicit cost, explicit cost and
revenues.
BUSINESS VS ECONOMIC PROFIT:

Accounting / Business profit

= TR – Explicit cost
Explicit cost is the cost paid for external
factors of production.
Economic profit
= TR – (Explicit + Implicit cost) economic
cost
Implicit cost refers to the cost incurred for
self owned factors of production along with
normal profit
TR= total revenue (P*Q)
Function of profit:

 Measurement of performance
 Incentive for expansion
 Incentive for new inventors and innovation
 Insures future capital
 Attracts new investor
 Increases risk bearing capacity
 Incentive for research and development
 Main heart of economy
 Indicator of success
CASE I
Asha a beautician , working as a manager of a company
for Rs 120000 per year, wants to start her own business
by investing her own money of Rs. 400000 on which she
can earn 10% interest if deposited in bank. Her
estimated revenue during the first year of operation is Rs
300000 and costs are salaries to employees Rs 90000,
supplies Rs 30000, rent Rs 20000 and utilities Rs 20000.
Questions
a) What is business profit?

b) What is economic profit?

c) If she ask you whether to start business or not what

will be your advice and why?
d) What will be your advice is if she could earn only 3%
interest on her own money with deposited in bank?
CASE 2

Rohan working in a bank earning Rs 15000 per

month he has deposited Rs 480000 in a bank which
yield 5% interest per annum. He wants to start his
own business investing his money and work as a
manager. He has estimated total revenue Rs 82000
per month and estimated cost of production raw
material Rs 50000 per month, advertisement Rs
10000 annual depreciation 15% of capital worth Rs
200000, utilities 3000/ month, miscellaneous
expenses Rs 8000.
Find
a) Business and economic profit
b) If Rohan asks whether to start business or
continue job, what is your suggestions and why?
THEORY OF FIRM

Profit maximization model:

 Classical objective – supported by classical and
neo-classical economists.
 Main objectives of firm is to maximization profit
 profit is the major incentive to produce and sell
goods and services in the market
 Each and every business organization has the aim
to maximization the profit with use of available
resources.
 Profit is the difference between total revenue and
total cost
Assumptions:
1. Only one commodity is produced by
the firm
2. The owner himself works as the
manager of the firm
3. Time period is static
4. Firm acts rationally i.e. it always
attempts to maximize profit by
investing limited investment budget.
5. Imperfect competitive market
Two approaches of profit maximization
model:
A. TR-TC Approach:
 According to this approach profit will be
maximized when the gap between TR and TC
will be maximum.
 Graphically, when the vertical distance
between TR curve and TC curve is maximum
 Trend of TR curve is different in perfectly and
imperfectly competitive market.
 Trend of TC has traditional types that is TC
increases at decreasing rate at initially and
after a certain output level increases at
increasing rate, it means U shaped average
cost
IMPERFECT COMPETITIVE MARKET
TC

TR,TC, profit
C TR

B
Points A and C are the
break even point

0 Q1 Q2 Q3 output
∏
B. MR-MC APPROACH:

 Alternative approach to explain profit

maximization objective of firms
 Meaning and trend of MR
 Meaning and trend of MC
 Two conditions of firms equilibrium under this
approach are:
necessary/first order condition: MR=MC d(profit)=0
sufficient/second order condition: slope of Mc >
slope of MR or MC curve must intersect MR curve
from below.
 IF MARKET IS PERFECTLY COMPETITIVE
MARKET
MR, MC approach
Cost ,revenue and price
MC

AC
P
AR=MR

O Q Output
Equilibrium condition, MC=MR and MC must cut MR from the below
IN IMPERFECT COMPETITIVE MARKET

Price, MR,AR,
MC, AC
MC

AC
B
P

C
A
e
AR
MR
O Q1 output
MATHEMATICALLY:
Profit = TR – TC
F.O.C.
MR= MC d(profit)=0 slope of profit
S.O.C.
Slope of MC > slope of MR

Criticism of this model

 The firm does not have only one objective
 Based on unrealistic assumptions
 Marginalize is very complex concept
 Risk averse managers avoid a policy of profit
maximization
Questions for discussion:
1. Rasuwagadhi hydropower has following
demand and cost functions, P= 2000 – 10Q
and C = 1000 + 200Q, Calculate,
a. Profit maximizing price and output
b. Total revenue (TR) and profit

2. A firm has the demand function Q= 30 – P,

total fixed cost of firm is Rs 20 and variable
cost per unit of output is Rs 4, then find
profit maximizing level of output, price and
profit of the firm. TR= P*Q = 30Q-Q2,P=30-
Q TC= TFC- TVC
VALUE MAXIMIZATION MODEL
 This model tries to solve the weaknesses of short-run
profit maximization goal
 It has the objective of the long-run profit maximization
 In case of organization, value of firm refers to the
shareholders wealth which is measured by the share
price of the stock.
 It is also expressed as wealth maximization model
 “ since share price represents the owner’s wealth in
the form, share price maximization is consistent with
owners wealth maximization” L.J. Gitman
 “when the time period is short and uncertainty is not
much, so profit maximization and value maximization
are same.” Solomom and Pringle.
 Value can be defined as the present value of
firm’s expected future net cash flows.
 Value of the firm = present value of the future
profits (P.V.)
P.V. =
….. (i)
Where,
P.V. = present value of expected future profits
1, 2 ….. n = means profits of each year
r = rate of discount or rate of interest
Contd….
 Since, profit is the difference between total
revenue and total cost. The eqn. (i) can be
written as
value of firm = …..(ii)
Features of value maximization model:
1. This model creates direct relationship
between profit and managers remuneration
2. It deals with both cost and benefit of the firm
in the long-run
3. It provides simple explanation and easy to
make managerial decision
4. This model is more useful in competitive
market.
SUPERIORITY OF VALUE MAXIMIZATION
MODEL:

Value maximization model is superior than profit

maximization model in the following respect,
1. Profit maximization model deals with short-
run and whereas value maximization model
deal with long-run
2. Profit maximization model is static model and
value maximization model is dynamic model
3. profit maximization model is focused on sole-
trading and value maximization model is
focused on corporate business.
SALES REVENUE MAXIMIZATION
BAUMOL
 W.J Baumol developed sales revenue maximization
model (1958) “Business behavior, value and Growth”
 Ultimate objective of the firm is to maximize sales
rather than profit.
 Sales refers to the revenue of the firm therefore he
named his hypothesis as sales maximization
hypothesis or revenue maximization hypothesis
 Sales maximization means maximizing TR from sales
 Firms need to spend minimum profit on expansion
plans, and to provide better return to the
shareholders.
ASSUMPTIONS:

1. The time horizon of a firm is single period

2. Firm attempts to maximize its total
revenue subject to profit constraint not
the physical volume of output
3. Traditional cost curves and downward
sloping demand curves
4. Market is imperfectly competitive.
5. Firms must realized a minimum level of
profit to keep shareholders happy and
avoid a fall of share prices.
BUSINESS MANAGERS PURSUE THE GOAL OF
SALES MAXIMIZATION RATHER THAN PROFIT
MAXIMIZATION FOR THE FOLLOWING REASONS:
 Sales is an index of performance of the firm
 Sales indicate growing market share and a greater
competitive strength and bargaining power of the firm
 Salaries and slack earning of the top management are
linked more closely to sales than profit
 Sustained growth of sale at large scale gives prestige
to the manager, while large profit go into the pocket
of shareholders.
 Business stability is the pre-condition for sustained
growth of business.
 Firms can easily handle personnel problems when
they have large sales.
TWO CASES UNDER SALES REVENUE
MAXIMIZATION:
1. Sales revenue maximization without
profit constraint: when firm sets its goal of
sales maximization without profit constraint, it
produces the level of output at which TR is
maximum with unitary price elasticity of
demand, ep = 1.
2. Sales revenue maximization with profit
constraint: if the board of director directed
the managers to meet profit target, firm
produces the level of output where TR is
increasing with positive MR and price elasticity
of demand, ep >1.
GRAPHICALLY,
TC
TR,TC,
e=1
b

TR

𝜋1
𝜋2
O Output
Q1 Q2 Q3Q4 Q5

sales revenue
𝜋 2=𝑝𝑟𝑜𝑓𝑖𝑡 𝑢𝑛𝑑𝑒𝑟 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑤𝑖𝑡h𝑜𝑢𝑡 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡
CONCLUSIONS OF BAUMOL’S THEORY:

 Sales maximizer produces more

output than profit maximizer.
 Sales maximizer determines low
price of the product in comparison to
profit maximizer.
 Sales maximizer obtains low profit in
comparison to profit maximizer.
 Sales maximization hypothesis has a
better predictive performance than
the tradition profit maximization
objective hypothesis.
CRITICISM OF SALES- REVENUE
MAXIMIZATION MODEL:
1. It is consistent with long-run profit maximization.
2. The firms can sell more than profit maximizing
level only due to the ignorance of their demand
curve.
3. Baumol fails to establish interrelationship between
firm and industry
4. According to W.G. Shepherd, in case of oligopoly,
the equilibrium lies at the point of kink, under
kinked demand curve. Therefore, in such a
situation profit maximization and sales
maximization do not become competitive.
5. It cannot be tested without knowing demand and
cost function of individual firm.
Case I
 A firm has following revenue and cost functions
Revenue function TR = 26Q – 3Q2
Total cost TC = 2Q2 – 4Q + 10
1. Find the output, price and total profit under the profit
maximization theory.
2. Find the revenue maximization level of output, price,
total revenue and profit.
Case II
 Given the demand function P = 20 – Q and total cost
function TC = 50 + 4Q
Determine the price, output and profit under
1. Profit maximization model

2. Sales revenue maximization model

3. Sales revenue maximization model with profit

constraint of Rs 13
CASE III
ABC company has following demand and cost function
P = 25 – 0.5Q (demand function)
C = 1.5Q2 + 5Q + 10 (cost function)
Where Q = quantity in units
P = price in rupees
C = total cost
Find the price, output and total profit of this company
under the objective of
1. Profit maximization.

2. Sales-revenue maximization and

3. Sales revenue maximization with a profit constraint

of Rs. 22 thousand
WILLIAMSON’S MODEL OF MANAGERIAL
DISCRETION:
 Oliver E. Williamson developed a full-fledged theory of firm
related to managerial discretion and he believed that the
managers look at their self interest while making decision of firm.
 Managers have discretion in pursuing policies which maximize
their own utility rather than attempting the maximization of
profits which maximizes the utility of the owner- shareholders.
 Profit acts as a constraint to the manager’s utility maximization
behavior because the financial market and the shareholders
expect maximum profit.
 The objective of a firm is to maximize their own utility function
with profit constraint.
 The job security of managers endangers, if managers fails to earn
a minimum profit to pay in the form of dividends to the owners.
CONTD…..

Manager’s utility function can be

written as,
U = f(S, M, ID)
Where, U = manager’s utility
S = staff expenditure
M = managerial emoluments
ID = discretionary investment
CONTD….

Simplified Model:
The model can be expressed as:
Maximize (U) = f(S, M, ID)
Subject to ≥ + T
Where is the reported profit (reported to tax
office) which is the differenced between actual
profit (P) and managerial emolument i.e. = – M,
and, is the minimum profit satisfy the
shareholders
The actual profit is the current profit of firm
which is the difference between revenue (R) and
total cost (C) including staff expenditure i.e.
CONTD….

When managerial emolument M = 0, the model can be expressed

as
Maximize (U) = f (S, )
Subject to ≥ + T
We know
Discretionary profit Subject to = – T,
Also,
Discretionary Investment ID = – T
Or ID = – T (… = – M)
When M = 0
Or ID = ( – T
Or ID = – T
Or ID =
MANAGER’S UTILITY CURVE.

Collection of indifference curves U1, U2, U3 are the

manager’s utility curve and shows the preference of
manager. Higher indifference curve gives higher
Discretionary profit
utility to manager

U3
U2
U1

0 Staffs expenditure
RELATION BETWEEN DISCRETIONARY
PROFIT AND STAFF EXPENDITURE:
Point e is the equilibrium
Discretionary profit

where discretionary curve is

tangent to the manager’s
utility curve U1. Hence, Se is
the staff expenditure and
is the discretionary
profit. In profit maximization
goal of firm’s staff
expenditure would be S and
𝜋 𝑑𝑚
maximum profit would be
𝜋 𝑑𝑚 U3 . This implies that manager
𝜋 𝑑𝑒 e prefers more amount of staff
U2 expenditure as compared to
U1
DPC profit maximizing situation
i.e Se >s
0 A S Se B Staff Expenditure
COMPARISON OF PROFIT MAXIMIZATION, SALES REVENUE
MAXIMIZATION AND MANAGERIAL DISCRETION MODEL:

 Williamson’s model is based on the implicit assumption “other

things remaining the same”.
 This model is valid only in the market not having strong rivalry.
 If the market is with strong rivalry, profit maximization is most
appropriate.
 Williamson’s model is practically useful model because this
model gives conclusions like change in discretionary
expenditures like staff expenditure, managerial emoluments
and discretionary investment are the tendencies and the
determinants of behavior of a rational manager.
 This model is also shows the effect of taxes on objective of the
firms or utility of the managers, therefore it is practically useful
model
 This model deals about reported profit, where as sales revenue
model and profit maximization model deal about actual profit.
International Framework for Managerial
Economics
 It introduce the global dimension in the study of
managerial economics.
 Many of the commodities we consume today are
imported, firms purchase many inputs from abroad and
sell an increasing share of their products overseas.
 Domestic firms face increasing competition from foreign
firms in the local market and around the world.
 The international flow of capital, technology, skill labor
has also reached unprecedented dimensions.
 In short, there is a rapid movement towards the
globalization of production, consumption and competition.
 In view of such a globalization of economic activity, it
would be unrealistic to study managerial economics in an
international vacuum, this requires the training of new
types of global executive, who requires many new skills
that are not easy to acquire.
ECONOMIST AND THE APPLICATION OF
MANAGERIAL ECONOMICS
i) Demand forecasting
ii) Production scheduling

iii) Market research

iv) Pricing and related decision

v) Economic analysis of the industry

vi) Investment appraisal

vii) Security management

viii) Analyzing and forecasting

environment
Thank you