1Chapter 1

NATURE AND SCOPE OF MANAGERIAL ECONOMICS

How do managers make good decisions? What pitfalls must be avoided? When are the
characteristics of a market, a line of business, or an industry so attractive that entry becomes
appealing? When are these attributes so unattractive that growth is not warranted and exit is
preferable to continued operation? Why do some professions continue to pay well, while others
offer only minimal financial rewards? How do you effectively motivate employees? All of these
questions involve important economic issues that pose a continuing challenge to the managerial
decision making process. Providing a logical and consistent framework that can be used to
derive an appropriate answer to each of these questions is a task for which managerial
economics is ideally suited. Managerial economics tells managers how things should be done to
achieve objectives efficiently, and helps them recognize how economic forces affect
organizations.
The nature and scope of managerial economics is laid out in this chapter. A primary
emphasis of managerial economics is the application of economic theory and methodology to the
practice of business decision making. Because managers of not-for-profit and government
agencies must also efficiently employ scarce resources, managerial economics is an important
tool for them as well. An important secondary emphasis in managerial economics is the study of
how managerial decisions are affected by the economic environment. Managerial economics is
applied economics; it is the use of economics theory and methodology to solve practical decision
problems.

CHAPTER OUTLINE

I. HOW IS MANAGERIAL ECONOMICS USEFUL?

A. Evaluating Choice Alternatives: Managerial economics links economic concepts

with quantitative methods to develop vital tools for managerial decision making.

1. Managerial economics identifies ways to efficiently achieve goals.

2. Managerial economics can be used to specify pricing and production

strategies.

3. Managerial economics provides production and marketing rules to help

maximize net profits.

B. Making the Best Decision: To establish appropriate decision rules, managers

must understand the economic environment in which they operate.

1. Once management has set relevant goals, managerial economics can be

used to efficiently attain those objectives.

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 2. Managerial economics can be used to deduce the underlying logic of
company, consumer, and government decisions.

II. THEORY OF THE FIRM

A. Expected Value Maximization: Firms exist because they are useful for
producing and distributing goods and services. The basic model of business is
called the theory of the firm.

1. In its simplest version, the firm’s owner-manager is assumed to be working

to maximize short-run profits.

2. In a more complete model, the primary goal of the firm is long-term

expected value maximization.

3. The value of the firm is the present value of the firm’s expected future net
cash flows.

a. If cash flows are equated to profits for simplicity, the value of the
firm today, or its present value, is the value of expected profits or
cash flows, discounted back to the present at an appropriate interest
rate.

B. Constraints and the Theory of the Firm: Managerial decisions are often made
in light of constraints imposed by technology, resource scarcity, contractual
obligations, and government laws and regulations.

1. To make decisions that will maximize value, managers must consider both
short-run and long-run implications and how external constraints affect
their ability to achieve organizational objectives.

2. The value of the firm is given by the equation:

func {Value ~=~ SUM from {t=1} to {n} ~{TR_t ~-~ TC_t} over {(1 ~+~ i)^t}}

where TR is total revenue, TC is total cost, and i is a risk-adjusted discount rate, all during period
t.
C. Limitations of the Theory of the Firm: In practice, it is difficult to determine
whether managers actually maximize firm value or merely attempt to satisfy
stockholders while pursuing other goals.

1. Alternative theories, or models, of managerial behavior have added to our

understanding of the firm.

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 a. Still, the basic value maximization model is a foundation for
analyzing managerial decisions.

2. Vigorous competition in markets for goods and services typically forces

managers to seek value maximization in their operating decisions.

3. Competition in the capital markets forces managers to seek value

maximization in their financing decisions.

4. Managers who pursue their own interests instead of stockholders’ interests

run the risk of being replaced.

a. Hostile takeovers are especially unfriendly to inefficient

management, which is usually replaced.

5. What sometimes appears to be satisficing on the part of management can

be interpreted as value-maximizing behavior once the costs of information
gathering and analysis are considered.

6. Short-run growth maximization strategies are often consistent with long-

run value maximization when the production, distribution, or promotional
advantages of large firm size are better understood.

III. PROFIT MEASUREMENT

A. Business Versus Economic Profit: The free enterprise system would fail to
operate without profits and the profit motive. Even in planned economies, where
state ownership rather than private enterprise is typical, the profit motive is
increasingly used to spur efficient resource use.

1. The general public and the business community typically define profit
using an accounting concept.

a. The amount available to fund equity capital after payment for all
other resources the firm uses is called accounting profit, or business
profit.

b. The risk-adjusted normal rate of return on capital is the minimum

return necessary to attract and retain investment.

2. Economic profit is business profit minus the implicit costs of capital and
other owner-provided inputs used by the firm.

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 B. Variability of Business Profits: The observed variation in business profits
makes it clear that many firms earn significant economic profits or experience
meaningful economic losses at any point in time.

1. The business profit concept is typically measured in percentage terms by

net income divided by the book value of stockholders’ equity, or the return
on equity (ROE).

IV. WHY DO PROFITS VARY AMONG FIRMS?

A. Frictional Theory of Economic Profits: Markets are sometimes in

disequilibrium because of unanticipated changes in demand or cost conditions.

1. Profits are sometimes above or below normal because of factors that

prevent instantaneous adjustment to new market conditions.

B. Monopoly Theory of Economic Profits: Monopoly profits exist when firms are
sheltered from competition by high barriers to entry.

1. Economies of scale, high capital requirements, patents, or import

protection, among other factors, enable some firms to build monopoly
positions that allow above-normal profits for extended periods.

C. Innovation Theory of Economic Profits: Innovation profit theory, describes the

above-normal profits that arise following successful invention or modernization.

1. As in the case of frictional or disequilibrium profits, innovation profits are

susceptible to the onslaught of competition from new and established
competitors.

D. Compensatory Theory of Economic Profits: Compensatory profit theory

describes above-normal rates of return that reward firms.

1. Superior firms provide goods and services that are better, faster or cheaper
than the competition.

E. Role of Profits in the Economy: Each of the preceding theories describe

economic profits obtained for different reasons. In some cases, several might
apply.

1. Above-normal profits signal that firm or industry output should be

increased.

2. Below-normal profits provide a signal for contraction and exit.

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V. ROLE OF BUSINESS IN SOCIETY

A. Why Firms Exist: Business contributes significantly to social welfare.

1. These contributions stem directly from the efficiency of business in serving

the economic needs of customers.

B. Role of Social Constraints: Regulation is sometimes imposed to promote

economic fairness.

1. Regulation is sometimes seen as a necessary means for stemming

unwarranted monopoly profits, worker exploitation, environmental
degradation, and so on.

C. Social Responsibility of Business: Firms exist by public consent to serve the

needs of society.

1. The firm can be viewed as a collaborative effort on the part of

management, workers, suppliers, and investors on behalf of consumers.

2. Taxes and restrictions on firms are taxes and restrictions on those people
associated with the firm.

3. The economic model of the firm emphasizes the close relation between the
firm and society, and suggests the importance of business participation in
the development and achievement of social objectives.

VI. STRUCTURE OF THIS TEXT

A. Objectives: This text will help you accomplish the following objectives:

1. Develop a clear understanding of economic theory and methods as they

relate to managerial decision making;

2. Acquire a framework for understanding the nature of the firm as an

integrated whole as opposed to a loosely connected set of functional
departments;

3. Recognize the relation between the firm and society and the key role of
business as a tool for social betterment.

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 B. Development of Topics: The value maximization framework is useful for
characterizing actual managerial decisions and for developing rules that can be
used to improve those decisions.

1. The basic test of the value maximization model, or any model, is its ability
to explain real-world behavior.

2. This text highlights the complementary relation between theory and

practice.

a. Theory is used to improve managerial decision making, and

practical experience leads to the development of better theory.

1 The profit-maximizing level of output occurs where:

a. marginal cost equals average cost.
b. marginal revenue equals zero.
c. total profit equals zero.
d. marginal cost equals marginal revenue.
2. Marginal profit is:
a. total revenue minus total cost.
b. the change in profit caused by a given managerial
decision.
c. the profit earned by the firm over a brief period of time.
d. the change in profit that results from a unitary change in
output.
3. Average cost will fall as output expands so long as:
a. marginal revenue is less than average revenue.
b. marginal cost equals zero.
c. marginal cost is less than average cost.
d. fixed costs equal zero.
4. If total revenue falls as output increases, marginal revenue:
a. is greater than average revenue.
b. is greater than marginal cost.
c. is negative.
d. equals zero.
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5. If TR = $500Q - $2Q2,
a. MR = $500 - $2Q.
b. MR = $500 - $4Q.
c. MR = $500Q - $2
d. MR = $500 - $4
6. The slope of a total profit curve indicates:
a. an inflection point.
b. average profit at that point.
c. marginal profit at that point.
d. total profit at that point.
7. If marginal cost equals average cost:
a. marginal cost is rising.
b. average cost is minimized.
c. marginal cost is falling.
d. marginal cost always equals zero.
8. If marginal revenue is less than average revenue, the:
a. total revenue curve is downward sloping.
b. demand curve is downward sloping.
c. average revenue curve is upward sloping.
d. marginal revenue curve is downward sloping.
9. Profit-maximizing firms always:
a. sell at lower prices than revenue-maximizing firms.
b. sell less output than revenue-maximizing firms.
c. set marginal cost equal to average cost.
d. none of these.
10. At the profit-maximizing activity level:
a. marginal cost is rising.
b. marginal revenue is falling.

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 c. marginal cost is falling.
d. none of these.

ANSWERS
Question 1: The profit-maximizing level of output occurs where:
Correct Answer: d

Question 2: Marginal profit is:

Correct Answer: d

Question 3: Average cost will fall as output expands so long as:

Correct Answer: c

Question 4: If total revenue falls as output increases, marginal revenue:

Correct Answer: c

Question 5: If TR = \$500Q - \$2Q2,

Correct Answer:

Question 6: The slope of a total profit curve indicates:

Correct Answer: c

Question 7: If marginal cost equals average cost:

Correct Answer: b

Question 8: If marginal revenue is less than average revenue, the:

Correct Answer: b

Question 9: Profit-maximizing firms always:

Correct Answer: b

Question 10: At the profit-maximizing activity level:

Correct Answer: d

CHAPTER NO 01
1. Economic profits rise with an increase in:
a. prices.
b. owner-supplied labor.

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 c. owner-supplied capital.
d. interest rates.

2. Compensatory profit theory describes above-normal profits due

to:
a. barriers to entry that limit competition.
b. anticompetitive practices.
c. efficient operations.
d. unanticipated changes in product demand or cost
conditions.
3. Managerial economics:
a. is not applicable to the not-for-profit sector.
b. helps managers identify choice alternatives.
c. helps managers identify organization goals.
d. cannot be used to identify the appropriate scale of
operation.
4. The value of the firm rises with an increase in:
a. wages.
b. interest rates.
c. prices.
d. risk.
5. Satisficing behavior is most common:
a. in vigorously competitive markets.
b. when institutional shareholders are vigilant.
c. when economic profits are low.
d. in markets sheltered from competition.
6. Sales revenue divided by total assets is the:
a. total asset turnover ratio.
b. return on assets.
c. return on stockholders' equity.
d. profit margin.

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7. Holding all else equal, the return on stockholders' equity will rise
with a decline in:
a. the book value of stockholders' equity.
b. economic profits.
c. accounting net income.
d. prices.
8. Unconstrained value-maximizing behavior does not include
consideration of:
a. the costs of owner-supplied inputs.
b. externalities.
c. information costs.
d. explicit costs.
9. Interest payments are an:
a. explicit cost.
b. economic rent.
c. entrepreneurial profit.
d. implicit cost.
10. Regulation of business has the potential to yield economic
benefits to society by:
a. increasing positive and negative externalities.
b. increasing the availability of substitutes.
c. restricting entry.
d. mandating economies of scale.

For Your Sake, I Live With My Lips Sealed.

Tere Liye, Ham Hain Jiye, Har Aansoo Piye

For Your Sake, I Live, Swallowing All My Tears.

Dil Mein Magar, Jalte Rahe, Chaahat Ke Diye

But In My Heart, The Lamp Of Love Continues To Burn

Tere Liye, Tere Liye

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For Your Sake, For Your Sake

Tere Liye, Ham Hain Jiye, Har Aansoo Piye

For Your Sake, I Live, Swallowing All My Tears.

Tere Liye, Ham Hain Jiye, Honton Ko Siye

For Your Sake, I Live With My Lips Sealed.

Dil Mein Magar, Jalte Rahe, Chaahat Ke Diye

But In My Heart, The Lamp Of Love Continues To Burn

Tere Liye, Tere Liye

For Your Sake, For Your Sake

Aa......
Zindagi, Le Ke Aayi Hai, Beete Dinon Ki Kitaab -2

Life Has Brought With It The Chronicle Of Days Past.

Ghere Hain, Ab Hamein, Yaadein Be-hisaab

Incomparable Memories Surround Us Now.

Bin Poochhe, Mile Mujhe, Kitne Saare Jawaab

Without Asking, I Received So Many Answers!

Chaaha Tha Kya, Paaya Hai Kya, Hamne Dekhiye

Look At What I Desired, And What, In Turn, I Received.

Dil Mein Magar, Jalte Rahe, Chaahat Ke Diye

But In My Heart, The Lamp Of Love Continues To Burn

Tere Liye, Tere Liye

For Your Sake, For Your Sake

Kya Kahoon, Duniya Ne Kiya, Mujh Se Kaisa Bair -2

What Can I Say? The World Has Shown Such Ill-will To Me.

Hukam Tha, Main Jiyun, Lekin Tere Baghair

I'm Commanded To Live Life, But Without You.

Naadaan Hai Woh, Kehte Hain Jo, Mere Liye Tum Ho Ghair

How Ignorant They Are, Who Say You Are A Stranger To Me.

Kitne Sitam, Hampe Sanam, Logon Ne Kiye

How Many Wrongs We Have Been Done, My Love!

Dil Mein Magar, Jalte Rahe, Chaahat Ke Diye

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But In My Heart, The Lamp Of Love Continues To Burn

Tere Liye, Tere Liye

For Your Sake, For Your Sake

Tere Liye, Ham Hain Jiye, Honton Ko Siye

For Your Sake, I Live With My Lips Sealed.

Tere Liye, Ham Hain Jiye, Har Aansoo Piye

For Your Sake, I Live, Swallowing All My Tears.

Dil Mein Magar, Jalte Rahe, Chaahat Ke Diye

But In My Heart, The Lamp Of Love Continues To Burn

Tere Liye, Tere Liye

For Your Sake, For Your Sake

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