MANAGERIAL

ECONOMICS
By: RUEL D. SABALBERINO
Instructor I
Amcott Loses $3.5 Million;
Manager Fired
On Tuesday software giant posted a year-ending operating loss of $3.5 million. Reported,
$1.7 million of the loss stemmed from its foreign language division.
With short-term interest rates at 7 percent, Amcott decided to use $20 million of its
retained earnings to purchase three-year rights to Magicword, a software package that converts
generic word processor files saved as French text into English. First-year sales revenue from
the software was $7 million, but thereafter sales were halted pending a copyright infringement
suit by Foreign, Inc. Amcott lost the suit and paid damages of $1.7 million. Industry insiders say
that the copyright violated pertained to “a very small component of Magicword.”
Ralph, the Amcott manager who was fired over the incident, was quoted as saying “Ï’m a
scapegoat for the attorneys who didn’t do their homework before buying the rights to Magicword.
I projected annual sales of $7 million per year for three years. My sales forecasts were right on
target.”
Do you know why Ralph was fired?
Managerial Economics – is the study of how to
direct resources in the way that most efficiently
achieves a managerial goal.

Manager – is a person who directs resources to

achieve a stated goal.

Economics – the science of making decisions in

the presence of scarce resources.
Functions of Management
1. Planning
“Planning is the continuous process of making present entrepreneurial decisions
systematically and with best possible knowledge of their futurity, organizing systematically
the efforts needed to carry out these decisions and measuring the results of these
decisions against the expectations through organized and systematic feedback”.(Peter
Drucker)
2. Organizing
“To organize a business is to provide it with everything useful for its functioning i.e.
raw material, tools, capital and personnel’s”.(Henry Fayol)
Organizing is concerned with:
1. Identifying the tasks that must be performed and grouping them whenever necessary
2. Assigning these tasks to the personnel while defining their authority and responsibility.
3. Delegating this authority to these employees
4. Establishing a relationship between authority and responsibility
5. Coordinating these activities
3. Staffing

“Managerial function of staffing involves manning the organization

structure through proper and effective selection, appraisal & development of
personnel to fill the roles designed in the structure”. (Kootz & O’Donell)

4. Directing
The directing function is concerned with leadership, communication,
motivation and supervision so that the employees perform their activities in
the most efficient manner possible, in order to achieve the desired goals.

5. Controlling
“Controlling is the measurement & correction of performance activities
of subordinates in order to make sure that the enterprise objectives and
plans desired to obtain them are being accomplished”. (Kootz & O’Donell)
The controlling function involves:
a. Establishment of standard performance.
b. Measurement of actual performance.
c. Measuring actual performance with the pre-determined standard
and finding out the deviations.
d. Taking corrective action.

All these five functions of management are closely interrelated.

However, these functions are highly indistinguishable and virtually
unrecognizable on the job. It is necessary, though, to put each
function separately into focus and deal with it.
The Economics of Effective Management

The nature of sound managerial decisions varies depending on the goals of

the manager. We will focus on managerial decisions as they relate to maximizing
profits, or more generally the value of the firm. But before we deal with this
special use of managerial economics, we must be aware of the basic principles
that comprise effective management. In particular, an effective manager must:
(1) Identify Goals and Constraints;
(2) Recognize the nature and importance of Profits;
(3) Understand Incentives;
(4) Understand Markets;
(5) Recognize the Time Value of Money; and
(6) Use Marginal Analysis.
1. Identify Goals and Constraints
The first step in making sound decisions is to have well-defined goals
because achieving different goals entail making different decisions.
Constraints make it difficult for managers to achieve goals such as
maximizing profits or increasing market share. Constraints are a sign of scarcity.
2. Recognize the Nature and Importance of Profits
The overall goal of most firms is to maximize profits or the firm’s value.
When people think of profit, they think of accounting profits. Accounting profit is
the total amount of money taken in from sales (total revenue minus the cost of
producing goods or services).
Economic profits are the difference between the total revenue and the total
opportunity cost of producing the firm’s goods and services. The opportunity
cost of using a resource includes both the explicit(accounting cost) of the
resource and the implicit cost of giving up the next-best alternative use of the
Implicit costs are very hard to measure and are therefore often overlooked
by managers. Effective managers, however, continually seek out data from other
sources to identify and quantify implicit costs.
The Role of Profits
A common misconception is that the firm’s goal of maximizing profit is
necessarily bad for society. Individuals who want to maximize profits are often
considered self-interested , a quality that many people view as undesirable.
However, consider Adam Smith’s classic line from The Wealth of Nations: “It is
not out of benevolence of the butcher, the brewer or the baker , that we expect
our dinner , but from their regard to their own interest.”
Smith is saying that by pursuing its self-interest---the goal of maximizing
profits---a firm ultimately meet the needs of society. By moving scarce resources
toward the production of goods most valued by society, the total welfare of
society is improved.
Profits signal to resource holders where resources are most valued by
3. Understand Incentives
Within a firm, incentives, affect how resources are used and how
workers work. To succeed as a manager, you must have a clear grasp of
the role of incentives within a firm and to construct incentives to induce
maximal effort from those you manage. The thrust, of managerial
economics is to provide a broad array of skills that enable you to make
sound economic decisions and to structure appropriate incentives within
your organization.
4. Understand Markets
In studying microeconomics in general, and managerial economics in
particular, it is important to bear in mind that there are two sides to every
transaction in a market: For every buyer of a good there is a corresponding
seller. The final outcome of the market process, then, depends on the
relative power of buyers and sellers in the marketplace.
b. Consumer-consumer Rivalry – reduces the negotiating power of
consumers in the marketplace. It arises because of the economic doctrine
of scarcity. When limited number of goods are available, consumers will
compete with one another for the right to purchase available goods.

c. Producer-producer Rivalry – a third source of rivalry in the marketplace.

Given that consumers are scarce, producers compete with one another for
the right to service the customers available.

d. Government and the Market – when agents on either side of the market
find themselves disadvantaged in the market process, they frequently
induce the government to intervene in their behalf .
5. Recognize the Time Value of Money
The timing of many decisions involve a gap between the time when the costs of a
project are borne, and the time when the benefits of the project are received. It is
important to understand that $1 today is worth more than $1 in the future. The reason is
simple: The opportunity cost of receiving $1 in the future is the foregone interest were $1
was received today. This opportunity cost reflects the time value of money.

Present Value – The amount that would be invested today at the prevailing interest rate to
generate the given future value.

PV = FV / (1 + i)n
Where:
PV = Present value of money
FV = Future value of money
i = interest rate (guaranteed)
n = number of years
The basic idea of the present value of a future amount can be
extended to a series of future payment.

Net Present Value – The present value of the income stream generated by
project minus the current cost of the project.

Principle: Maximizing profit means maximizing the value of the firm, which
is the present value of the present and future profits.

6. Use Marginal Analysis

Marginal analysis is one of the most important managerial tools. It
states that optimal managerial decisions involve comparing the marginal (or
incremental) benefits of a decision with the marginal (or incremental) costs.
Determining the Optimal Level of a Control Variable
Control Total Total Net Marginal Marginal Marginal
Variable Benefits Costs Benefits Benefits Cost Net Benefit
(1) (2) (3) (4) (5) (6) (7)
Given Given Given (2)-(3) (2) (3) (5)-(6)
1 90 10 80 90 10 80
2 170 30 140 80 20 60
3 240 60 180 70 30 40
4 300 100 200 60 40 20
5 350 150 200 50 50 0
6 390 210 180 40 60 -20
7 420 280 140 30 70 -40
8 440 360 80 20 80 -60
9 450 450 0 10 90 -80
Marginal Benefit – The change in Total Benefits arising from a change in the managerial control variable.

Marginal Cost – The change in Total Costs arising from a change in the managerial control variable.

Managerial Principle
To maximize net benefits, the manager should increase the managerial control variable to the point where
marginal benefits equal marginal costs. This level of the managerial control variable corresponds to the level at which
marginal net benefits are zero; nothing more can be gained by further changes in that variable.
LEARNING MANAGERIAL ECONOMICS

1. The best way to learn Economics is to practice, practice, and practice

some more. Practicing managerial economics means practicing making
decisions.
2. The terminology in Economics has two purposes:
a. The definitions and formula used by Economists are used for
precision. Economics deal with very complex issues which
economists designed to break down issues into manageable
components.
b. Precise terminology helps practitioners of economics communicate
more efficiently. It will be difficult to communicate if each of us
use words that mean whatever we want them to mean.