01 Chapterrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrrr.ppt

mz

1. AN INTRODUCTION TO
MANAGERIAL ECONOMICS
AND THEORIES OF FIRM
UNIT 1

2. AN INTRODUCTION TO
MANAGERIAL ECONOMICS AND
THEORIES OF FIRM
Syllabus of this Unit
a.Concept and scope of managerial economics, Managerial
economics and business decision-making. D
b.Business profit and economic profit.
c.Theories of firm: Profit maximization, Value
maximization, Sales revenue maximization,
Williamson’s model of managerial discretion.
Learning Objectives
On completion of this unit, students will be able to:
•understand the concept and scope of managerial economics
•explain the role of managerial economics in the business
decision making
•describe about the business profit and economic profit
•analyse various theories of firm like Profit Maximization,
Value Maximization, Sales Revenue Maximization, and
Williamson's Model of Managerial Discretions.

3. Introduction
Economicsisthestudyofhowindividualsandsocietieschoosetoutilisescarce
resourcestosatisfytheirunlimitedwants.Thesewantsencompassallthegoods
andservicesthatindividualsdesireincludingfood,clothing,shelter,and
anythingthatenhancesthequalityofhumanlife.

4. Concept of Managerial Economics
•Althoughthesystematicstudyofeconomicswasstartedfrom18
th
century,
thehistoryofdevelopmentofmanagerialeconomicsisnotsolong.Itwas
bornduringthe1950s.
•Managerialeconomicsapplieseconomictheoriesandmethodstobusiness
andmanagerialdecisionmaking.

5. Definition of Managerial Economics
•Managerialeconomicsisthebranchofeconomicswhichdealswiththe
applicationofeconomictheoriesandmethodsforbusinessandmanagerial
decisionmakingofafirm.
•Managerialeconomicsis,thus,apartofeconomicknowledgeandeconomic
theorieswhichisusedasatoolofanalysingbusinessproblemsforrational
decisionmaking.Managerialeconomicsisalsocalledbusinesseconomicsor
economicsoffirm.

6. Definition of Managerial Economics cont.
•According to Edwin Mansfield, "Managerial economics is concerned with application of
economic concepts and economic analysis to the problem of formulating rational economic decision."
•According to Joel Dean, “The purpose of managerial economics is to show how economic
analysis can be used in formulating business policies.”
•In the words of Dominick Salvatore, "Managerial economics refers to the applications of
economic theory and tool of analysis of decision science to examine how an organization can
achieve its aim or objective most efficiently."
•According to J.L. Pappas andHirscheyM.,"Managerial economics is the application of
economic theory and methodology to business administration practice. More specifically, managerial
economics is the use of tools and techniques of economic analysis to analyse and solve managerial
problems."

7. Definition of Managerial Economics cont.
From the above definitions, we can draw following conclusion:
•Managerial economics is a branch of economics.
•The term managerial economics can be used in place of business economics.
•Managerial economics integrates the economic theories with business practices.
•Managerial economics is the science of decision making.
•Managerial economics has both descriptive and prescriptive roles.
•Managerial economics predicts the consequences of decisions made by the firms.

8. Features of Managerial Economics
On the basis of meaning and definition, the features or characteristics of managerial
economics can be explained. The major features of managerial economics are as follows:
1.Based on microeconomics
2.Normative and prescriptive nature
3.Pragmatic
4.Uses of theory of firm
5.Use of macroeconomics
6.Integration of economics and business practice

9. Scope of Managerial Economics
Managerial economics is relatively a new field of study in economics. So there are some
contradictions among the economists regarding its scope. In general, the scope of managerial
economics covers following field of studies:
1.Demand analysis and forecasting
2.Theory of production and cost analysis
3.Price theory or theory of exchange
4.Theory of profit
5.Theory of capital and investment
6.Business environment

10. Role/ Importance/ Uses of Managerial
Economics in Business Decision Making
The major role or importance or uses of managerial economics can be
explained as follows:
1.Foundation of business decision making
2.Estimating economics relationship
3.Useful to understand business environment
4.Useful for pricing decision
5.Prediction of relevant economic quantities

11. Concept of Profit
Profit is reward of the entrepreneur, in the same sense as wage is reward to the
labour; rent is reward to the land and interest is reward to the capital. It is paid
for effort, skill, risk and innovations of the entrepreneur.
•According to C.H. Petersen and W.C. Lewis, "Profit is defined as the revenue
minus cost."
•According to Edwin Mansfield, "When economists speak up profit over and above
what the owner's labour and capital employed in the business could earn elsewhere."

12. Business Profit and Economic Profit
ConceptofExplicitCost,ImplicitCostandEconomicCost
Explicitcost:Explicitcostisdefinedasthepaymentmadebyafirmforthe
useofinputspurchasedorhiredfromoutsideorothers.Inotherwords,itis
thecostofinputswhichrequiresonexpenseofmoneybythefirm.
Implicitcost:Implicitcostisdefinedasthevalueoffactorsorinputsowned
andusedbythefirmortheentrepreneuronitsownproductionprocess.
EconomicCost:Economiccostisthesumofimplicitandexplicitcost.

13. Business Profit and Economic Profit cont.
BusinessProfit:Businessprofitistheexcessoftotalrevenueover
theexplicitcostoraccountingcost.Inthebusinesssense,business
profitistheexcessoftotalrevenueoverthetotalcostofproduction.
Businessprofitisalsoknownastheaccountingprofit.
Business Profit (Accounting Profit) = Total Revenue –
Explicit Cost = Total Revenue –Accounting Cost

14. Business Profit and Economic Profit cont.
EconomicProfit:Economicprofitistheexcessoftotalrevenueovertheeconomic
cost.Economiccostisthesumofimplicitcostandexplicitcost.Itmeansthat
economiccostincludesbothvisiblecostandinvisiblecost.
Economic Profit = Business Profit –Implicit Cost
Or
Economic Profit = Total Revenue –Economic Cost
= Total Revenue –(Implicit Cost + Explicit Cost)
= Total Revenue –Implicit Cost –Explicit Cost

15. Functions of Profit
Theimportantfunctionsofprofitcanbeexplainedasfollows:
1.Incentive for expansion
2.Measure of performance
3.Ensuring supply of future capital
4.Attracting new investor
5.Research and development
6.Operation of free market economy

16. Theories of Firm
Afirmisanorganizationthatcombinesandorganizesresourcesforthepurposeof
producinggoodsandservices.Inotherwords,itisanindependentunitproducing
goodsandserviceforsale.Firmsexistbecausetheyareusefulintheprocessof
producinganddistributinggoodsandservices.Theobjectivesandtheoriesofthefirm
arediscussedbelow.
•Profit Maximization Objective/ Theory of Firm
•Value Maximization Theory / Model
•Sales Revenue Maximization Theory or Objective of the Firm
•Williamson’s Model of Managerial Discretion

17. Profit Maximization Objective/
Theory of Firm
Theprofitmaximizationobjectiveortheoryoffirmwasdevelopedbyclassicaleconomists.
Theyregardedprofitmaximizationasthemostimportantobjectiveofthefirm.Theattempt
ofanentrepreneurtomaximizeprofitisregardedastherationalbehaviour.
Assumptions
•The firm has only one objective, i.e. profit maximization.
•Only one commodity is produced by the firm.
•There is existence of imperfect competition in the market.
•The investor himself is manager of the firm.
•The entrepreneur is rational.

18. Profit Maximization Objective/
Theory of Firm cont.
Therearetwoapproachestoexplaintheprofitmaximizationobjectiveofthefirm
whichareexplainedbelow.
1. Total Revenue and Total Cost Approach (TR-TC Approach)
Profit is the difference between total revenue and total cost. Profit is maximized when
difference between total revenue (TR) and total cost (TC) is maximum. Symbolically,
= TR –TC
where
= Profit
TR = Total revenue
TC = Total cost

19. Profit Maximization
Objective/
Theory of Firm cont.
TR TC approach can be explained by
the help of given Figure 1-1:
TR
TC
Q
3
Q
2Q
1
A

BM
N
Loss
Maximum
Profit
E
Loss
Profit
Loss
LossO
X
Y
Cost and Revenue
Quantity
Figure 1-1: Total Revenue and Total Cost Approach
(TR-TC Approach)

20. Profit Maximization Objective/
Theory of Firm cont.
2. Marginal Revenue and Marginal Cost Approach (MR-MC Approach)
According to the marginal revenue and marginal cost approach, the firm attains equilibrium or
maximizes profit when following two conditions are fulfilled:
i. MR = MC
ii. MC must intersect MR from below (slope of MC > slope of MR).

21. Profit Maximization
Objective/
Theory of Firm cont.
TheMR-MCapproachcanbeexplainedby
thehelpofFigure1-2.
Inthefigure,
TR=OQBP
TC=OQAC
Profit()=TR–TC
=OQBP–OQAC
=ABPC
Figure 1-3: Marginal Revenue and Marginal Cost Approach
(MR MC Approach)
MC
AC
AR
MR
Q
C
B
P
A
E
Quantity
Cost, Revenue
and Profit
Y
X
O
M
Profit

22. Profit Maximization Objective/
Theory of Firm cont.
Criticisms/Limitations
1.Not a practical theory
2.No uniform definition of profit
3.Static model
4.Risk and uncertainty
5.Owner itself cannot be manager
6.Lack of precision
7.Ignores time value of money

23. Profit Maximization Objective/
Theory of Firm cont.
AppropriatenessofProfitMaximizationObjective/TheoryofFirm
•Business activities rationally aim profits.
•Profit is essential for the existence and operation of the firm.
•It can maximize social and economic welfare.
•Profit is necessary to enjoy capital markets.
•Profit is necessary to provide high benefit package for employees.
•Profit offers more dividends in the short run.

24. Value Maximization Theory / Model
Valuemaximizationtheoryisalsoknownasthewealthmaximizationtheory.This
theorywasdevelopedasanalternativetotheprofitmaximizationtheoryduetoits
weaknessesorlimitations.Valuemaximizationisthelongrunobjectiveofthefirm
thatguidesresourceallocationdecisionsofthefirmsoastomaximizeshareholder's
wealthorvalueofthefirm.
•According to L.J. Gitman, “Since share price represents owner’s wealth in the firm, share
price is consistent with owner’s wealth maximization”
•In the words of Solomon and Pringle, “When time period is short and uncertainty is not
much, profit maximization and value maximization are same.”

25. Value Maximization Theory cont.
Theconceptofvaluemaximizationcanbeillustratedasbelow:
Discountrateofinterestisdeterminedby:
(i) Riskanduncertaintyfacedbythe
firm
(ii) Conditionsinfinancialmarket
Streamofexpectedfutureprofitsorrevenuesgeneratedwhich
dependon:
(i) Demandfunctionandmarketingstrategiesofthe
firm.
(ii) Costswhicharedeterminedbyproduction
technology,natureofcostfunctionandpricesofinputs
Value of a Firm (PV)

26. Value Maximization Theory cont.
•

27. Value Maximization Theory cont.
Superiority of Value Maximization Theory
The value maximization or wealth maximization model of the firm removes two major defects
of the profit maximization objectives, which are as follows:
•Profit maximization objective is failure to incorporate the time dimension in the decision
process.
•Profit maximization objective is failure to deal explicitly with the risk and uncertainty in
decision-making.

28. Value Maximization Theory cont.
For these reason’s profit maximization has become a static objective. The value
maximizing equation gives both the requirements, which are as follows:
•It considers time dimensions by incorporating in the equation net discounted
earnings during the future periods at a certain required rate of return.
•It also perceives and considers the element of differential risk associated with
alternative projects by adjusting the required rate of return. Both, financial
conditions and the level of inflation are taken into account while
determining such a rate of return.

29. Value Maximization Theory cont.
Constraint on Value Maximization Objective (Limitations)
A large variety of constraints can arise in managerial decision problem, most fall within
following four broad categories:
1.Resource constraints
2.Contractual requirements
3.Legal constraints
4.Implicit constraints

30. Sales Revenue Maximization Theory or
Objective of the Firm
The sales revenue maximization model was developed by W.J. Baumolin 1958. This theory is
an important alternative theory of firm's behaviour. According to this theory, firms seek to
maximize sales revenue rather than maximizing profit. Baumolalso argues that firms need to
earn minimum profit in order to spend on expansion plans and provide dividend to the
shareholders.
Rational for Sales Revenue Maximization
•The reasons which explain rational for sales revenue maximization objective are as follows:
•There is evidence that salaries and other slack earnings (payment above minimum necessary)
of top managers are correlated more closely with sales than profits.

31. Sales Revenue Maximization Theory or
Objective of the Firm cont…
•Personal problems can be handled more satisfactorily when sales are growing.
•Larger sales growing over time given prestige to the managers, while large profits go into the
pockets of shareholders.
•Managers find profit maximization a difficult objective to fulfil consistently over time and at
the same level. Profit may fluctuate with changing conditions.
•Large and growing sales strengthen the power of the firm to adopt the competitive tactics.
•Increased sales revenue increase competitive capacity of managers in the market.

32. Sales Revenue Maximization Theory or
Objective of the Firm cont.
Assumptions
•The sales revenue maximization objective is based on the following assumptions:
•The time horizon of a firm is a single period.
•During this time period, the firm attempts to maximize the total sales revenue subject to
profit constraint.
•Firms earn minimum profit to keep shareholders happy and prevent the fall in share price.
•The market is imperfectly competitive.
•The demand curve is downward slopping and average cost curves are U-shaped.

33. Profit Maximization
Objective/
Theory of Firm cont.
Thesalesrevenuemaximizationmodel
canbeexplainedbythehelpof
Figure1-3.
Figure 1-3: Sales Revenue Maximization Model
TR
TC
Q
3
Q
1

M
N
A
C D
G

4(Profit under profit maximization)

2(Optimum profit constraint)

1(Non-operative profit constraint)
Revenue, Cost and Profit
Quantity
X
Y
O
R
1
R
2
B

3(Operative profit constraint)
Q
2

34. Sales Revenue Maximization Theory or
Objective of the Firm cont.
This model or theory can be explained under the two cases: sales revenue maximization without
profit constraint and sales revenue maximization with profit constraint.
Case 1: Sales Revenue Maximization without Profit Constraint
If there is no profit constraint or shareholders of the firm do not demand any type of profit, the
manager will produce and sell OQ
3quantity of output. At this output, total revenue is OR
2which
is the maximum revenue and total profit is CQ
3.

35. Sales Revenue Maximization Theory or
Objective of the Firm cont.
Case 2: Sales Revenue Maximization with Profit Constraint
Under the profit constraint case, there are three situations which are as follows:
i.If minimum profit constraint imposed by shareholders is 
2, the manager will sell OQ
3
output, where total revenue is maximum. This is known as the optimum profit constraint.
ii.If minimum profit constraint imposed by shareholders is 
3, the manager will sell OQ
2
output. This is known as the operative profit constraint.
iii.If minimum profit constraint is 
1, the manager will sell OQ
3output. This is known as the
non-operative profit constraint.

36. Sales Revenue Maximization Theory or
Objective of the Firm cont.
Criticisms/ Comments/ Limitations
The criticisms or limitations of sales revenue maximization theory developed by W.J. Baumolare
as follows:
1.Hypothesis cannot be tested
2.No differences between sales revenue maximization and profit maximization
3.Relationship between firm and industry
4.Core problem of uncertainty
5.Implicit assumption
6.Logic of social welfare is not true

37. Williamson’s Model of Managerial
Discretion
The model of managerial theory of the firm presented by O.E. Williamsonis known as the
Williamson's Model of Managerial Discretion. This model was presented by Williamsonin
1963 in his article 'Managerial Discretion and Business Behaviour'published in 'American
Economic Review'.
Williamsonargues that managers are motivated by their self-interest and they try to maximise
their utility or satisfaction which depends upon the various items like salary, bonus, prestige,
security, status, etc. in the firm.

38. Williamson’s Model of Managerial
Discretion
Thesecanbegainedbyadditionalvaluesofexpenditureonstaff(S),managerialemoluments(M),
anddiscretionaryinvestment(I
D).Itisalsoarguedthattheseprovideadditionalutility,anditis
utility'U'whichmanagersaimtomaximize.Themanager'sutilityfunctioncanbeexpressedas
MaximizeU=f(S,M,I
D)

39. Williamson’s Model of
Managerial Discretion
cont.
Williamson'smodelofmanagerial
discretioncanalsobeexplainedbythe
helpofFigure1-6.
Figure 1-4: Williamson's Model of Managerial Discretion
U
1
U
2
U
3
S
maxS
E
–s Curve
D
E
O
X
Y
Staff Expenditure
Discretionary Profit
E
b
D
M

40. Williamson’s Model of Managerial
Discretion cont.
Criticisms / Limitations
The criticisms of Williamson'smodel of managerial discretion are as follows:
1.This model or theory does not explain the problems of interdependence of firms under the
oligopolistic competition.
2.This model or theory applies only when rivalry among the firms is not so strong.
3.This model has underestimated the concept of profit maximization because this theory says
that managerial utility is impossible to maximize if economic profit is maximized by the firm.
4.There is no adequate evidence to evaluate this theory.

41. Superiority of Williamson’s Model of
Managerial Discretion over the Profit
Maximization Model
The Williamson’s model of managerial discretion is regarded superior over the profit maximization
model. The reasons behind this are as follows:
1.The profit maximization model of the firm is based on only one objective of profit maximization
whereas Williamson’s model of managerial discretion is based on the multiple objectives of
satisfying managers, consumers, workers as well as shareholders.
2.The profit maximization theory is based on the unrealistic assumptions whereas Williamson’s
theory of managerial discretion is based on relatively realistic assumptions.
3.The structure of modern corporate business, i.e. separation of ownership and management may
divert interest of managers maximizing profit to maximizing their own welfare. This realistic
concept has not been considered by the profit maximization theory.
4.The Williamson’s model of managerial discretion is full-fledged managerial theory whereas profit
maximization model is not full-fledged managerial theory.

42. EXERCISE 1
TwoformerMBSstudentsworkedintheworldBankatasalaryRs.30,00,000eachforoneyear
aftertheygraduated.Afterayeartheydecidedtoquittheirjobandstartedaresearchinstitute.They
usedRs.15,00,000tooverheads(i.e.computer,furniture,etc.)Forthenextyear,theytook
Rs.150,00,000inrevenueeachyearandpaidfiveresearchassistantsRs.10,00,000annuallyeachand
rentedanofficeforRs.10,00,000peryearwithmiscellaneousexpensesRs.5,00,000peryear.
a.Defineaccountingcostandeconomiccost.
b.Computeaccountingprofitandeconomicprofit.Shouldtheyremaininresearchinstituteafter
theyeariftheyareindifferentbetweenworkingforthemselvesorotherinasimilarcapacity?
[2014Semester]

43. SOLUTION
b. Calculation of Accounting Profit and Economic Profit
Since, economic profit is positive, they should remain in the research institute.
Particular Amount (Rs.) Amount (Rs.)
Total revenue (TR) 150,00,000
Less: Explicit costs/Accounting costs
Overhead costs
Wages and Salaries of previous job
Rent
Miscellaneous Expenses
15,00,000
50,00,000
10,00,000
5,00,000 80,00,000
Business/Accounting Profit 70,00,000
Less:Implicit cost/ Opportunity cost (Salary) 60,00,000 60,00,000
Economic Profit 10,00,000

44. Alternative Method
Given
Total revenue (TR) = Rs. 15000000 Overhead costs = Rs. 1500000
Wages and salaries = Rs. 5000000 Rent = Rs. 1000000
Miscellaneous expenses = Rs. 500000
Explicit cost /Accounting cost =Overhead cost + Wages and Salaries + Rent + Miscellaneous
Expenses
=1500000 + 5000000 + 1000000 + 500000
= Rs. 8000000
Accounting/Business profit = Total Revenue Explicit /Accounting cost
= 15000000 8000000
= Rs. 7000000
Implicit cost (Opportunity cost)= Salary of the previous job
= Rs. 6000000
Economic profit = Accounting /Business profit Implicit cost
= 7000000 6000000
= Rs. 1000000
Since, economic profit is positive, they should remain in the research institute.

45. EXERCISE 2
Letdemandfunction:P=1004Q,costfunction:TC=50+6Q
2
.Computeprofitmaximizing
output,price,TRandmaximumprofit. [2015Semester]
SOLUTION
Given
Demand function: P = 100 4Q
Cost function: TC = 50 + 6Q
2
We know that,
TR = P Q
= (100 4 Q) Q
= 100Q 4Q
2
Profit () = TR TC
= 100Q 4Q
2
(50 + 6Q
2
)
= 100Q 4Q
2
50 6Q
2
= 50 + 100Q 10Q
2

48. P = 20 Q
= 20 10
= Rs. 10
TR = P Q
= 10 10
= Rs. 100
Profit ()= TR TC
= 100 (Q
2
+ 8Q + 2)
= 100 (10
2
+ 8 10 + 2)
= 100 (100 + 80 + 2)
=100 182
= 82 (loss)
Hence
Revenue or sales maximizing output (Q) = 10 units
Revenue maximizing price (P) = Rs. 10
Profit () = –Rs. 82 (Loss)
Total revenue (TR) = Rs. 100

49. EXERCISE 7
TamakoshiElectronics Limited has following demand and cost functions:
P = 2000 –10Q (demand function)
C = 1000 + 200 Q (cost function)
Calculate the price, P; output, Q; total profit, ; and total revenue, R of the firm under the objective
of
a.Profit maximization
b.Sales revenue maximization, and
c.Sales revenue maximization subject to a profit constraint of Rs. 79,500.
SOLUTION
Given
Demand function: P = 2,000 –10Q
Cost function: C = 1,000 + 200Q

53. Since, objective of firm is revenue maximization
when, Q = 97.07 units
TR = 2000 Q –10Q
2
= 2000 ×97.07 –10 ×97.07
2
= Rs. 99914.15
when, Q = 82.93 units
TR = 2000 Q –10Q
2
= 2000 ×82.93 –10 ×82.93
2
= Rs. 97086.15
TR at Q = 97.07 is greater than TR at Q = 82.93
Hence Q = 97.09 units is maximum output.
P = 2000 –10Q
= 2000 –10 ×97.07
= Rs. 1029.3
Hence total revenue (TR) = Rs. 99,914.15
Output (Q) = 97.07 units
Price (P) = Rs. 1,029.3

54. Thank You