1.0 introduction to managerial economics

1.0 introduction to managerial economics

1. MANAGERIAL ECONOMICS (ECO 556) CHAPTER 1 INTRODUCTION TO MANAGERIAL ECONOMICS PREPARED BY: DR MASTURAH MA’IN 1

2. INTRODUCTION TO MANAGERIAL ECONOMICS DEFINITION Application of economic theory and tools of analysis of decision science tools to solve managerial decision problems. -Application of economic concepts to business problems -It applies economic models and reasoning in making managerial decisions. -Managerial economics identifies ways to efficiently achieve the organization’s goals. -Firm is one of the economic units. Hence, it can be analyzed in the context of economic models. 2

3. Management Decision Problem Economic Theory Decision Science 3 Microeconomics Macroeconomics Numerical analysis Statistical estimation Forecasting Optimization Managerial economics Optimal Solutions

4. RATIONALE FOR THE FIRM OBJECTIVE OF THE FIRM a) Maximize profit Profit= Revenue – cost b) Maximize revenue c) Minimize Cost d) Maximize output Many constrains exist that may influence the decision making of firm. The constraints include: Legal Financial Contractual Technological Decision making means choosing one of the best alternative from several alternatives Managers must evaluate the implications of alternatives and chooses the best alternative. There are various areas involve in decision making Marketing- Maximize sales Production-Minimize cost or maximize output Overall Management-maximize profit Decisions are based on limitations 4

5. IMPORTANCE OF MANAGERIAL ECONOMICS Guidance for business decision making To solve managerial problems and the theory can be applied to mgt decisions in private and public sectors of the economy (e.g of decisions-selection of goods and services, choice of production methods, determine price and output,etc) Provide mgt with a strategic planning tool Offer decision makers a way of thinking about changes and framework for analyzing the consequences of strategic options 5

6. FIRM IN MACROECONOMIC ANALYSIS (CIRCULAR FLOW DIAGRAM) 6 ProductMarket Resource Market Firm Household G&S Resources Costs Revenue

7. Basic training Functional relation and economic model Function- shows how one or more independent variables can be transformed into, or associated with a dependent variable. e.g Y- dependent variable X1,X2,X3 -independent variables A change in X1,X2,X3 causes a change in Y. e.g Total revenue depends on output TR=f(Q) Basic economic relations can be shown through: -Table- list of economic data -Graph-Visual representation of data -Equation-analytical expression of functional relationship. TYPES OF FUNCTIONS Linear Function Y= a+ bX a-intercept b-Slope/coefficient 7

8. ii) Quadratic function ax 2 + bx + c = 0 iii) Cubic function e.g TC = 100 + 20 Q – 5Q 2 + Q 3 iv) Power Functions e.g Y = ax b METHODS OF DIFFERENTIATION First Derivative Derivative of a function (e.g dy/dx) -Measure of its slope or marginal value at a particular point. -Measure the marginal change in Y asssociated with a a very small change in X at that point. e.g Dependent variable- Y Independent variable- X Derivative: dy/dx 8

9. RULES OF DERIVATIVE 1. Derivative of a constant e.g Y= 20 dy/dx = 0 2.Derivative of a constant times a function Y = a f(X) e.g Y = 3x dy/dx = a f’(X) dy/dx = 3 3. Derivative of a power function Y = ax b e.g y=4x 2 dy/dx = b a X b-1 dy/dx= 8x 4. Derivative of a sum or difference Y = f(X) + g(X) y = 2 x + 4x 3 dy/dx= f’(X) + g’(X) dy/dx= 2 + 12 x 2 5. Derivative of the product of two functions Y= f(X) g(X) dy/dx =f’(X) g(X) + f(X) g’(X) y= (x 2 + 2x) (4x) dy/dx= (2x + 2) (4x) + (x 2 + 2x) (4) = 8x 2 + 8x + 4x 2 + 8x = 12 x 2 + 16x 9

10. 6. Derivative of a quotient of 2 functions Y= f(x) /g(x) dy/dx = g(x)f’(x) – f(x) g’(x) [g(x)] 2 e.g y = 2x 2 –5x x 2 dy/dx = 5 x 2 Derivative of a function of a function (Chain Rule) e.g y = (4x +2) 4 u= (4x +2) y =u 4 dy/dx=(dy/du) (du/dx) = 4u 3 4 =4(4x +2) 3 4 =16 (4x +2) 3 10

11. SECOND DERIVATIVE To distinguish maximum or minimum points of a function. Derivative of first derivative The rate of change of the rate of change. If negative- the rate of change is falling If positive- the rate of change is increasing Rule: Maximum - Second derivative is negative If total function is maximized, marginal function has a negative slope dy/dx= 0 d 2 y/dx 2 < 0 occurs if the slope passes through 0, changing from positive to negative y dy/dx =0 11 dy/dx >0 dy/dx <0

12. ii) Minimum - Second derivative is positive Total function is associated with a positive slope of marginal function dy/dx = 0 d 2 y/dx 2 > 0 Occurs if the slope passes through 0, changing from negative to positive. PARTIAL DERIVATIVE To show the change in Y as a result of a change in one of the independent variable while holding other variables constant 12 dy/dx=0 dy/dx>0 dy/dx<0 y x

13. To see the marginal effect of each independent variable on dependent variable. When the function has more than one independent variable, we will use partial derivative to see how each of the independent variable affect the value of dependent variable. E.g Total profit,  = 60 x- 2x 2 -xy – 3y 2 =100y d /dx = 60 –4x –y = 0 d /dy= -x-6y =100 OPTIMIZATION TECHNIQUE Objective of the firms – Maximize profit Maximize revenue or sales Minimize cost Maximum or minimum values of functions- marginal value or derivative is zero Two methods in the optimization: Without Constraint Maximize or minimize without having any constraint or limitation e.g TR = 45Q – 0.5Q 2 d(TR)/d Q = 45-Q=0 Q =45 13

14. b) Constrained Optimization Maximize or minimize the function subject to some constraint. E.g maximize output subject to limitations on quantity of resources Minimize total cost subject to output constraint Maximize total utility subject to income constraint e.g TC = 4x 2 + 8y 2 –2xy Constraint= x + y = 28-------- x+ y –28 = 0 Lagrangian function : LTC =4x 2 + 8y 2 –2xy -  (x+ y –28) dTC/dx =8x –2 y -  =0 (1) dTC/dy= 16y-2x - =0 (2) dTC/d  = -x-y +28 =0 (3) Solution : x= 18 y= 10 = 124 Interpretation of Lagrangian multiplier() Increase in output constraint by 1 unit, total cost increases by $ 124 14

15. ECONOMIC CONCEPTS Total, average, and marginal relationships 1.Revenue a) Total Revenue (TR)- total number of dollars received by a firm from the sale of a product b) Average Revenue -Total revenue from the sale of product divided by quantity of product sold c) Marginal Revenue -additional revenue received from selling additional unit of output - A change in total revenue associated with one unit change in output TR= PQ AR =TR/Q MR = d(TR)/d Q 2. Costs a)Total Cost(TC)- Sum of fixed costs and variable costs b) Average Costs(AC)- Cost per unit of output c) Marginal Cost- Additional cost for producing an additional unit of A change in total cost associated with one unit change in total cost output 15

16. TC = FC + VC AC =TC/Q MC =d(TC)/ d Q 3. Profit a) Total profit -Total Revenue minus total cost b)Average profit -Profit per unit of outp ut c) Marginal profit -Additional profit from additional unit of output Total profit= TR –TC Average profit=Total profit/Q Marginal profit =(d  ) /d Q In order to maximize profit, Q = ? 2 methods: Aggregate Approach : dprofit / dQ = 0 Marginal Approach : MR = MC 16