Introduction to Managerial Economics Managerial economics (sometimes referred to as business economics) is a branch of economics that applies microeconomic analysis to decision methods of businesses or other management units. As such, it bridges economic theory and economics in practice. It draws heavily from quantitative techniques such as regression analysis and correlation, Lagrangian calculus (linear).
If there is a unifying theme that runs through most of managerial economics it is the attempt to optimize business decisions given the firm’s objectives and given constraints imposed by scarcity, for example through the use of operations research and programming. Almost any business decision can be analyzed with managerial economics techniques, but it is most commonly applied to: * Risk analysis – various models are used to quantify risk and asymmetric information and to employ them in decision rules to manage risk. Production analysis – microeconomic techniques are used to analyze production efficiency, optimum factor allocation, costs, economies of scale and to estimate the firm’s cost function. * Pricing analysis – microeconomic techniques are used to analyze various pricing decisions including transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing the optimum pricing method. * Capital budgeting – Investment theory is used to examine a firm’s capital purchasing decisions. Definition Managerial economics is the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management” Decisions made by managers are crucial to the success or failure of a business. Roles played by business managers are becoming increasingly more challenging as complexity in the business world grows. Business decisions are increasingly dependent on constraints imposed from outside the economy in which a particular business is based—both in terms of production of goods as well as the markets for the goods produced.
The impact of rapid technological change on innovation in products and processes, as well as in marketing and sales techniques, figures prominently among the factors contributing to the increasing complexity of the business environment. Moreover, because of increased globalization of the marketplace, there is more volatility in both input and product prices. The continuous changes in the economic and business environment make it ever more difficult to accurately evaluate the outcome of a business decision. In such a changing environment, sound economic analysis becomes all the more important as a basis of decision making.
Managerial economics is a discipline that is designed to provide a solid foundation of economic understanding in order for business managers to make well-informed and well-analysis managerial decisions. THE NATURE OF MANAGERIAL ECONOMICS There are a number of issues relevant to businesses that are based on economic thinking or analysis. Examples of questions that managerial economics attempts to answer are: What determines whether an aspiring business firm should enter a particular industry or simply start producing a new product or service?
Should a firm continue to be in business in an industry in which it is currently engaged or cut its losses and exit the industry? Why do some professions pay handsome salaries, whereas some others pay barely enough to survive? How can the business best motivate the employees of a firm? The issues relevant to managerial economics can be further focused by expanding on the first two of the preceding questions. Let us consider the first question in which a firm (or a would-be firm) is considering entering an industry.
For example, what led Frederick W. Smith the founder of Federal Express, to start his overnight mail service? A service of this nature did not exist in any significant form in the United States, and people seemed to be doing just fine without overnight mail service provided by a private corporation. One can also consider why there are now so many overnight mail carriers such as United Parcel Service and Airborne Express. The second example pertains to the exit from an industry, specifically, the airline industry in the United States.
Pan Am, a pioneer in public air transportation, is no longer in operation, while some airlines such as TWA (Trans World Airlines) are on the verge of exiting the airlines industry. Why, then, have many airlines that operate on international routes fallen on hard times, while small regional airlines seem to be doing just fine? Managerial economics provides answers to these questions. In order to answer pertinent questions, managerial economics applies economic theories, tools, and techniques to administrative and business decision-making.
The first step in the decision-making process is to collect relevant economic data carefully and to organize the economic information contained in data collected in such a way as to establish a clear basis for managerial decisions. The goals of the particular business organization must then be clearly spelled out. Based on these stated goals, suitable managerial objectives are formulated. The issue of central concern in the decision-making process is that the desired objectives be reached in the best possible manner.
The term “best” in the decision-making context primarily refers to achieving the goals in the most efficient manner, with the minimum use of available resources—implying there is no waste of resources. Managerial economics helps the manager to make good decisions by providing information on waste associated with a proposed decision. APPLICATIONS OF MANAGERIAL ECONOMICS Some examples of managerial decisions have been provided above. The application of managerial economics is, by no means, limited to these examples. Tools of managerial economics can be used to achieve virtually all the goals of a business organization in an efficient manner.
Typical managerial decision making may involve one of the following issues: * Deciding the price of a product and the quantity of the commodity to be produced * Deciding whether to manufacture a product or to buy from another manufacturer * Choosing the production technique to be employed in the production of a given product * Deciding on the level of inventory a firm will maintain of a product or raw material * Deciding on the advertising media and the intensity of the advertising campaign * Making employment and training decisions Making decisions regarding further business investment and the mode of financing the investment It should be noted that the application of managerial economics is not limited to profit-seeking business organizations. Tools of managerial economics can be applied equally well to decision problems of nonprofit organizations. Mark Hershey and James L. Pappas cite the example of a nonprofit hospital. While a nonprofit hospital s not like a typical firm seeking to maximize its profits, a hospital does strive to provide its patients the best medical care possible given its limited staff (doctors, nurses, and support staff), equipment, space, and other resources. The hospital administrator can use the concepts and tools of managerial economics to determine the optimal allocation of the limited resources available to the hospital.
In addition to nonprofit business organizations, government agencies and other nonprofit organizations (such as cooperatives, schools, and museums) can use the techniques of managerial decision making to achieve goals in the most efficient manner. While managerial economics is helpful in making optimal decisions, one should be aware that it only describes the predictable economic consequences of a managerial decision. For example, tools of managerial economics can explain the effects of imposing automobile import quotas on the availability of domestic cars, prices charged for automobiles, and the extent of competition in the auto industry.
Analysis of managerial economics will reveal that fewer cars will be available, prices of automobiles will increase, and the extent of competition will be reduced. Managerial economics does not address, however, whether imposing automobile import quotas is good government policy. This latter question encompasses broader political considerations involving what economists call value judgments. ECONOMIC CONCEPTS USED IN MANAGERIAL ECONOMICS Managerial economics uses a wide variety of economic concepts, tools, and techniques in the decision-making process.
These concepts can be placed in three broad categories: (1) the theory of the firm, which describes how businesses make a variety of decisions; (2) the theory of consumer behavior, which describes decision making by consumers; and (3) the theory of market structure and pricing, which describes the structure and characteristics of different market forms under which business firms operate. THE THEORY OF THE FIRM Discussing the theory of the firm is a useful way to begin the study of managerial economics, since the theory provides a broad framework within which issues relevant to managerial decisions are analyzed.
A firm can be considered a combination of people, physical and financial resources, and a variety of information. Firms exist because they perform useful functions in society by producing and distributing goods and services. In the process of accomplishing this, they use society’s scarce resources, provide employment, and pay taxes. If economic activities of society can be simply put into two categories—production and consumption—firms are considered the most basic economic entities on the production side, while consumers form the basic economic entities on the consumption side.
The behavior of firms is usually analyzed in the context of an economic model, an idealized version of a real-world firm. The basic economic model of a business enterprise is called the theory of the firm. PROFIT MAXIMIZATION AND THE FIRM. Under the simplest version of the theory of the firm it is assumed that profit maximization is its primary goal. In this version of the theory, the firm’s owner is the manager of the firm, and thus, the firm’s owner-manager is assumed to maximize the firm’s short-term profits (current profits and profits in the near future).
Today, even when the profit maximizing assumption is maintained, the notion of profits has been broadened to take into account uncertainty faced by the firm (in realizing profits) and the time value of money (where the value of a dollar further and further in the future is increasingly smaller than a dollar today). In this more complete model, the goal of maximizing short-term profits is replaced by goal of maximizing long-term profits, the present value of expected profits, of the business firm.
Defining present value of expected profits is based on first defining “value” and then defining “present value. ” Many concepts of value, such as book value, market value, going-concern value, break-up value, and liquidating value, are encountered in business and economics. The value of the firm is defined as the present value of expected future profits (net cash flows) of the firm. Thus, to obtain an estimate of the present value of expected profits, one must identify the stream of net cash flow in future years.
Once this is accomplished, these expected future profit values are converted into present value by discounting these values by an appropriate interest rate. For illustration, assume that a firm expects a profit of $10,000 in one year and $20,000 in the second year it is assumed that the firm earns no profits after two years. Let us assume that the prevailing interest rate is 10 percent per annum. Thus, $10,000 in a year from now is only equal to about $9,091 at the present ([$10,000/ (1 +0. )] = $9,091)—that is, the present value of a $10,000 profit expected in a year from now is about $9,091. Similarly, the present value of an expected profit of $20,000 in two years from now is equal to about $16,529 (since [$20,000/ (1 + 0. 1)2] = $16,529). Therefore, the present value of future expected profits is $25,620 (equal to the sum of $9,091 and $16,529). The present value of expected profits is a key concept in understanding the theory of the firm, and maximizing this profit is considered the primary goal of a firm in most models.
It should be noted that expected profit in any one period can itself be considered as the difference between the total revenue and the total cost in that period. Thus, one can, alternatively, find the present value of expected future profits by subtracting the present value of expected future costs from the present value of expected future revenues. THE CONSTRAINED PROFIT MAXIMIZATION. Profit maximization is subject to various constraints faced by the firm. These constraints relate to resource scarcity, technology, contractual obligations, and laws and government regulations.
In their attempt to maximize the present value of profits, business managers must consider not only the short-term and long-term implications of decisions made within the firm, but also various external constraints that may limit the firm’s ability to achieve its organizational goals. The first external constraint of resource scarcity refers to the limited availability of essential inputs (including skilled labor), key raw materials, energy, specialized machinery and equipment, warehouse space, and other resources.
Moreover, managers often face constraints on plant capacity that are exacerbated by limited investment funds available for expansion or modernization. Contractual obligations also constrain managerial decisions. Labor contracts, for example, may constrain managers’ flexibility in worker scheduling and work assignment. Labor contracts may also determine the number of workers employed at any time, thereby establishing a floor for minimum labor costs. Finally, laws and regulations have to be observed. The legal restrictions can constrain decisions regarding both production and marketing activities.
Examples of laws and regulations that limit managerial flexibility are: the minimum wage, health and safety standards, fuel efficiency requirements, antipollution regulations, and fair pricing and marketing practices. PROFIT MAXIMIZATION VERSUS OTHER MOTIVATIONS BEHIND MANAGERIAL DECISIONS. The present value maximization criterion as a basis for the study of the firm’s behavior has come under severe criticism from some economists. The critics argue that business managers are interested, at least partly, in factors other than the firm’s profits.
In particular, they may be interested in power, prestige, leisure, employee welfare, community well-being, and the welfare of the larger society. The act of maximization itself has been criticized; there is a feeling that managers often aim merely to “satisfied” (seek solutions that are considered satisfactory), rather than really try to optimize or maximize (seek to find the best possible solution, given the constraints). This question is often rhetorically posed as: does a manager really try to find the sharpest needle in a haystack or does he or she merely stop upon finding a needle sharp enough for sewing needs?
Under the structure of a modern firm, it is hard to determine the true motives of managers. A modem firm is frequently organized as a corporation in which shareholders are the legal owners of the firm, and the manager acts on their behalf. Under such a structure, it is difficult to determine whether a manager merely tries to satisfy the stockholders of the firm while pursuing other goals, rather than truly attempting to maximize the value (the discounted present value) of the firm.
It is, for example, difficult to interpret company support for a charitable organization as an integral part of the firm’s long-term value maximization. Similarly, if the firm’s size is increasing, but profits are not, can one attribute the manager’s decision to expand as being motivated by the increased prestige associated with larger firms, or as an attempt to make the firm more noticeable in the marketplace? As it is virtually impossible to provide definitive answers to these and similar questions, the attempt to analyze these issues has led to the development of alternative theories of firm behavior.
Some of the preeminent alternate models assume one of the following: (1) a firm attempts primarily to maximize its size or growth, rather than its present value; (2) the managers of firms aim at maximizing their own personal utility or welfare; and (3) the firm is a collection of individuals with widely divergent goals, rather than a single common, identifiable goal. While each of the alternative theories of the firm has increased our understanding of how a modern firm behaves, none has been able to completely take the place of the basic profit maximization assumption for several reasons.
Numerous academic studies have shown that intense competition in the markets for goods and services of the firm usually forces the manager to make value maximization decisions; if a firm does not decide on the most efficient alternative (implying the need to seek the minimum costs for each output level, given the market price of the commodity the firm is producing), others can outcompete the firm and drive it out of existence. Competition also has its effects through the capital markets.
As one would expect, stockholders are primarily interested in their returns on stocks and stock prices, which in turn, are determined by the firm’s value (the discounted present value of expected profits). Thus, managers are forced to maximize profits in order to maximize firm value, an important basis for returns on common stocks in the long run. Managers who insist on goals other than maximizing shareholder wealth risk being replaced. An inefficiently managed firm may also be bought out; in almost all such hostile takeovers, managers pursuing their own interests will most likely be replaced.
Moreover, a number of academic studies indicate that managerial compensation is closely correlated to the profits generated for the firm. Thus, managers themselves have strong financial incentives to seek profit maximization for their firms. Before arriving at the decision whether to maximize profits or to satisfied, managers (like other economic entities) have to analyze the costs and benefits of their decisions. Sometimes, when all costs are taken into account, decisions that appear merely aimed at a satisfactory level of performance turn out to be consistent with value-maximizing behavior.
Similarly, short-term firm-growth maximization strategies have often been found to be consistent with long-term value maximization behavior, since large firms have advantages in production, distribution, and sales promotion. Thus, many other goals that do not seem to be oriented to maximizing profits may be intimately linked to value or profit maximization—so much so that the value maximization model even provides an insight into a firm’s voluntary participation in charity or other socially responsible behavior. 1. ECONOMIC THEORY Economic theories broadly fall under two categories: microeconomics and macroeconomics.
In most basic terms, microeconomics deals with the economy at a smaller level or at a smaller scale, such as the market for a particular product (e. g. , automobiles) or the behavior of an individual firm in a particular industry (e. g. , decisions made by one of the Big Three in the U. S. automobile industry). Macroeconomics, on the other hand, studies the behavior of the overall economy (e. g. , the U. S. economy as a whole), although it sometimes also looks at economies of different regions that comprise the overall economy. MICROECONOMIC THEORIES
Economics in general (and microeconomics in particular) is defined as the social science that deals with the problem of allocating limited resources to satisfy unlimited human wants. Solving this riddle is based on the price mechanism that, in turn, uses forces of supply and demand for different products. Price mechanism refers to an adjustment mechanism in which the price of a product serves as a signal to both buyers and sellers; it is often considered the centerpiece of microeconomic theory. Theories of demand, supply, and the price mechanism are briefly discussed in what follows. . THEORY OF DEMAND, SUPPLY, AND THE PRICE MECHANISM. The demand for a particular product by an individual consumer is based on three important factors. First, the price of the product determines how much of the product the consumer buys, given that all other factors remain unchanged. In general, the lower the price of the product the more a consumer buys. Second, the consumer’s income also determines how much of the product the consumer is able to buy, given that all other factors remain constant. In general, the greater is his or her income, the more commodities a consumer will buy.
Third, prices of related products are also important in determining the consumer’s demand for the product. The total of all consumer demands yields the market demand for a particular commodity. The market demand curve shows quantities of the commodity demanded at different prices, given that all other factors remain constant; as price increases, the quantity demanded falls. The amount supplied by an individual firm depends on profit and cost considerations. In general, a producer produces the profit by maximizing output. The total of all individual company supplies yields the market supply for a particular commodity.
The market supply curve shows quantities of the commodity supplied at different prices, given that all other factors remain constant; as price increases, the quantity supplied increases. The interaction between market demand and supply determines the equilibrium or market price (where demand equals supply). Shifts in the demand curve and/or the supply curve lead to changes in the equilibrium price. The market price and the price mechanism play crucial roles in the capitalist system—they send signals to both producers and consumers.
The price mechanism is an integral part of the study of market structures that constitute the bulk of microeconomic theory. Analyses of different market structures have yielded economic theories that dominate the study of microeconomics. Four such theories, associated with four kinds of market organizations, are discussed below: perfect competition, monopolistic competition, oligopoly, and monopoly. Based on the differing outcomes of different market structures, economists consider some market structures more desirable, from the point of view of the society, than others. . PERFECT COMPETITION MARKET STRUCTURE. Perfect competition is the idealized market structure that provides a foundation for understanding how markets work in a capitalist economy. The nature of competition under the perfectly competitive market form is based on three conditions that need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production.
The first condition, the homogeneity of product, requires that the product sold by any one seller is identical with the product sold by any other supplier—if products of different sellers are identical, buyers do not care whom they buy from, so long as the price charged is also the same. The second condition, existence of many buyers and sellers, also leads to an important outcome—individual buyers or sellers are so small relative to the entire market that they do not have any power to influence the price of the product under consideration, and they simply decide how much to buy or sell at the given market price.
The implication of the third condition, the perfect mobility of resources or factors of production, is that resources move to the most profitable industry. There is no industry in the world that can be considered perfectly competitive in the strictest sense of the term. Token examples of industries, however, come quite close to having perfectly competitive markets. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation.
The study of the idealized version of perfect competition leads to some important conclusions regarding the solutions of key economic problems, such as the quantity of the relevant product produced, price charged, and the mechanism of adjustment in the industry. The total output produced under perfect competition is larger than, say, under monopoly. This follows from the mechanics of maximizing profit, the guiding force behind a supplier’s output decision. In order to maximize profits, a supplier has to look at costs and revenues.
The firm will stop production at the level where marginal revenue (the revenue that the sale of an additional unit generates) equals marginal cost (the cost of producing an additional unit of the product under consideration)—this output level maximizes profits (or minimizes loss). In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue, as the firm can sell additional units at the going market price. This is not so for a monopolist. A monopolist must reduce price to increase sales—as a result, a monopolist’s price is always higher than the marginal revenue.
Thus, even though a monopolist also produces the profit-maximizing output, where marginal revenue equals marginal cost, it does not produce to the point where price equals marginal cost (as does a perfectly competitive firm). Perfect competition is therefore considered desirable from the point of the view of society for at least two reasons—in general, output produced under a perfectly competitive market structure is larger and the price charged is lower than under other market structures. 4. MONOPOLISTIC COMPETITION MARKET STRUCTURE. Many industries have market structures that are monopolistic competition or oligopoly.
The apparel retail industry, which features stores and differentiated products, provides an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually, if an industry has 50 or more firms (producing products that are close substitutes for each other), it is said to have a large number of firms. The sellers under monopolistic competition differentiate product—unlike under perfect competition, products are not considered identical. This characteristic is often called the product differentiation.
In addition, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market structure. As in the case of perfect competition, a firm under monopolistic competition determines the quantity of the product produced on the basis of the profit maximization principle—it stops production when marginal revenue equals marginal cost of production. One very important difference between perfect competition and monopolistic competition, however, is that a firm under monopolistic competition has some control over the price it charges, since it differentiates its products from those of others.
As a result, the price associated with the product (at the equilibrium or profit-maximizing output) is higher than the marginal cost (which equals marginal revenue). Thus, the production under monopolistic competition does not take place to the point where price equals marginal cost of production. The net result of the profit-maximizing decisions of monopolistically competitive firms is that the price charged is higher than under perfect competition and the quantity produced is simultaneously lower. Thus, both on the basis of price charged and output produced, monopolistic competition is less socially desirable than perfect competition. . OLIGOPOLY MARKET STRUCTURE. Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with about three large firms each) provide good examples of oligopolistic market structures. The most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry.
Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions. There are huge, though not insurmountable, barriers to entry into an oligopolistic market. These barriers can exist because of large financial requirements, availability of raw materials, access to the relevant technology, or simply existence of patent rights with the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry; for example, the U.
S. automobile industry has financial barriers to entry. An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production imply that as the level of production rises the cost per unit of product falls from the use of any plant (generally, up to a point). Thus, economies of scale are an obvious advantage to a large producer. There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances.
One of these circumstances refers to an oligopoly in which there are asymmetric reactions from rivals when a particular firm formulates policies—if a certain oligopolistic firm cuts price, it is met with price reductions by competing firms; if it raises the price of its product, however, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period. Due to theoretical difficulties, it is hard to make concrete statements regarding price charged and quantity produced under oligopoly.
Nevertheless, from the point of view of the society, an oligopolistic market structure provides a fair degree of competition in the market place if the oligopolists in the market do not collude. Collusion occurs if firms in the industry agree to set price and/or quantity. In the United States, there are laws that make collusion illegal. 6. MONOPOLY MARKET STRUCTURE. Monopoly can be considered the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rare, several industries in the United State have monopolies.
Local electricity companies are examples of monopolists. There are many factors that give rise to a monopoly. Patents can lead to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by an appropriate government agency. Provision of local telephone services in the United States provides an example of such a monopoly.
Finally, a monopoly may arise due to the declining cost of production for a particular product. In such a case the average cost of production keeps on falling and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. Such an industry is popularly dubbed natural monopoly. A good example of a natural monopoly is the electric power industry, which reaps the benefits of economies of scale and yields decreasing average cost.
Government agencies usually regulate natural monopolies. Generally speaking, price and output decisions of a monopolist are similar to a monopolistically competitive firm, with the major distinction that there are a large number of firms under monopolistic competition and only one firm under monopoly. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure).
An industry characterized by a monopolistic market structure produces less output and charges higher prices than under perfect competition (and presumably under monopolistic competition). Thus, on the basis of price charged and quantity produced a monopoly is less socially desirable. One must recognize, however, that a natural monopoly is generally considered desirable if the monopolist’s price behavior can be regulated. 7. SUMMARY OF MARKET STRUCTURES. The real world is rarely characterized by perfect competition, and in certain circumstances, the society has to tolerate a monopoly (e. g. a natural monopoly or a monopoly due to patent rights). Nevertheless, the idea of competition is very deeply ingrained in the society. So long as there is a reasonable degree of competition (as in the case of monopolistic competition or oligopoly), the society feels reasonably secure with respect to the working of its markets. MACROECONOMICS Macroeconomics is a social science that studies an economy at the aggregate (or nationwide) level. Macroeconomic theories study an overall economy and prescribe policy recommendations based on the study of the behavior of key macroeconomic variables.
While numerous additional measures or variables are used to understanding the behavior of an economy, the following four variables are considered to be the most important in gauging the state or health of an economy: aggregate output or income, the unemployment rate, the inflation rate, and the interest rate. 1. OUTPUTANCOME. An economy’s overall economic activity is summarized by a measure of aggregate output. As the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure.
The United States now uses an aggregate output indicator known as the gross domestic product or GDP. The GDP is a measure of all currently produced goods and services valued at market prices. Other related measures of output can be derived from the GDP measure. 2. UNEMPLOYMENT RATE. The level of employment is the next crucial macroeconomic variable. The employment level is often quoted in terms of the unemployment rate. The unemployment rate itself is defined as the fraction of the labor force not working but actively seeking employment. Labor force, in turn, is defined as consisting of those working and those not working but seeking work.
Thus, the unemployment rate leaves out people who are not working but also not seeking work—termed by economists as voluntarily unemployed. For purposes of government macroeconomic policies, only those who are involuntarily unemployed are of primary concern. For various reasons, it is not possible to reduce the unemployment rate to zero even in the best of circumstances. Realistically, economists expect the labor force to always include an unemployed fraction—usually estimated at six percent for the U. S. labor market. The six percent unemployment rate is often referred to as the benchmark unemployment rate.
In effect, if the unemployment level is at the six percent level, the economy is considered to be at full employment. 3. INFLATION RATE. Inflation is considered to be a macroeconomic variable of key concern. The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index which measures the level of prices of goods and services at any point of time. The numbers of items included in a price index vary depending on the objective of the index.
Usually three kinds of price indexes are periodically reported by government sources: the consumer price index or (CPI), which measures the average retail prices paid by consumers for goods and services typically bought by them; the producer price index or (PPI), which measures the wholesale prices of items that are typically used by producers; and the implicit GDP price deflator, which measures the prices of all goods and services included in the GDP. The inflation rate index most commonly reported in the popular media is the consumer price index. 4. INTEREST RATE.
The concept of the interest rate used by economists is the same as the one commonly used. The interest rate is invariably quoted in nominal terms—i. e. , the rate is not adjusted for inflation. Thus, the commonly followed interest rate is actually the nominal interest rate. Nevertheless there are hundreds of nominal interest rates. Fortunately, while the hundreds of interest rates that one encounters may appear baffling, they are closely linked to each other. Two characteristics that account for the linkage are the risk worthiness of the borrower and the maturity date of the loan involved.
So, for example, the interest rate on a six-month U. S. Treasury bill is related to that on a 30-year Treasury bond, just as bonds and loans of different maturities command different rates. Furthermore, a 30-year General Motors bond will carry a higher interest rate than a 30-year U. S. Treasury bond, since a General Motors bond is riskier than a U. S. Treasury bond. 5. OPPORTUNITY COST An opportunity cost is defined as the value of a forgone activity or alternative when another item or activity is chosen. Opportunity cost comes into play in any decision that involves a tradeoff between two or more options.
It is expressed as the relative cost of one alternative in terms of the next-best alternative. Opportunity cost is an important economic concept that finds application in a wide range of business decisions. Opportunity costs are often overlooked in decision making. For example, to define the costs of a college education, a student would probably include such costs as tuition, housing, and books. These expenses are examples of accounting or monetary costs of college, but they by no means provide an all-inclusive list of costs.
There are many opportunity costs that have been ignored: (1) wages that could have been earned during the time spent attending class, (2) the value of four years’ job experience given up to go to school, (3) the value of any activities missed in order to allocate time to studying, and (4) the value of items that could have purchased with tuition money or the interest the money could have earned over four years. These opportunity costs may have significant value even though they may not have a specific monetary value. The decision maker must often subjectively estimate Opportunity costs.
If all options were purely financial, the value of all costs would be concrete, such as in the example of a mutual fund investment. If a person invests $10,000 in Mutual Fund ABC for one year, then he forgoes the returns that could have been made on that same $10,000 if it was placed in stock XYZ. If returns were expected to be 17 percent on the stock, then the investor has an opportunity cost of $1,700. The mutual fund may only expect returns of 10 percent ($1,000), so the difference between the two is $700. This seems easy to evaluate, but what is actually the opportunity cost of placing the money into stock XYZ?
The opportunity cost may also include the peace of mind for the investor having his money invested in a professionally managed fund or the sleep lost after watching his stock fall 15 percent in the first market correction while the mutual fund’s losses were minimal. The values of these aspects of opportunity cost are not so easy to quantify. It should also be noted that an alternative is only an opportunity cost if it is a realistic option at that time. If it is not a feasible option, it is not an opportunity cost. Opportunity-cost evaluation as many practical business applications, because opportunity costs will exist as long as resource scarcity exists. The value of the next-best alternative should be considered when choosing among production possibilities, calculating the cost of capital, analyzing comparative advantages, and even choosing which product to buy or how to spend time. According to Kroll, there are numerous real-world lessons about opportunity costs that managers should learn: 1. Even though they do not appear on a balance sheet or income statement, opportunity costs are real.
By choosing between two courses of action, you assume the cost of the option not taken. 2. Because opportunity costs frequently relate to future events, they are often difficult to quantify. 3. Most people will overlook opportunity costs. Because most finance managers operate on a set budget with predetermined targets, many businesses easily pass over opportunities for growth. Most financial decisions are made without the consultation of operational managers. As a result, operational managers are often convinced by finance departments to avoid pursuing value-maximizing opportunities, assuming that the budget simply will not allow it.
Instead, workers slave to achieve target production goals and avoid any changes that might hurt their short-term performance, for which they may be continually evaluated. Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.
Price elasticity is almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Griffin goods have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively arge effect on the quantity of a good demanded. Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or “burden”) of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales. Economic Theory Managerial economics is the application of economics theory to decision making of the business firm. As a specialized branch of economics, it aims to integrate economic theory with business practice.
Economic theory has two dimensions, namely the positive dimension and the normative dimension. Hence, economics is also divided into positive economics and normative economics. Economics’ like prof. Marshall and Pigou believes that economics should be normative economics. i. e it should be prospecitive in nature while being objective. Prof. Robbins believes that economics is a positive science and it aims to make an objective study of economics facts. Positive economics is concerned with the description and explanation of the economic behavior of economic entities, such as firms, households and individuals.
Managerial economics heavily borrows from positive economics while studying consumer behavior and while making analysis of the firm. Managerial economics is also dependent on normative economics because the firm as a production unit has to produce those goods and services which are desirable from the society’s point of view. Areas of economic theory found useful to managerial economist 1. Opportunity cost Opportunity cost is the cost related to the next-best choice available to someone who has picked among several mutually exclusive choices. It is a key concept in economics.
It has been described as expressing “the basic relationship between scarcity and choice. The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs. The concept of an opportunity cost was first developed by John Stuart Mill. The consideration of opportunity costs is one of the key differences between the oncepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action. ————————————————- 2.
Price elasticity of demand Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall. Price elasticity’s are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity.
Only goods which do not conform to the law of demand, such as Veblen and Griffin goods have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded. Revenue is maximized when price is set so that the PED is exactly one.
The PED of a good can also be used to predict the incidence (or “burden”) of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data and conjoint analysis. ————————————————- ————————————————- ————————————————- 3. Income elasticity of demand In economics, income elasticity of demand measures the responsiveness of the demand for a good to a change in the income of the people demanding the good, holding all prices constant.
It is calculated as the ratio of the percentage change in demand to the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2. ————————————————- Mathematical definition More formally, the income elasticity of demand, for a given Marshallian demand function for a good is Or alternatively: This can be rewritten in the form: With income I, and vector of prices.
Many necessities have an income elasticity of demand between zero and one: expenditure on these goods may increase with income, but not as fast as income does, so the proportion of expenditure on these goods falls as income rises. This observation for food is known as Engel’s law. 4. The multiplier theory In economics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable. For example, suppose a one-unit change in some variable x causes another variable y to change by M units. Then the multiplier is M. Money multiplier
In monetary macroeconomics and banking, the money multiplier measures how much the money supply increases in response to a change in the monetary base. The multiplier may vary across countries, and will also vary depending on what measures of money are considered. For example, consider M2 as a measure of the U. S. money supply, and M0 as a measure of the U. S. monetary base. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10. Fiscal multipliers Multipliers can be calculated to analyze the effects of fiscal policy, or other exogenous changes in spending, on aggregate output.
For example, if an increase in German government spending by €100, with no change in taxes, causes German GDP to increase by €150, then the spending multiplier is 1. 5. Other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes (such as lump-sum taxes or proportional taxes). Keynesian multiplier Keynesian economists often calculate multipliers that measure the effect on aggregate demand only. (To be precise, the usual Keynesian multiplier formulas measure how much the IS curve shifts left or right in response to an exogenous change in spending. Opponents of Keynesianism have sometimes argued that Keynesian multiplier calculations are misleading; for example, according to the theory of Ricardian equivalence, it is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future. ————————————————- ————————————————- ————————————————- ————————————————- 5. Marginal propensity to consume
In economics, the marginal propensity to consume (MPC) is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0. 65, then of that dollar, the household will spend 65 cents and save 35 cents. Mathematically, the marginal propensity to consume (MPC) function is expressed as the derivative of the consumption (C) function with respect to disposable income (Y).
OR , where ? C is the change in consumption, and ? Y is the change in disposable income that produced the consumption. The marginal propensity to consume is measured as the ratio of the change in consumption to the change in income, thus giving us a figure between 0 and 1. The MPC can be more than one if the subject borrowed money to finance expenditures higher than their income. One minus the MPC equals the marginal propensity to save (in a two sector closed economy), both of which are crucial to Keynesian economics and are key variables in determining the value of the multiplier. . Incremental cost The cost of the next kilowatt-hour of generated energy also referred to in the industry as the next unit. Incremental costs change as production increases or decreases, but these changes don’t always occur in a predictable pattern. As an example, incremental costs typically decrease as production rises to comfortable capacity. But once that limit is reached, incremental costs increase because additional costs (construction of new facilities, costs of stressing production facilities, etc. need to be factored into the cost of the next unit. Incremental cost is often used interchangeably with marginal cost, but incremental cost is a strict value applied to the next unit only, whereas marginal costs are often expressed as averages of large numbers of next units. ————————————————- ————————————————- 7. Liquidity preference Liquidity preference in macroeconomic theory refers to the demand for money, considered as liquidity. The concept was first developed by John Maynard
Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds. Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless, refrained from consuming all his current income.
Instead of a reward for saving, interest in the Keynesian analysis is a reward for parting with liquidity. According to Keynes, demand for liquidity is determined by three motives: 1. The transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending. 2. The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs.
The amount of money demanded for this purpose increases as income increases. 3. Speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa). The liquidity-preference relation can be represented graphically as a schedule of the money demanded at each different interest rate.
The supply of money together with the liquidity-preference curve in theory interacts to determine the interest rate at which the quantity of money demanded equals the quantity of money supplied. ————————————————- 8. Production function In microeconomics and macroeconomics, a production function is a function that specifies the output of a firm, an industry, or an entire economy for all combinations of inputs. This function is an assumed technological relationship, based on the current state of engineering knowledge; it does not represent the result of economic hoices, but rather is an externally given entity that influences economic decision-making. Almost all economic theories presuppose a production function, either on the firm level or the aggregate level. In this sense, the production function is one of the key concepts of mainstream neoclassical theories. Some non-mainstream economists, however, reject the very concept of an aggregate production function. ————————————————- Concept of production functions In micro-econotmics, a production function is a function that specifies the output of a firm for all combinations of inputs.
Ameta-production function compares the practice of the existing entities converting inputs into output to determine the most efficient practice production function of the existing entities, whether the most efficient feasible practice production or the most efficient actual practice production In either case, the maximum output of a technologically-determined production process is a mathematical function of one or more inputs. Put another way, given the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function.
Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology. By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting from the engineering and managerial problems inherently associated with a particular production process.
The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use and how much output to produce, given the cost (purchase price) of each factor, the selling price of the output, and the technological determinants represented by the production function. A decision frame in which one or more inputs are held constant may be used; or example, (physical) capital may be assumed to be fixed (constant) in the short run, and labor and possibly other inputs such as raw materials variable, while in the long run, the quantities of both capital and the other factors that may be chosen by the firm are variable. In the long run, the firm may even have a choice of technologies, represented by various possible production functions. The relationship of output to inputs is non-monetary; that is, a production function relates physical inputs to physical outputs, and prices and costs are not reflected in the function.
But the production function is not a full model of the production process: it deliberately abstracts from inherent aspects of physical production processes that some would argue are essential, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management. ). The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors.
Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production. 9. Theory of Demand Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period. Each of us has an individual demand for particular goods and services and the level of demand at each market price reflects the value that consumers place on a product and their expected satisfaction gained from purchase and consumption.
Market demand Market demand is the sum of the individual demand for products from each consumer in the market. If more people enter the market and they have the ability to pay for items on sale, then demand at each price level will rise. Effective demand and willingness to pay Demand in economics must be effective which means that only when a consumers’ desire to buy a product is backed up by an ability to pay for it does demand actually have an effect on the market. Consumers must have sufficient purchasing power to have any effect on the allocation of scarce resources.
For example, what price are you willing to pay to view a world championship boxing event and how much are you prepared to spend to watch Premiership soccer on a pay-per-view basis? Would you be willing and able to pay to watch Elton John perform live through a subscription channel? ————————————————- ————————————————- 10. Theory of the firm The theory of the firm consists of a number of economic theories that describe the nature of the firm, company, or corporation, including its existence, behavior, structure, and relationship to the market.
In simplified terms, the theory of the firm aims to answer these questions: 1. Existence – why do firms emerge, why are not all transactions in the economy mediated over the market? 2. Boundaries – why is the boundary between firms and the market located exactly there as to size and output variety? Which transactions are performed internally and which are negotiated on the market? 3. Organization – why are firms structured in such a specific way, for example as to hierarchy or decentralization? What is the interplay of formal and informal relationships? 4.
Heterogeneity of firm actions/performances – what drives different actions and performances of firms? Firms exist as an alternative system to the market-price mechanism when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be very difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. It might also be costly for employees to shift companies every day looking for better alternatives. Thus, firms engage in a long-term contract with their employees to minimize the cost 1. Fiscal policy In economics, fiscal policy is the use of government expenditure and revenue collection to influence the economy.  Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the money supply. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy: * Aggregate demand and the level of economic activity; The pattern of resource allocation; * The distribution of income. Fiscal policy refers to the use of the government budget to influence the first of these: economic activity. Monetary policy Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.  The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and a contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. 12.
A Theory of Money and Banking In economics, money creation is the process by which the money supply of a country is expanded. There are two principal stages of money creation. First, the central bank of a country can introduce or issue new money into the economy (termed ‘expansionary monetary policy’). A central bank usually injects new money into the economy by purchasing financial assets. Second, the new money introduced by the central bank is multiplied by commercial banks through fractional reserve banking, expanding the amount of broad money (i. e. cash plus demand deposits) in the economy.
Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. Monetary circuit theory is a heterodox theory of monetary economics, particularly money creation, often associated with the post-Keynesian school.  It holds that money is created endogenously by the banking sector, rather than exogenously by central bank le
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