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The Economics of Effective Management

• Identify Goals and Constraints
• Recognize the Role of Profits
• Understand Incentives
• Five Forces Model
• Understand Markets
• Recognize the Time Value of Money
• Use Marginal Analysis

Manager

A person who directs resources to achieve a stated goal.

Economics
The science of making decisions in the presence of scare resources.

Managerial Economics

The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

Accounting Profits

Total revenue (sales) minus dollar cost of producing goods or services.
Reported on the firm’s income statement.
Economic Profits
Total revenue minus total opportunity cost.
Opportunity Cost
The cost of the explicit and implicit resources that are foregone when a decision is made.
Porter’s Five Forces Model

Time value of money:

Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

PV = FV \ (1+i) ^ n

Marginal (Incremental) Analysis

Control Variables
Output
Price
Product Quality
R&D

Basic Managerial Question:
How much of the control variable should be used to maximize net benefits?
Few functions you should remember
• Net Benefits = Total Benefits – Total Costs
• Profits = Revenue – Costs
• Revenue = Quantity * Cost per Item
• Marginal Benefit = Change in Total Benefit / Change in Quality
• Marginal cost = Change in total cost / Change in quantity

• To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC (or MNB=0).

• MB > MC means the last unit of the control variable increased benefits more than it increased costs.
• MB < MC means the last unit of the control variable increased costs more than it increased benefits.
Example
If Q = 500 – 10 P
Find Price (p) for which revenue is maximum.
Now Revenue = P*Q
Q = 500 – 10 *P                       ———- (1)
therefore 10 * P =  500 – Q
P = 50 – 0.1 * Q
Now multiplying both sides by Q
P*Q (Revenue) = 50 Q – 0.1 Q*Q
Now to maximize revenue we need to take derivative of revenue against quantity
d (Revenue)/ d(Q) = 50 – 0.2 Q
No maximize it we will equal it to zero.
50 – 0.2 Q = 0
Q = 250. So putting in equation (1)
P = 25
Max Revenue = P *Q = 6250
Few graphs of better understanding

AFC: Avg fix cost
MC : Marginal cost
AC  : Avg Cost
AVC : Avg Variable Cost
Law of diminishing returns

Sometimes referred to as variable factor proportions, law of diminishing returns states that as equal quantities of one variable factor are increased, while other factor inputs remain constant, ceteris paribus, a point is reached beyond which the addition of one more unit of the variable factor will result in a diminishing rate of return and the marginal physical product will fall.

We will cover elasticities in next posts…

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