Nature, Scope and Methods of Managerial Economics
Summary
1. Managerial economics is about the application of economic theory and methods to business decision-making.
2. The term business must be considered in very broad terms, to include any transaction between two or more parties. Only then can we fully appreciate the breadth of application of the discipline.
3. Decision-making involves a number of steps: problem perception, definition of objectives, examination of constraints, identification of strategies, evaluation of strategies and determination of criteria for choosing among strategies.
4. Managerial economics is linked to the disciplines of economic theory, decision sciences and business functions.
5. The core elements of the economic theory involved are the theory of the firm, consumer and demand theory, production and cost theory, price theory and competition theory.
6. A neoclassical approach involves treating the individual elements in the economy as rational agents with quantitative objectives to be optimized.
7. Positive statements are statements of fact that can be tested empirically or by logic; normative statements express value judgements.
8. The application of economic principles is useful in making both of the above types of statement.
9. A theory is a statement that describes or explains relationships between phenomena that we observe, and which makes testable predictions.
10. Economic theories have to be tested using empirical studies and econometric methods.
11. Economics is a discipline that proceeds by initially making many assumptions in order to build simple models, and then gradually relaxing these assumptions to make things more realistic and provide better theories.
12. As the situations being analysed become more complex, so more sophisticated and advanced methods of analysis become necessary.
The Theory of the Firm
Summary
1. In order to understand the nature of the firm we need to consider five main areas of economic theory: transaction costs, motivation, agency, information costs and game theory.
2. Transaction costs consist of co-ordination (Coasian) costs and motivation (agency) costs.
3. Transactions have four main dimensions: asset specificity, frequency, complexity and relationship with other transactions.
4. According to Coasian theory there is an optimal size for the firm, since as the firm becomes larger the costs of transacting in the market decrease while the costs of co-ordinating transactions within the firm increase.
5. The ownership of a complex asset like a firm is a difficult concept since four parties have different types of claims regarding control and returns: shareholders, directors, managers and other employees.
6. The conventional economic model of motivation is that individuals try to maximize their utilities; this assumes that people act rationally in their self-interest.
7. The nature of the agency problem is that there is a conflict of interest between principal and agent.
8. The agency problem is aggravated by the existence of asymmetric information, leading to adverse selection and moral hazard.
9. Adverse selection means that only the products or customers with the worst quality characteristics are able to have or make transactions; others are driven from the market.
10. Moral hazard is sometimes referred to as the problem of hidden action, in that the behaviour of a party cannot be reliably or costlessly observed after entering a contract. This, in turn, provides an incentive for post-contract opportunism.
11. There are various control measures that firms and shareholders can use to combat agency problems in their internal and external transactions: increased monitoring, screening, signalling, risk-pooling, internalization and the structure of pay incentives.
12. The basic profit-maximizing model (BPM) is useful because it enables managers to determine strategy regarding price and output decisions; it thus enables the economist to predict firms’ behaviour.
13. The basic model involves many other assumptions that do not appear to be at all realistic.
14. Agency problems arise because of conflicts of interest between share-holders and lenders, between shareholders and managers and between managers and other employees.
15. There are various problems in measuring profit. Managers can take advantage of various legal and accounting loopholes in reporting profits, which are in their interests and may boost the share price, but are against the interests of shareholders.
16. The shareholder-wealth maximization model (SWMM) is a superior model because it takes into account profits in all future time periods, not just those in the present. As such it represents a long-run profit maximization model.
17. The SWMM also has the advantage that it takes into account risk and uncertainty, by discounting future profits by a required rate of return.
18. The SWMM has certain limitations because it ignores the fact that managers tend to have better information than shareholders and investors.
19. In order to understand the behaviour of multiproduct firms we need to consider the concepts of product line and product mix profit maximization, and the associated strategies to achieve these.
20. The public sector and not-for-profit organizations pursue different objectives depending mainly on the nature of their funding.
21. Satisficing behaviour by managers can arise for a number of reasons: risk aversion, transaction costs, diminishing returns to managerial effort and conflicts of objectives between different managers.
22. Claims regarding ethical behaviour and altruism need to be closely examined; empirical evidence does not support the existence of these if theyconflict with maximizing profit.
23. The profit-maximization assumption cannot be rejected on purely theoretical grounds. It must be tested by empirical study, and when this is done the assumption proves to be a good working theory in terms of predicting the behaviour of firms and manager
Production Theory
Summary
1. A production function shows the maximum amounts of output that can be produced from a set of inputs.
2. All points on a production function involve technical efficiency, but only one represents economic efficiency, given prices for the inputs.
3. The functional form of a production function is important because it gives information about the marginal products of the inputs, output elasticities and returns to scale.
4. An isoquant shows different combinations of inputs that can produce the same technically efficient level of output.
5. The marginal rate of technical substitution (MRTS) of X for Y shows the amount of one input Y that must be substituted for another X in order to produce the same output. It is given by the ratio MPX / MPY and graphically by the slope of the isoquant.
6. Returns to scale describe how a proportionate increase in all inputs affects output; they can be increasing, constant or decreasing.
7. The optimal combination of inputs in the long run is achieved when the marginal product of each input as a ratio of its price is equal.
8. In the short run, production is subject to increasing and then diminishing returns.
9. The optimal level of use of the variable factor in the short run is given by the condition MRP = MFC.
10. There are three main applications of production theory in terms of managerial decision-making: capacity planning, marginal analysis and evaluation of trade-offs.
Cost Theory
Summary
1. The relevant costs for decision-making involve opportunity costs, replacement costs and incremental costs.
2. The nature of a firm’s production function determines the nature of its cost functions, both in the short run and in the long run.
3. Managers want to know the type of cost function their firm has in order to make pricing and other marketing mix decisions, and to forecast and plan for the level of costs and inputs for producing a given level of output.
4. In the short run the law of diminishing returns causes marginal cost, average variable cost and average total cost to rise beyond a certain level of output.
5. The most efficient level of output in the short run for a given plant size involves a trade-off between spreading fixed costs and getting diminishing returns.
6. Short-run cost functions can take several mathematical forms: linear, quadratic and cubic.
7. Managers want to know the nature of their firm’s long-run cost function in order to determine the appropriate plant size.
8. In the long run, unit costs are affected by economies and diseconomies of scale, which often cause the long-run average cost curve to be U-shaped.
9. Economies of scale are aspects of increasing scale that lead to falling long-run average costs; diseconomies of scale are the opposite. They can thus be regarded as the cost advantages and cost disadvantages for a firm or plant in growing larger.
10. Economies and diseconomies can arise at the level of the product, the plant and the firm as a whole.
11. Because of uncertainties regarding demand levels there may be a mismatch between the level of output produced by the firm and its sales; there are a number of different strategies that firms can use in this situation.
12. Economies of scope arise when there are cost complementarities of producing products together.
13. The learning curve describes the situation where unit costs are reduced as cumulative output increases, because of learning better ways of performing a task or tasks.
14. CVP analysis analyses relationships between output levels and costs, revenues and profits. It is normally based on the assumption that both total cost and total revenue functions are linear.
Pricing Strategy
Summary
1. Pricing is only one component of the marketing mix and pricing decisions should be interdependent with other marketing mix and positioning decisions.
2. Competitive advantage refers to the situation where a firm creates more value than its competitors, where value is measured in terms of perceived benefit minus input cost.
3. The value created by a firm can be divided into consumer surplus and producer surplus; the former represents the excess of perceived benefit over the price paid, while the latter represents the excess of the price charged over the input cost.
4. Market positioning essentially involves aiming for a cost advantage or a benefit advantage.
5. Positioning depends both on the nature of a firm’s competitive advantage, in terms of its resources and capabilities, and on environmental forces in the market, particularly those relating to customers and competition.
6. Price elasticity is important in guiding a firm’s general pricing strategy, in terms of aiming for increasing market share or increasing profit margin.
7. Segmentation involves dividing a market into component parts according to relevant characteristics related to buyer behaviour.
8. Segmentation and targeting are important because different strategies are appropriate for different segments.
9. Targeting involves determining whether a broad coverage strategy is appropriate, or whether a focus strategy is better. In the latter case the appropriate product or segment must be selected, again according to competitive advantage.
10. Price discrimination means charging different prices for the same or similar products, where any price differentials are not based on differences in marginal cost.
11. Price discrimination always increases the profit of the seller because it enables the seller to capture some of the consumer surplus.
12. Price discrimination can only occur if market segments have different demand elasticities and they can be separated from each other.
13. Firms producing many products in a product line or product mix face more complex pricing decisions because of demand and cost interdependencies.
14. Transfer pricing occurs when one part of a firm charges an internal price to another part of the same firm, a common practice in large firms.
15. Charging the right transfer price is important to the firm, not just in maximizing overall profit, but also in evaluating the performance of different divisions.
16. Pricing is only one element in the marketing mix, and pricing decisions need to be made in conjunction with other marketing mix decisions.
17. Interactions between different components of the marketing mix need to be carefully considered by managers when constructing the demand models necessary for making pricing and other marketing mix decisions.
18. Firms generally charge different prices for a product during different stages of the product life-cycle, even if there are no changes in quality. These changes have to do with changes in demand elasticity, and also often with unit cost changes.
19. Behavioural models are important in that they can enable managers to understand consumer behaviour and reactions to the firm’s marketing strategies. Pricing strategies therefore need to take these models into consideration, even though they are more complex than the traditional neoclassical economic model of consumer behaviour.
For more Information:
International Economic Indicators, Essential Economics, Rethinking Pension Reform, Understanding Business Cycles
Summary
1. Managerial economics is about the application of economic theory and methods to business decision-making.
2. The term business must be considered in very broad terms, to include any transaction between two or more parties. Only then can we fully appreciate the breadth of application of the discipline.
3. Decision-making involves a number of steps: problem perception, definition of objectives, examination of constraints, identification of strategies, evaluation of strategies and determination of criteria for choosing among strategies.
4. Managerial economics is linked to the disciplines of economic theory, decision sciences and business functions.
5. The core elements of the economic theory involved are the theory of the firm, consumer and demand theory, production and cost theory, price theory and competition theory.
6. A neoclassical approach involves treating the individual elements in the economy as rational agents with quantitative objectives to be optimized.
7. Positive statements are statements of fact that can be tested empirically or by logic; normative statements express value judgements.
8. The application of economic principles is useful in making both of the above types of statement.
9. A theory is a statement that describes or explains relationships between phenomena that we observe, and which makes testable predictions.
10. Economic theories have to be tested using empirical studies and econometric methods.
11. Economics is a discipline that proceeds by initially making many assumptions in order to build simple models, and then gradually relaxing these assumptions to make things more realistic and provide better theories.
12. As the situations being analysed become more complex, so more sophisticated and advanced methods of analysis become necessary.
The Theory of the Firm
Summary
1. In order to understand the nature of the firm we need to consider five main areas of economic theory: transaction costs, motivation, agency, information costs and game theory.
2. Transaction costs consist of co-ordination (Coasian) costs and motivation (agency) costs.
3. Transactions have four main dimensions: asset specificity, frequency, complexity and relationship with other transactions.
4. According to Coasian theory there is an optimal size for the firm, since as the firm becomes larger the costs of transacting in the market decrease while the costs of co-ordinating transactions within the firm increase.
5. The ownership of a complex asset like a firm is a difficult concept since four parties have different types of claims regarding control and returns: shareholders, directors, managers and other employees.
6. The conventional economic model of motivation is that individuals try to maximize their utilities; this assumes that people act rationally in their self-interest.
7. The nature of the agency problem is that there is a conflict of interest between principal and agent.
8. The agency problem is aggravated by the existence of asymmetric information, leading to adverse selection and moral hazard.
9. Adverse selection means that only the products or customers with the worst quality characteristics are able to have or make transactions; others are driven from the market.
10. Moral hazard is sometimes referred to as the problem of hidden action, in that the behaviour of a party cannot be reliably or costlessly observed after entering a contract. This, in turn, provides an incentive for post-contract opportunism.
11. There are various control measures that firms and shareholders can use to combat agency problems in their internal and external transactions: increased monitoring, screening, signalling, risk-pooling, internalization and the structure of pay incentives.
12. The basic profit-maximizing model (BPM) is useful because it enables managers to determine strategy regarding price and output decisions; it thus enables the economist to predict firms’ behaviour.
13. The basic model involves many other assumptions that do not appear to be at all realistic.
14. Agency problems arise because of conflicts of interest between share-holders and lenders, between shareholders and managers and between managers and other employees.
15. There are various problems in measuring profit. Managers can take advantage of various legal and accounting loopholes in reporting profits, which are in their interests and may boost the share price, but are against the interests of shareholders.
16. The shareholder-wealth maximization model (SWMM) is a superior model because it takes into account profits in all future time periods, not just those in the present. As such it represents a long-run profit maximization model.
17. The SWMM also has the advantage that it takes into account risk and uncertainty, by discounting future profits by a required rate of return.
18. The SWMM has certain limitations because it ignores the fact that managers tend to have better information than shareholders and investors.
19. In order to understand the behaviour of multiproduct firms we need to consider the concepts of product line and product mix profit maximization, and the associated strategies to achieve these.
20. The public sector and not-for-profit organizations pursue different objectives depending mainly on the nature of their funding.
21. Satisficing behaviour by managers can arise for a number of reasons: risk aversion, transaction costs, diminishing returns to managerial effort and conflicts of objectives between different managers.
22. Claims regarding ethical behaviour and altruism need to be closely examined; empirical evidence does not support the existence of these if theyconflict with maximizing profit.
23. The profit-maximization assumption cannot be rejected on purely theoretical grounds. It must be tested by empirical study, and when this is done the assumption proves to be a good working theory in terms of predicting the behaviour of firms and manager
Production Theory
Summary
1. A production function shows the maximum amounts of output that can be produced from a set of inputs.
2. All points on a production function involve technical efficiency, but only one represents economic efficiency, given prices for the inputs.
3. The functional form of a production function is important because it gives information about the marginal products of the inputs, output elasticities and returns to scale.
4. An isoquant shows different combinations of inputs that can produce the same technically efficient level of output.
5. The marginal rate of technical substitution (MRTS) of X for Y shows the amount of one input Y that must be substituted for another X in order to produce the same output. It is given by the ratio MPX / MPY and graphically by the slope of the isoquant.
6. Returns to scale describe how a proportionate increase in all inputs affects output; they can be increasing, constant or decreasing.
7. The optimal combination of inputs in the long run is achieved when the marginal product of each input as a ratio of its price is equal.
8. In the short run, production is subject to increasing and then diminishing returns.
9. The optimal level of use of the variable factor in the short run is given by the condition MRP = MFC.
10. There are three main applications of production theory in terms of managerial decision-making: capacity planning, marginal analysis and evaluation of trade-offs.
Cost Theory
Summary
1. The relevant costs for decision-making involve opportunity costs, replacement costs and incremental costs.
2. The nature of a firm’s production function determines the nature of its cost functions, both in the short run and in the long run.
3. Managers want to know the type of cost function their firm has in order to make pricing and other marketing mix decisions, and to forecast and plan for the level of costs and inputs for producing a given level of output.
4. In the short run the law of diminishing returns causes marginal cost, average variable cost and average total cost to rise beyond a certain level of output.
5. The most efficient level of output in the short run for a given plant size involves a trade-off between spreading fixed costs and getting diminishing returns.
6. Short-run cost functions can take several mathematical forms: linear, quadratic and cubic.
7. Managers want to know the nature of their firm’s long-run cost function in order to determine the appropriate plant size.
8. In the long run, unit costs are affected by economies and diseconomies of scale, which often cause the long-run average cost curve to be U-shaped.
9. Economies of scale are aspects of increasing scale that lead to falling long-run average costs; diseconomies of scale are the opposite. They can thus be regarded as the cost advantages and cost disadvantages for a firm or plant in growing larger.
10. Economies and diseconomies can arise at the level of the product, the plant and the firm as a whole.
11. Because of uncertainties regarding demand levels there may be a mismatch between the level of output produced by the firm and its sales; there are a number of different strategies that firms can use in this situation.
12. Economies of scope arise when there are cost complementarities of producing products together.
13. The learning curve describes the situation where unit costs are reduced as cumulative output increases, because of learning better ways of performing a task or tasks.
14. CVP analysis analyses relationships between output levels and costs, revenues and profits. It is normally based on the assumption that both total cost and total revenue functions are linear.
Pricing Strategy
Summary
1. Pricing is only one component of the marketing mix and pricing decisions should be interdependent with other marketing mix and positioning decisions.
2. Competitive advantage refers to the situation where a firm creates more value than its competitors, where value is measured in terms of perceived benefit minus input cost.
3. The value created by a firm can be divided into consumer surplus and producer surplus; the former represents the excess of perceived benefit over the price paid, while the latter represents the excess of the price charged over the input cost.
4. Market positioning essentially involves aiming for a cost advantage or a benefit advantage.
5. Positioning depends both on the nature of a firm’s competitive advantage, in terms of its resources and capabilities, and on environmental forces in the market, particularly those relating to customers and competition.
6. Price elasticity is important in guiding a firm’s general pricing strategy, in terms of aiming for increasing market share or increasing profit margin.
7. Segmentation involves dividing a market into component parts according to relevant characteristics related to buyer behaviour.
8. Segmentation and targeting are important because different strategies are appropriate for different segments.
9. Targeting involves determining whether a broad coverage strategy is appropriate, or whether a focus strategy is better. In the latter case the appropriate product or segment must be selected, again according to competitive advantage.
10. Price discrimination means charging different prices for the same or similar products, where any price differentials are not based on differences in marginal cost.
11. Price discrimination always increases the profit of the seller because it enables the seller to capture some of the consumer surplus.
12. Price discrimination can only occur if market segments have different demand elasticities and they can be separated from each other.
13. Firms producing many products in a product line or product mix face more complex pricing decisions because of demand and cost interdependencies.
14. Transfer pricing occurs when one part of a firm charges an internal price to another part of the same firm, a common practice in large firms.
15. Charging the right transfer price is important to the firm, not just in maximizing overall profit, but also in evaluating the performance of different divisions.
16. Pricing is only one element in the marketing mix, and pricing decisions need to be made in conjunction with other marketing mix decisions.
17. Interactions between different components of the marketing mix need to be carefully considered by managers when constructing the demand models necessary for making pricing and other marketing mix decisions.
18. Firms generally charge different prices for a product during different stages of the product life-cycle, even if there are no changes in quality. These changes have to do with changes in demand elasticity, and also often with unit cost changes.
19. Behavioural models are important in that they can enable managers to understand consumer behaviour and reactions to the firm’s marketing strategies. Pricing strategies therefore need to take these models into consideration, even though they are more complex than the traditional neoclassical economic model of consumer behaviour.
For more Information:
International Economic Indicators, Essential Economics, Rethinking Pension Reform, Understanding Business Cycles
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