Lecture 1

Introduction to managerial
economics
Norwegian Cruises Managing Director Replaced
Following Acquisition of Rival Firm
• Norwegian Cruises is a company that owns and
manages a large fleet of ships used primarily for
cruises along the Norwegian fjords. Following a
spike in tourist arrivals in Norway, Kristofer, the
company’s managing director decided to increase
the company’s fleet by acquiring another rival
business. With the short-term interest rate at 8%,
Norwegian Cruises used $9million of its retained
earnings to acquire the assets and settle the
debts of Fjords Unlimited, a local struggling
• Business providing similar services. Kristofer’s
acquisition was based on predicted annual
sales of $2 million over the first five years.
After close review of the acquisition, the
board of directors qualified Kristofer’s
performance as poor and decided to
immediately terminate his employment and
appoint ANNGERD, Kristofer’s assistant
manager as the acting managing director. Do
you know why Kristofer was sacked?
 Introduction
• Why study Managerial Economics
• The Manager
Anyone who channels resources to attain a
specific goal
• Economics
How individuals and societies make choices or
decisions subject to constraints or scarce
resources.
 Economics

• Scarcity calls for a trade-off (concept of

opportunity cost)
• Concept of scarcity is embodied in “there is no
free lunch”
• Economic goods
• Free goods
 Managerial Economics Defined
It is the study of how to direct scarce resources
in the way that most efficiently achieves a
managerial objective

Think of any examples of managerial decisions:

Basic principles that make up effective
Management
(1) Identify goals and constraints
(2) recognise the nature and importance of
profits
(3)understand incentives
(4) understand markets
(5) Recognise the time value of money
(6) Use marginal analysis
 Recognise the nature and Importance
of profit
• Typical firm’s objective is to maximise profit
• Economic profits versus accounting profits
• Accounting Profits: πA = TR-TC explicit
• Economic Profit:
π = TR-TC = TR-TC explicit - TC implicit or accounting
profit- TC implicit
 Example
Festus operates a small shop specialising in
drinking cups. He owns the building and supplies
all his own labour and money capital. Thus,
Festus incurs no explicit rental or wage costs.
Before starting his own business Festus earned
1000 gh per month by renting out the store and
earned 2500 gh per month as a teacher. Because
Festus uses his own money capital, he also
sacrificed 1000 gh per month in
interest earned on treasury bills. Festus’
monthly income from operating his shop is
10,000 gh and his total monthly expenses for
Labour and supplies amounted to 6000 gh.
Calculate Festus’ accounting and Economic
Profit.
 Solution : Accounting Profit
• Total accounting profit is calculated as follows:
Total Revenue 10,000 gh
Total Explicit cost 6000 gh
Accounting profit 4000 gh
 Solution: Economic Profit
• Total Revenue 10,000 gh
• Total Explicit cost 6000 gh
• Forgone rent 1000 gh
• Forgone Salary 2500 gh
• Forgone Interest Income 1000 gh
• Total Implicit costs 4500 gh
• Total Economic costs 10,500 gh
• Economic Profit (loss) (500) gh
 Role of Profits
• Profit Principle:
– Profits are a signal to resource holders where
resources are most highly valued by society.
 Understand Incentives
• Within a firm, incentives impact how
resources are used and how hard workers
work.
– One role of a manager is to construct incentives to
induce maximal effort from employees.
 Understand Markets
• Two sides to every market transaction:
– Buyer.
– Seller.
• Bargaining position of consumers and producers
is limited by three rivalries in economic
transactions:
– Consumer-producer rivalry.
– Consumer-consumer rivalry.
– Producer-producer rivalry.
• Government and the market.
 The Time Value of Money
• Often a gap exists between the time when
costs are borne and benefits received.
– Managers can use present value analysis to
properly account for the timing of receipts and
expenditures.
 Economics of Effective Management

Present Value Analysis 1

1-17
 Economics of Effective Management

Present Value Analysis II

1-18
 Economics of Effective Management

Net Present Value

1-19
 Economics of Effective Management

Present Value of Indefinitely Lived Assets

1-20
 Economics of Effective Management

Present Value and Profit Maximization

• Profit maximization principle
– Maximizing profits means maximizing the value of
the firm, which is the present value of current and
future profits.

1-21
 Marginal Analysis
• Given a control variable, Q, of a managerial
objective, denote the
—Total benefit as B(Q)
—Total cost as C(Q)
• Manager’s objective is to maximise
• N(Q) =B(Q) –C(Q)
 Using Marginal Analysis
• How can the manager maximise net benefits
• Use marginal analysis:
• Marginal Benefit: MB(Q)
– Change in total benefit arising from a change in the
managerial control variable, Q
• Marginal Cost: MC(Q)
—Change in total cost resulting from a change in the
managerial control variable, Q.
• Marginal Net Benefit: MNB (Q)
—MNB (Q)= MB (Q) – MC(Q)
 Marginal Analysis Principle I
• Marginal principle
– To maximize net benefits, the manager should
increase the managerial control variable up to the
point where marginal benefits equal marginal
costs. This level of the managerial control variable
corresponds to the level at which marginal net
benefits are zero; nothing more can be gained by
further changes in that variable.
 Marginal Analysis Principle II
• Marginal Principle (calculus alternative)
• Slope of a continuous function is the
derivative/marginal value of that function
• MB= dB(Q)/d(Q)
• MC= dC(Q)/d(Q)
• MNB = dN(Q)/d(Q)
 Marginal Analysis using the Calculus
Alternative
• It is estimated that the benefit and cost structure of a firm
• B(Q) = 250Q -4Q2
• C(Q) = Q2

• Find the MB and MC functions

MB= 250-8Q
MC= 2Q

• What value of Q makes NMB =0

250-8Q-2Q=0
Q=25
 Conclusion
• Make sure you include all costs and benefits
when making decisions (opportunity costs).
• When decisions span time, make sure you are
comparing apples to apples (present value
analysis).
• Optimal economic decisions are made at the
margin (marginal analysis).
 Theory of the firm
• Firm is an activity that combines scarce
productive resources to produce goods and
services that are demanded by society.

• Neoclassical theory attempts to maximise the

present value of the firm’s stream of future
profits.
• Refer to present value and profit maximising
principle
• This recognises the decisions made in several
divisions of an organisation
 How Realistic is the Assumption
• Transaction cost theory
• Satisficing behaviour
• Maximization of manager’s utility
 Assignment
• Discuss the notion that a firm’s primary
objective is profit-maximisation.