Managerial Economics

MANAGERIAL ECONOMICS

Managerial decisions are strategies carried out to obtain a specific aim, that is maximising profit. In order to reach this goal, the firm must be efficient.

Macroeconomic is the study of the economic system as a whole, while microeconomic is the study of individual choices of both consumers and producers. Managerial economics takes concepts from both these two disciplines that are interrelated in the economic policies. Managerial economics is the study of the manager’s choices.

A management is effective when there are some results that are producing at the minimum cost (being effective means being efficient). The basic principles comprising Effective Management are:

• Identify goals and constraints (the most common are costs, but they could be also government constraints in terms of pollutions, environmental sustainability such as tax emissions, minimum and maximum prices);
• Recognize the nature and importance of profits (there is more than one definition of profit that depends on the type of costs);
• Understand incentives (for employees if some goals are reached, for the firm if it produces environmentally friendly goods);
• Understand markets (in every market there is a demand and a supply, so understanding market means understanding the interactions of demand and supply. There are different kinds of market, depending on the type of good/service offered, the labour, the financial market... On the demand side, a negative correlation takes place between prices and quantities. In the labour market, on the supply side, there is a positive correlation between prices and quantities. If prices increase, the firm is more prone to produce higher quantity of goods. Only in the equilibrium point we can find the equilibrium price and quantity → the manager’s aim).
• Recognize the time value of money (there is a time gap between the instant in which the costs are born and the one in which revenues are received);
• Use marginal analysis (a way in which we see if we can increase benefits by increasing or changing our production. One of the decisions of the firm is producing within the firm or externalise the production).

The manager is a person who directs resources (L-labour, C-capital such as machineries/buildings/money and A-technologies that help to improve the efficiency in the input use and also in the human activities) to achieve a stated goal (profit maximisation).

• Responsibility for her/his own actions as well as for actions of individuals, machines and/or inputs under the manager’s control. Responsibility means controlling these actions;
• Directs the efforts of others (by motivating and giving incentives);
• Purchases inputs used in the production of the firm's output;
• Directs the product price or quality decisions (if the production is standardised, a manager can adopt a quantity strategy, while if the production is specialised, a manager can adopt a price strategy).

Economics is the science of making decisions in the presence of scarce resources. Resources are anything used to produce a good or service, or achieve a goal. A manager decides first if a production should take place and second if the production should be done within the firm or in an external place. Then, the quantity needs to be calculated. Moreover, a manager has to think about if it is beneficial to create a new line of production (that means differentiation). Decisions are important because scarcity implies trade-offs. The economics aim is driving production and consumption of goods. The main goal is minimising the resources used in the production process in order to be the most efficient possible.

Managerial Economics is the study of how to direct scarce resources (input) in the way that most efficiently achieves a managerial goal. Manager of a Fortune 500 company that makes computer:

1. Should the company purchase components (like disk drives and chips) from other manufacturers or produce them within the firm?
2. Should the firm specialize in making one type of computer or produce several different types (differentiation)?
3. How many computers should the firm produce, and at what price should you sell them?
4. How many employees (L)? What about their productivity (that is the contribution of each employee to the total revenue)?

A typical firm’s objective is to maximize profits. The nature of profit can be different and depends on the type of cost taken into consideration:

1. Accounting profit is the total amount of money taken in from sales (total revenue) minus the dollar cost of producing goods or services (total cost).

2. Economic profit is the difference between total revenue and total opportunity cost (that is higher than the total cost). The opportunity cost is the cost of the explicit (what we pay) and implicit (costs of the alternative) resources that are foregone when a decision is made. On the contrary, total cost takes into account only the explicit costs.

3. Accounting profits overstate economic profits, because the costs include only accounting costs.

Profit Principles from Adam Smith’s classic line “An Inquiry into the Nature and Causes of the Wealth of Nations (1776):

1. Profits are a signal to resource holders where resources are most highly valued by society. This statement means that when you see a profit, you see a signal, that is resources such as raw materials or intermediate goods are efficiently used. For example, in Italy we use GDP for the wealth measurement of nations. For individuals wealth instead, we use incomes, and for firms wealth we use profits. So, already in the past, Adam Smith started to defined the wealth.

2. By moving scarce resources toward the production of goods most valued by society, the total welfare of society is improved. In other words, it is important where the resources are allocated.

FIVE FORCES AND INDUSTRY PROFITABILITY (PORTER, 1980)

Now we talk about profitability. Each firm in the industry is able to realize profits and this implies the interaction of different actors, issues and economic indicators. The final aim is to obtain a certain level, growth and sustainability of industry profits.

1. Entry: increases competition and reduces the margins of the existing firms. For this reason, the ability of existing firms to sustain profits depends on how barriers to entry affect the ease with which other firms can enter the industry.
   • Entry costs = capital requirement (machines/buildings/labour/land) —> the higher are the costs, the more concentrated will be the market (few companies);
   • Speed of adjustment = companies have to adapt their production to government policies (environmental policies for example);
   • Sunk costs = once they’re born, they can’t be recovered. For example, marketing and advertising costs;

2. Economies of scale = is the firm capacity to increase the outputs produced by increasing the volume of inputs (new workers, new machines). We have three different economies of scale: constant or proportional economies (if 1 increase one unit of capital, the production w1 increase by one unit), less then proportional economies (if the firm increase 1 unit of input, there will be a less than 1 unit increase in output) and more than proportional economies (if the firm increase 1 unit of input, there will be a more than 1 unit increase in output);