Module 1 Wed Bsa Core 1

1
BSA CORE 1
MANAGERIAL ECONOMICS
MODULE 1
(Wednesday)
ECONOMIC VIEW ON PRIVATE AND PUBLIC DECISION
Private decisions
Approach to managerial economics is based on a model of the firm

o How firms behave and what objectives they pursue.
The main idea of this model or theory of the firm is that management strives to
maximize the firm’s profits.
o This objective is unambiguous for decisions involving predictable
revenues and costs occurring during the same period of time.
The most general theory of the firm states that management’s primary goal is to
maximize the value of the firm.
o The firm’s value is defined as the present value of its expected future
profits.
o Thus, in making any decision, the manager must attempt to predict its
impact on future profit flows and determine whether, indeed, it will add to
the value of the firm.
Value maximization is a compelling prescription concerning how managerial

decisions should be made.
o Even if value maximization is the ultimate corporate goal, actual decision
making within this complex organization may look quite different. There
are several reasons for this:
 1. Managers may have individual incentives (such as job security,
career advancement, increasing a division’s budget, resources,
power) that are at odds with value maximization of the total firm.
 For instance, it sometimes is claimed that company
executives are apt to focus on short-term value maximization
(increasing next year’s earnings) at the expense of long-run
firm value.
 2. Managers may lack the information (or fail to carry out the
analysis) necessary for value-maximizing decisions.
 3. Managers may formulate but fail to implement optimal decisions.
Three decision models

o Model of satisficing behavior
Samuelson, Willian F. & Marks, Stephen G. 2012. Managerial Economics, 7th Edition. John Wiley and
Sons, Inc.
2
 It posits that the typical firm strives for a satisfactory level of

performance rather than attempting to maximize its objective.
 Thus, a firm might aspire to a level of annual profit, say $40 million,
and be satisfied with policies that achieve this benchmark.
 More generally, the firm may seek to achieve acceptable levels of
performance with respect to multiple objectives (profitability being
only one such objective).
o Second model posits that the firm attempts to maximize total sales subject
to achieving an acceptable level of profit.
 Total dollar sales are a visible benchmark of managerial success.
 For instance, the business press puts particular emphasis on
the firm’s market share.
 In addition, a variety of studies show a close link between executive
compensation and company sales.
 Thus, top management’s self-interest may lie as much in
sales maximization as in value maximization.
o A third model centers on the social responsibility of business.

 In modern capitalist economies, business firms contribute
significantly to economic welfare.
 Within free markets, firms compete to supply the goods and
services that consumers demand.
 Pursuing the profit motive, they constantly strive to produce goods
of higher quality at lower costs.
 By investing in research and development and pursuing
technological innovation, they endeavor to create new and
improved goods and services.
 In the large majority of cases, the economic actions of firms
(spurred by the profit motive) promote social welfare as well:
 Business production contributes to economic growth,
provides widespread employment and raises standards of
living.
The objective of value maximization implies that management’s primary

responsibility is to the firm’s shareholders.
o But the firm has other stakeholders as well:
o its customers
o its workers
o local community to which it might pay taxes.
This observation raises an important question:

o To what extent might management decisions be influenced by the likely
effects of its actions on these parties?
Sons, Inc.
3
 For instance, suppose management believes that downsizing its

workforce is necessary to increase profitability.
 Should it uncompromisingly pursue maximum profits even if this
significantly increases unemployment?
 Alternatively, suppose that because of weakened international
competition, the firm has the opportunity to profit by significantly
raising prices. Should it do so?
 Finally, suppose that the firm could dramatically cut its production
costs with the side effect of generating a modest amount of
pollution. Should it ignore such adverse environmental side effects?
All of these examples suggest potential trade-offs between value maximization

and other possible objectives and social values.
o Although the customary goal of management is value maximization, there
are circumstances in which business leaders choose to pursue other
objectives at the expense of some foregone profits.
 For instance, management might decide that retaining 100 jobs at a
regional factory is worth a modest reduction in profit.
Public decisions
In government decisions, the question of objectives is much broader than simply

an assessment of profit.
The purpose of public decisions is to promote the welfare of society, where the
term society is meant to include all the people whose interests are affected when
a particular decision is made.
Some groups will gain and others will lose from any public decision.
o Examples:
 A bridge constructed by the government
 Businesses and commuters in the region can expect to gain,
but nearby neighbors who suffer extra traffic, noise, and
exhaust emissions will lose.
 The program to convert utilities from oil to coal will benefit the
nation by reducing our dependence on foreign oil.
 It will increase many utilities’ costs of producing electricity,
which will mean higher electric bills for many residents.
 The accompanying air pollution will bring adverse health and
aesthetic effects in urban areas.
 Strip mining has its own economic and environmental costs, as
does nuclear power.
In short, any significant government program will bring a variety of new benefits
and costs to different affected groups.
How do we weight these benefits and costs to make a decision that is best for
society as a whole?
o Benefit-cost analysis
Sons, Inc.
4
It begins with the systematic enumeration of all of the potential

benefits and costs of a particular public decision.
 It goes on to measure or estimate the dollar magnitudes of these
benefits and costs.
 It follows the decision rule = undertake the project or program if
and only if its total benefits exceed its total costs.
o Benefit-cost analysis is similar to the profit calculation of the private firm
with one key difference:
 Whereas the firm considers only the revenue it accrues and the
cost it incurs, public decisions account for all benefits, whether or
not recipients pay for them (that is, regardless of whether revenue
is generated) and all costs (direct and indirect).
Summary
1. Decision making lies at the heart of most important problems managers face.
2. Managerial economics applies the principles of economics to analyze business
and government decisions. The prescription for sound managerial decisions
involves six steps:
a. Define the problem.
b. Determine the objective.
c. Explore the alternatives.
d. Predict the consequences.
e. Make a choice.
f. Perform sensitivity analysis.
3. This framework is flexible. The degree to which a decision is analyzed is itself a
choice to be made by the manager.
4. Experience, judgment, common sense, intuition, and rules of thumb all make
potential contributions to the decision-making process. However,none of these
can take the place of a sound analysis.
Sons, Inc.

Module 1 Wed Bsa Core 1

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Module 1 Wed Bsa Core 1

Uploaded by

Copyright:

Available Formats

1

ECONOMIC VIEW ON PRIVATE AND PUBLIC DECISION

Approach to managerial economics is based on a model of the firm

Value maximization is a compelling prescription concerning how managerial

 3. Managers may formulate but fail to implement optimal decisions.

Three decision models

 It posits that the typical firm strives for a satisfactory level of

o A third model centers on the social responsibility of business.

The objective of value maximization implies that management’s primary

This observation raises an important question:

 For instance, suppose management believes that downsizing its

All of these examples suggest potential trade-offs between value maximization

In government decisions, the question of objectives is much broader than simply

It begins with the systematic enumeration of all of the potential

You might also like