Managerial Economics &
Policy Analysis
MBSA1523
Managers, profits & markets
Dr Nur Azam Perai
1-2 Managers, profits & markets
1. Economic way of thinking about business & strategy
2. Measuring & maximising economic profit
3. Separation of ownership & control of firm
4. Market structures
5. Economic systems
6. Government regulation of business
Ref: Thomas & Maurice, ch. 1, 11, 12, 16
Lesson objectives
▪ Difference between economic and accounting profit
▪ Relate economic profit to the value of the firm
▪ Principal-agent problems
▪ Price-taking & price-setting firms
▪ Characteristics of market structures
▪ Globalisation – opportunities & threats
Managerial Economics & Theory
▪ Economic theory facilitates understanding of real-world business problems
▪ Economic analysis to achieve firm’s goal of profit maximization
▪ Marginal analysis – foundation for understanding everyday business decisions
▪ Microeconomics
▪ Studies behaviour of individual economic agents
▪ Industrial organisation
▪ Branch of microeconomics focusing on behavior & structure of firms & industries
Economic cost of using resources
▪ Market-supplied resources – owned by others outside firm
▪ Owner-supplied resources – owned by firm
▪ Opportunity cost = cost of alternative use of resources
▪ Explicit costs → monetary opportunity cost = market-supplied resources
▪ Implicit costs → non-monetary costs = owner-supplied resources
▪ Total economic cost = explicit costs + implicit costs
Economic profits
▪ Economic profit = revenues minus economic costs
▪ All economic costs measured in terms of opportunity costs
▪ NOT the same as accounting profits
▪ Economic profit = Total revenue – Total economic cost
▪ Includes implicit and explicit costs of all resources used by the firm
▪ Accounting profit = Total revenue – Explicit costs
▪ Does not subtract implicit costs from total revenue
Maximising the value of a firm
▪ Value of a firm
▪ Price for which it can be sold
▪ Equal to NPV of expected future profit
▪ Risk premium
▪ Accounts for risk of not knowing future profits
▪ Larger the risk, higher the risk premium, & the lower the firm’s value, vice versa
Maximising the value of a firm
▪ Maximise firm’s value by maximizing profit in each time period
▪ Cost & revenue conditions must be independent across time periods
▪ Value of a firm =
Some common mistakes
▪ Never increase output simply to reduce average costs
▪ Pursuit of market share usually reduces profit, unless ‘network effect’ is present
▪ Maximizing total revenue reduces profit
▪ Focusing on profit margin won’t maximize total profit
▪ Cost-plus pricing formulas do not produce profit-maximising prices
▪ will return to these in L3-4
Separation of ownership & control
▪ Principal-agent problem
▪ Conflict - goals of management (agent) do not match goals of owner (principal)
▪ Moral Hazard
▪ Incentive not to abide & cannot cost effectively monitor the agreement
▪ Corporate control mechanisms
▪ Equity ownership among managers
▪ Independent non-executive directors
▪ Debt financing
Price-takers vs. Price-setters
▪ Price-taking firm
▪ Cannot set price of its product
▪ Price is determined strictly by market forces of demand & supply
▪ Price-setting firm
▪ Can set price of its product
▪ Has a degree of market power - ability to raise price without losing all sales
What is a market?
▪ Any arrangement through which buyers & sellers exchange goods & services
▪ Physical or virtual
▪ Reduce transaction costs i.e. costs other than price of good/service
▪ Market structures - characteristics that determine the economic environment in which
a firm operates
1. Number & size of firms in market
2. Degree of product differentiation
3. Likelihood of new firms entering market
Market structures
Perfect competition
Monopoly
• Large number of relatively
• Single firm
small firms
• Product with no close substitutes
• Undifferentiated product
• Protected by strong barriers to entry
• No barriers to entry
Oligopoly
Monopolistic Competition
• Few firms produce all or most of
• Large number of relatively
market output
small firms
• Interdependent - actions by any one
• Differentiated products
firm will affect sales & profits of
• No barriers to entry
other firms
Economic systems
Set of institutional arrangements and coordinating mechanism, most economists
identify 2 types – market & command
Market system / capitalism Command system
• Private ownership of resources • State owns property & resources
• Markets & prices coordinate & direct • Economic decision made centrally by
economic activity govt.
• Limited govt. role – laissez-faire • Industries are nationalised
Mixed economic system
• Cross between market & command
• Free of government ownership except for a few key industries
• Govt. involved in regulation of businesses, intervene to correct market failures
• Government involved in social welfare & income redistribution programmes
Government regulation of business
▪ Market failure - market fails to achieve social economic efficiency & fails to maximise
social surplus
▪ Forms of market failure can undermine economic efficiency:
1. Monopoly power
2. Natural monopoly
3. Negative (& positive) externalities
4. Common property resources
5. Public goods
6. Information problems
Government intervention
▪ To address inflation and/or unemployment
▪ Inflation occurs due to increase in general price levels from an increase in aggregate
demand or a decrease in aggregate supply.
▪ Increase in domestic consumption caused by increase in aggregate income
increase in aggregate demand
▪ Unemployment = fall in aggregate demand/income
▪ Intervention through fiscal and monetary policy
▪ Expansionary policy increase aggregate demand/income
▪ Contractionary policy decrease in aggregate demand
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