Application and Scope of Managerial Economics:

Chapter Summary:

Managerial economics is a science of directing limited resources to administer cost efficiently. It comprises of three branches: competitive markets, imperfect markets and market power. A market comprises of sellers and buyers which communicate with each other for voluntary exchange. Whether a market is global or local, the similar managerial economics apply.

The seller with market power will have freedom to select suppliers, set prices, and employ advertising to persuade demand. A market is imperfect whenever one party directly conveys a profit or cost to others, or whenever one party has better information than others.

An organization should decide its horizontal and vertical boundaries. For efficient management, it is significant to distinguish marginal from average values and stocks from flows. The Managerial economics applies models which are essentially less than totally realistic. Usually, a model focuses on one issue, holding other things equivalent.

Key Concepts:

General Chapter Objectives:

A) Define managerial economics and introduce students to the usual issues encountered in the field.

B) Discuss the methodology and scope of managerial economics.

C) Differentiate a marginal concept from its average and stock concept from the flow.

D) Explain the significance of the "other things equal” supposition in managerial economic analysis.

E) Explain what comprises a market, differentiate competitive from non-competitive markets, and discuss imperfect markets.

F) Highlight the globalization of markets.
 
Notes:

A) Definition: Managerial economics is a science of directing limited resources to administer cost effectively. 
 
B) Application: Managerial economics applies to:

(i) Businesses (similar to decisions in relation to customers comprising pricing and advertising; competitors; suppliers; or the internal workings of the organization), non-profit groups, and households.

(ii) The ‘old economy’ and ‘new economy’ in essentially similar way except for two distinctive aspects of new economy: the significance of network effects and scope and scale economies.

Network effects in demand: the advantage provided by a service based on total number of other users, example: if only one person had email, she had no one to communicate with, however with 100 mm users on line, the demand for Internet services mushroomed.

Scale and scope economies: scaleability is the degree to which scope and scale of a business can be raised without a corresponding raise in costs, example: the information in Yahoo is highly scaleable (that is, the same information can serve 100 and also 100 mm users) and to serve a bigger number of users, Yahoo requires only raise the capacity of its computers and links.

(iii)  Both local and global markets.
 
C) Scope:

(i) Microeconomics: It is the study of individual economic behavior where resources are expensive, example: how consumers respond to modifications in prices and income, how businesses decide on sales and employment, voter’s behavior and setting of tax policy.

(ii) Managerial economies: the application of microeconomics to managerial issues (that is, a scope more restricted than microeconomics).

(iii) Macroeconomics: the study of aggregate economic variables directly (that is, as opposed to the aggregation of individual consumers and businesses), example: issues relating to exchange rates, interest, inflation, unemployment, import and export policies.

D) Methodology:

(i) Basic premise: economic behavior is systematic and thus can be studied. Systematic economic behavior signifies individuals share common motivations and behave systematically in forming economic choices, that is, a person who faces similar choices at two different times will behave in similar way both times.

(ii) Economic model: a concise explanation of behavior and outcomes:

• Focuses on specific issues and key variables (example: price and salary), omits considerable information, therefore unrealistic at times;
• Made by the inductive reasoning;
• To be tested with the empirical data and revised as suitable.

 
E) Basic concepts:

(i) Margin in relation to average variables in the managerial economics analysis.

• Marginal value of a variable: the change in variable related with a unit raise in a driver, example: amount earned by working one or more additional hour;
• Average value of a variable: the total value of variable divided by the total quantity of a driver, example: total pay divided by total number of hrs worked;
• Driver: the independent variable, example:  number of hrs worked;
• The marginal value of a variable might be less than, equivalent to, or greater than the average value, based on whether the marginal value is increasing, decreasing or constant with respect to the driver;
• If the marginal value of a variable is bigger than its average value, then the average value rises, and vice-versa.

(ii) Stocks and flows:

Stock: the quantity at a particular point in time, measured in units of the item, example: items on a balance sheet (that is, liabilities and assets), the world’s oil reserves in the starting of a year;

Flow: the change in stock over some time period, measured in units per time period example: items on an income statement (that is, expenses and receipts), the world’s present production of oil per day.

(iii) Holding other things equivalent: the supposition that all other relevant factors do not modify, and is made up so that modifications due to the factor being studied might be examined independently of such other factors. Having analyzed the consequences of each factor, they can be put altogether for the whole picture.
 
F) Organizational boundaries:

(i) Organizations comprise businesses, non-profits and households.

(ii) Vertical boundaries: delineate activities nearer to or further from end user.

(iii) Horizontal boundaries: relate to economies of scale (that is, rate of production or delivery of a service or good) and scope (range of various items generated or delivered).

(iv) Organizations that are members of similar industry might select different horizontal and vertical boundaries.
 
G) Competitive markets:

(i) Markets:

• A market comprises of sellers or buyers which communicate with one other for voluntary exchange. This is not limited by the physical structure.
• In markets, for consumer products, the buyers are households and the sellers are businessmen.
• In markets, for industrial products, both buyers and sellers are businesses.
• In markets for human resources, buyers are businesses and sellers are households.

Note: an industry is made up of businesses engaged in the production or delivery of similar items.

(ii) Competitive markets:

• Markets with lots of buyers and numerous sellers, where buyers give the demand and sellers give the supply, example: the silver market.
• The demand-supply model: basic beginning point of managerial economics, the model explains the systematic effect of modifications in prices and other economic variables on sellers and buyers, and the interaction of these selections.

(iii) Non-competitive markets: a market in which, the market power exists.
 
H) Market power:

(i) Market power: the capability of a seller or buyer to influence market situation. A seller with market power will contain the freedom to select suppliers, set prices and persuade demand.

(ii) Businesses with market power, whether sellers or buyers, still require understanding and managing their costs.

(iii) Additionally to managing costs, sellers with market power want to manage their demand via advertising, price and policy toward competitors.
 
I) Imperfect Market:

(i) Imperfect market: where one party directly expresses a profit or cost to others, or where one party has enhanced information than others.

(ii) The challenge is to solve the imperfection and be cost-efficient.

(iii) Imperfections can as well arise in an organization, and therefore, another issue in managerial economics is how to structure organizations and incentives.
 
J) Local and global markets:

(i) Local markets: owing to comparatively high costs of communication and trade, various markets are local, example: housing and groceries. The price in one local market is self-governing of prices in other local markets.

(ii) Global markets: owing to comparatively low costs of trade and communication, various markets are global, example: shipping, mining and financial services. The price of an item with global market in one place will move altogether with the price somewhere else.

(iii) Whether a market is global or local, the similar managerial economic principles apply.

Note: Falling costs of trade and communication are causing more markets to be more integrated across geographical border; enabling the prospect to sell in new markets and also global sourcing. Foreign sources might provide specialized resources, cheaper skilled labor, or superior quality, resultant in lower production costs and/or enhanced quality.
 
Question-Answer:

Venus Car Rental offers two schemes for rental of a compact car. They charges $60 per day for an indefinite mileage plan, and $40 per day for a time-and-mileage plan with 100 free miles plus 20 cents a mile for the mileage in excess of free allowance.

i) For a customer who plans to drive 50 miles, which is the cheaper plan? Determine the average and marginal costs per mile of rental? (That is, the marginal cost is a cost of an extra mile of usage.)

ii) For a customer, who plans to drive 150 miles, what is the cheaper plan? Determine the average and marginal costs per mile of rental?

iii) When Venus raises the basic charge for the time-and-mileage plan to $44 per day, how would that influence the marginal and average costs for a customer who drives 50 miles?

Answer:

(i) It is obliging to sketch the total rental cost as a function of mileage (as shown in figure below). The breakeven among the two plans is at 200 miles per day.

For 50 miles, the time-and-mileage plan is cheaper. 
Average cost = $40/50 = 80 cents per mile.  Marginal cost = 0.

(ii) For 150 mile customer, the time-and-mileage plan is still cheaper.
Average cost = $(40 + 0.2 x 50)/150 = 33 cents per mile; and
Marginal cost = 20 cents per mile.

(iii) After the raise in the basic charge, the average cost = $(44 + 0.2 x 50)/150 = 36 cents per mile, whereas marginal cost = 20 cents per mile. The raise in the basic charge does not affect the marginal cost.

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