Description
Select an article from the news of the past week that illustrates one or two of the concepts that are discussed in chapters 1 and 2. In a paper of no more than two pages (double spaced, one inch margins, 12 point type) briefly summarize the article and discuss the underlying economic concept(s) of the article.
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Chapter 1 Introduction
Learning Objectives
Upon completion of this chapter, readers should be able to:
Define managerial economics and discuss briefly its relationship to microeconomics and other related fields of study such as
finance, marketing, and statistics.
Cite the important types of decisions that managers must make concerning the allocation of a company’s scarce resources.
Cite and compare the three basic economic questions from the standpoint of both a country and a company.
The Situation
The last of the color slides was barely off the screen when Bob Burns, the CEO of Global Foods, Inc., turned to his board of
directors to raise the question that he had been waiting all week to ask. “Well, ladies and gentlemen, are you with me in this new
venture? Is it a ‘go’? Shall we get into the soft drink business?”
“It’s not that easy, Bob. We need some time to think it over. You’re asking us to endorse a very major decision, one that will have
a long-term impact on the direction of the company.”
“I appreciate your wish to deliberate further, Dr. Breakstone,” Bob responded, “but I would like to reach a decision today. As the
president of a major university, you have been especially valuable in advising this company in matters relating to social and
governmental policies. But we must diversify our business very soon in order to maintain the steady growth in profits that we
have achieved in recent years. As my presentation showed, the manufacturing and marketing of our own brand of soft drink is
one of the best ways to do this. It represents a significant diversification, yet it is very closely related to our core business: food.
“The economics of the soft drink market tell us that we would be foolish to pass up the kind of investment return that the market
offers to those newcomers willing to take the risk. The food business is generally a mature one. On the other hand, our forecast
indicates that there is still a lot of room for growth in the soft drink market. To be sure, there is a tremendous amount of
competition from the ‘red team’ and the ‘blue team.’ But we already have expertise in the food business, and it should carry over
into the beverage market.”
“That’s just it, Bob,” interjected another board member. “Are we prepared to take this risk? You yourself acknowledged that the
market power wielded by the two dominant companies in this business is not to be taken lightly. Others have tried to take
market share from them and have failed miserably. Moreover, the projections that you have shown for a growing soft drink
market are based on the assumption that the growth rate will remain the same as it has been in the past ten years or so. As we
all know, the soft drink market has been growing, but it has also been very fickle. Only recently, Americans were on a health kick,
and fruit juices and bottled waters along with health foods were in fashion. Now it seems that soft drinks are back in style again.
Who knows what people will want in the future? Maybe we’ll all go back to drinking five cups of coffee a day. And what about all
the money that we’re going to have to spend up front to differentiate our product? As you well know, in the processed-food
business, establishing brand recognition—not to mention brand loyalty—can be extremely difficult and costly.”
“Well, ladies and gentlemen, all your concerns are certainly legitimate ones, and believe me, I have given much thought to these
drawbacks. This is one of the biggest decisions that I will have made since becoming CEO. My staff has spent hundreds of hours
analyzing all available data to arrive at a judgment. Our findings indicate a strong probability of earning an above-average return
on an investment in the soft drink business, a return commensurate with the kind of risk we know exists in that market. But if we
could make all our decisions with 100 percent certainty simply by feeding numbers into a computer, we’d all be out of a job. To
be sure, details on production, cost, pricing, distribution, advertising, financing, and organizational structure remain to be ironed
out. However, if we wait until all these details are worked out, we may be missing a window of opportunity that might not
appear again in this market for a long time. I say that we should go ahead with this project as soon as possible. And unanimity
among the board members will give me greater confidence in this endeavor.”
Introduction: Economics and Managerial Decision Making
Managerial Economics is one of the most important and useful courses in your curriculum of studies. It will provide you with a
foundation for studying other courses in finance, marketing, operations research, and managerial accounting. It will also provide
you with a theoretical framework for tying together courses in the entire curriculum so you can have a cross-functional view of
your studies.
Economics is “the study of the behavior of human beings in producing, distributing and consuming material goods and services in
a world of scarce resources.” 1 Management is the discipline of organizing and allocating a firm’s scarce resources to achieve its
desired objectives.2 These two definitions clearly point to the relationship between economics and managerial decision making.
In fact, we can combine these two terms and define managerial economics as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources.
1 Campbell McConnell, Economics, New York: McGraw-Hill, 1993, p.1.
2 For books supporting this definition, see Peter Drucker, Management, New York: Harper & Row, 1973.
Joel Dean, author of the first managerial economics textbook, defines managerial economics as “the use of economic analysis in
the formulation of business policies.” He also notes a “big gap between the problems of logic that intrigue economic theorists
and the problems of policy that plague practical management [which] needs to be bridged in order to give executives access to
the practical contributions that economic thinking can make to top-management policies.3
3 Joel Dean, Managerial Economics, Englewood Cliffs, NJ: Prentice-Hall, 1951, p. vii.
William Baumol, a highly respected economist and industry consultant, stated that an economist can use his or her ability to
build theoretical models and apply them to any business problem, no matter how complex, break it down into essential
components, and describe the relationship among the components, thereby facilitating a systematic search for an optimal
solution. In his extensive experience as a consultant to both industry and government, he found that every problem that he
worked on was helped in some way by “the method of reasoning involved in the derivation of some economic theorem.4
4 William Baumol, “What Can Economic Theory Contribute to Managerial Economics?” American Economic Review, 51, 2 (May
1961), p.114.
William H. Meckling, the former dean of the Graduate School of Management at the University of Rochester, expressed a similar
sentiment in an interview conducted by The Wall Street Journal. In his view, “economics is a discipline that can help students
solve the sort of problems they meet within the firm.” Recalling his experience as the director of naval warfare analysis at the
Center for Naval Analysis and as an economic analyst at the Rand Corporation, one of the nation’s most prominent think tanks,
Meckling stated that these institutions are “dominated by physical scientist types, really brilliant people.” However, he went on to
say that “the economists knew how to structure the problems . . . the rest of the people knew a lot about technical things but
they had never thought about how you structure big issues.5
5 “Economics Has Much to Teach the Businessman,” Wall Street Journal, May 3, 1983.
As it has evolved in undergraduate and graduate programs over the past half century, managerial economics is essentially a
course in applied microeconomics that includes selected quantitative techniques common to other disciplines such as linear
programming (management science), regression analysis (statistics, econometrics, and management science), capital budgeting
(finance), and cost analysis (managerial and cost accounting). From our perspective as economists, we see that many disciplines
in business studies have drawn from the core of microeconomics for concepts and theoretical support. For example, the
economic analysis of demand and price elasticity can be found in most marketing texts. The division of markets into four types—
perfect competition, pure monopoly, monopolistic competition, and oligopoly—is generally the basis for the analysis of the
competitive environment presented in books on corporate strategy and marketing strategy.6
6 Professor Michael Porter, whose books on strategy have greatly influenced this field of study, is himself a Ph.D. in economics.
There are a number of other examples to be found. The economic concept of opportunity cost serves as the foundation for the
analysis of relevant cost in managerial accounting and for the use of the “hurdle rate7 in finance. As shown in Chapter 2,
opportunity cost also plays an important part in understanding how firms create “economic value” for their shareholders. Finally,
in recent years, certain authors have linked their managerial economics texts thematically with strategy and human resources.8
Figure 1.1 illustrates our view that managerial economics is closely linked with many other disciplines in a business curriculum.
7 Essentially, this is a company’s cost of funds expressed as a percentage (e.g., 15 percent). Any project funded by the company
should have a rate of return that is greater than this level.
8 See for example, David Besanko et al., Economics of Strategy, New York: John Wiley & Sons, 2009, and James A. Brickley et al.,
Managerial Economics and Organizational Architecture, New York, McGraw-Hill, 2003.
Our approach in this text is to show linkages of economics with other business functions, while maintaining a focus on the heart
of managerial economics—the microeconomic theory of the behavior of consumers and firms in competitive markets. When
clearly understood and exemplified in actual business examples, this theory provides managers with a basic framework for
making key business decisions about the allocation of their firm’s scarce resources. In making these decisions, managers must
essentially deal with the following questions listed in abridged form:
What are the economic conditions in a particular market in which we are or could be competing? In particular:
Market structure?
Supply and demand conditions?
Technology?
Government regulations?
International dimensions?
Future conditions?
Macroeconomic factors?
Should our firm be in this business?
If so, what price and output levels should we set in order to maximize our economic profit or minimize our losses in the short
run?
How can we organize and invest in our resources (land, labor, capital, managerial skills) in such a way that we maintain a
competitive advantage over other firms in this market?
Cost leader?
Product differentiation?
Focus on market niche?
Outsourcing, alliances, mergers, acquisitions?
International dimension—regional or country focus or expansion?
What are the risks involved?
Perhaps the most fundamental management question is question 2, which concerns whether a firm should be in the business in
which it is operating. This is the very question addressed by Bob Burns and the rest of the board of directors of Global Foods in
this chapter’s “The Situation” vignette.
Note that question 5 has to do with a firm’s risk. Uncertainty pervades our everyday lives, especially when we are considering
what may happen in the future, and uncertainty, or risk, is always present in the operations of a business. Of course, some things
are fairly certain. A company that buys steel can get a price quote and be certain what it will pay for a ton. A company with
temporary excess cash to invest for a short period of time can ascertain the interest rate it will earn. An investor purchasing a
U.S. Treasury bill is virtually certain that he or she will be repaid in full at maturity.
However, when it comes to future impacts, few things are certain. We can define risk or uncertainty (we explain the difference
between these two terms in Chapter 12) as a chance or possibility that actual future outcomes will differ from those expected
today. Actually we are usually only concerned with unfavorable results. Thus we can say that risk is the possibility that the
outcomes of an action will turn out to be worse than expected. Typical of the types of risk that businesses face include:
Changes in demand and supply conditions
Technological changes and the effect of competition
Changes in interest rates and inflation rates
Exchange rate changes for companies engaged in international trade
Political risk for companies with foreign operations
You may not literally see the term risk in many of the chapters of this book. In some of the chapters we implicitly assume that we
know the level of demand, the product price, production cost, and the economic profit resulting from operations. However, we
really know that risk is present in most situations. In Chapter 12, we show how businesses attempt to quantify risk and how
decisions are made under these conditions, but this is not all. Chapter 5 deals with estimating the effects of changes in the
variables that determine the demand for products. It also looks at predicting future results based on past experience, assuming
we have sufficient historical data. It also talks about the challenges of estimating what may happen in the future if historical data
do not exist.
A Brief Review of Important Economic Terms and Concepts
For purposes of study and teaching, economics is divided into two broad categories: microeconomics and macroeconomics. The
former concerns the study of individual consumers and producers in specific markets, and the latter deals with the aggregate
economy. Topics in microeconomics include supply and demand in individual markets, the pricing of specific outputs and inputs
(also called factors of production, or resources), production and cost structures for individual goods and services, and the
distribution of income and output in the population. Topics in macroeconomics include analysis of the gross domestic product
(also referred to as “national income analysis”), unemployment, inflation, fiscal and monetary policy, and the trade and financial
relationships among nations.
Microeconomics is the category that is most used in managerial economics. However, certain aspects of macroeconomics must
also be included because decisions by managers of firms are influenced by their views of the current and future conditions of the
macroeconomy. For example, we can well imagine that the management of a company producing capital equipment (e.g.,
computers, machine tools, trucks, or robotic instruments) would indeed be remiss if they did not factor into their sales forecast
some consideration of the macroeconomic outlook. For these and other companies whose businesses are particularly sensitive
to the business cycle, a recession would have an unfavorable effect on their sales, whereas a robust period of economic
expansion would be beneficial. However, for the most part, managerial economics is based on the variables, models, and
concepts that embody microeconomic theory.
As defined in the previous section, economics is the study of how choices are made regarding the use of scarce resources in the
production, consumption, and distribution of goods and services. The key term is scarce resources. Scarcity can be defined as a
condition in which resources are not available to satisfy all the needs and wants of a specified group of people. Although scarcity
refers to the supply of a resource, it makes sense only in relation to the demand for the resource. For example, there is only one
Mona Lisa. Therefore, we can safely say that the supply of this particular work of art by da Vinci is limited. Nevertheless, if for
some strange reason no one wanted this magnificent work of art, then in purely economic terms it would not be considered
scarce. Let us take another example: broken glass on the streets of New York City. Here we have a case of a “resource” that is not
scarce not only because there is a lot of broken glass to be found, but also because nobody wants it! Now suppose there were a
new art movement inspired by the use of materials retrieved from the streets of urban areas, with broken glass from the streets
of New York being particularly desirable. The once-plentiful resource would fast become a “scarce” commodity.
The relative nature of scarcity is represented in Figure 1.2. As seen in Figure 1.2, the supply of resources is used to meet the
demand for these resources by the population. Because the population’s needs and wants exceed the ability of the resources to
satisfy all the demands, scarcity exists.
In an introductory economics course, the concept of scarcity is usually discussed in relation to an entire country and its people.
For example, you will probably recall from your first course in economics the classic example of “guns” (representing a country’s
devotion of resources to national defense) versus “butter” (representing the use of resources for peacetime goods and services).
To be sure, scarcity is a condition with which individual consumers and producers must also deal. This text is primarily concerned
with the way in which managers of the producing organizations contend with scarcity. However, before discussing this particular
aspect of the problem, let us review the condition of scarcity from the perspective of an entire country.
The intent of the “guns versus butter” example is to illustrate that scarcity forces a country to choose the amounts of resources
that it wants to allocate between defense and peacetime goods and services. In so doing, its people must reckon with the
opportunity cost of their decision. This type of cost can be defined as the amount or subjective value that must be sacrificed in
choosing one activity over the next best alternative. In the “guns versus butter” example, one activity involves the production of
war goods and services, and the other pertains to the production of peacetime goods and services. Because of the scarcity of
resources, the more that the country allocates to guns, the less it will have to produce butter, and vice versa. The opportunity
cost of additional units of guns are the units of butter that the country must forgo in the resource allocation process. The
opposite would apply as resources are allocated more for the production of butter than for guns.
Figure 1.2
Supply, Demand, and Scarcity
In the presence of a limited supply relative to demand, countries must decide how to allocate their scarce resources. This
decision is central to the study of economics. In fact, economics has been defined as “the science which studies human behavior
as a relationship between ends and scarce means which have alternative uses.”9 Essentially, the allocation decision can be
viewed as comprising three separate choices:
9 Lionel Robbins, An Essay on the Nature and Significance of Economic Science, 2nd ed., London: Macmillan, 1935, p.16.
What goods and services should be produced and in what quantities?
How should these goods and services be produced?
For whom should these goods and services be produced?
The first question incorporates the “guns versus butter” decision. Should a country with scarce resources produce guns? Should
it produce butter? If so, how much butter and how many guns? The same applies to the countless other goods and services or
product groups that a country is capable of producing.
The second question involves the allocation of a country’s resources in the production of a particular good or service. Suppose a
country decides to produce a certain amount of butter. What amounts of land, labor, capital, and entrepreneurial efforts should
it devote to this end? Should it use more workers than machinery (a labor-intensive process), or vice versa (a capital-intensive
process)?
The meaning of the third question should be readily apparent. It is a decision that must be made about the distribution of a
country’s output of goods and services among the members of its population.
All countries must deal with these three basic questions because all have scarce resources. Scarcity is a more serious problem in
some countries than in others, but all have needs and wants that cannot be completely met by their existing resources. Precisely
how these countries go about making allocation decisions is the question to which we now turn.
There are essentially three ways a country can answer the questions of what, how, and for whom. These ways, referred to as
processes, are as follows:
Market process: The use of supply, demand, and material incentives to answer the questions of what, how, and for whom.
Command process: The use of the government or some central authority to answer the three basic questions. (This process is
sometimes referred to as the political process.)
Traditional process: The use of customs and traditions to answer the three basic questions.
Countries generally employ a combination of these three processes to allocate their scarce resources. The market process is
predominant in the United States, although the command process plays an important role. Hence, the United States is said to
have a mixed economy. Based on the levels of spending by the federal, state, and local governments, we can state that
approximately one-fifth of the goods and services produced in the United States are influenced by the command process. The
command process does not necessarily mean that a government literally orders the production of certain amounts of guns,
butter, or other goods or services; rather, a government may use the material incentives of the market process to allocate
resources in certain ways, a process often referred to as indirect command. For example, the government offers defense
contractors the opportunity to earn a profit by producing military goods and services. In addition, the government can control
the allocation of resources in a more direct way through various laws governing the actions of both consumers and producers.
For example, the government controls manufacturing and distribution through such agencies as the U.S. Food and Drug
Administration. It attempts to control consumer use of certain foods and drugs through various laws and regulations. A simple
but important example of this pertains to the tobacco industry. Over the past several decades, the U.S. government has made
determined efforts to convince people to stop smoking. These efforts range from warnings on cigarette packages to the banning
of smoking on airline flights and in restaurants.
In addition to using rules and regulations and its fiscal power, the government can also influence the allocation of scarce
resources through subsidies, tariffs, and quotas. Further discussion of these aspects of the command process in the U.S.
economy is found in other sections of this chapter and throughout the text. In fact, Chapter 14 is devoted to a discussion of the
role of government in the market economy.
The traditional process is also at work in the U.S. economy, but this process can be better understood by considering its impact
on different countries throughout the world, particularly those whose economies are still developing. Examples of the traditional
process are found in the eating habits, and in the patterns of work and social interaction, in such countries. Two examples of how
the traditional process influences the allocation of scarce resources are religious restrictions on certain foods, such as beef and
pork, and hiring practices based primarily on familial relationships. A branch of anthropology called economic anthropology is
particularly concerned with the impact of customs and traditions on the economic questions of what, how, and for whom. In the
business curriculum, students will find this subject of particular importance in courses on international business.
Because of the predominance of the market process in the U.S. economy, our discussion of the allocation of scarce resources is
based on the assumption that managers operate primarily through the mechanisms of supply, demand, and material incentive
(i.e., the profit motive). Their decisions about what goods to produce, how they should be produced, and for whom they should
be produced are essentially market oriented. That is, firms choose to produce certain goods and services because, given the
demand for these products and the cost of using scarce resources, they can earn sufficient profit to justify their particular use of
these resources. Moreover, they combine their scarce resources to produce maximum output in the least costly way. Finally, they
supply these goods and services to those segments of the population expected to provide the most material reward for their
efforts.
Table 1.1 compares the three basic questions from the standpoint of a country and from the standpoint of a company, where
they form the basis of the economic decisions for the firm. From the firm’s point of view, question 1 is the product decision. At
some particular time, a firm may decide to provide new or different goods or services or to stop providing a particular good or
service. For example, consider Apple’s decision to get into the music business by offering its iPod and iTunes music download
service. Another good example is the various “non-computer-service” businesses that have gotten into the market for providing
cloud-computing services. For example, telecom companies such as Verizon, AT&T, Deutsche Telecom, and British Telecom (BT)
all provide cloud-computing services. Even companies such as Amazon and Dell have gotten into this market.
Table 1.1 The Three Basic Economic Questions
From the Standpoint of a Country
From the Standpoint of a Company
1. What goods and services should be produced?
1. The product decision
2. How should these goods and services be produced? 2. The hiring, staffing, procurement, and capital budgeting decisions
3. For whom should these goods and services be produced?
3. The market segmentation decision
Question 2 is a basic part of a manager’s responsibility. It involves personnel practices such as hiring and firing, as well as
questions concerning the purchase of items ranging from raw materials to capital equipment. For example, the decision to
automate certain clerical activities using a network of personal computers results in a more capital-intensive mode of
production. The resolution to use more supplementary, part-time workers in place of full-time workers is another example of a
management decision concerning how goods and services should be produced. A third example involves the selection of
materials in the production of a certain item (e.g., the combination of steel, aluminum, and plastic used in an automobile).
The firm’s decision concerning question 3 is not completely analogous to that of a country. Actually, a firm’s decision regarding
market segmentation (a term used in the marketing field) is closely related to question 1 for a country. In deciding on what
segment of the market to focus, the firm is not literally deciding who gets the good or service. For example, suppose a firm
decides to target a certain demographic segment by selling only a “high-end” or premium version of a product. However, the way
in which a company markets the product (which includes its pricing and distribution policies) makes certain segments of the
market more likely to purchase the product.
Perhaps one of the best ways to link the economic problem of making choices under conditions of scarcity with the tasks of a
manager is to consider the view put forth by Professor Robert Anthony that a manager is essentially a person who is responsible
for the allocation of a firm’s scarce resources.10
10 Actually, Anthony divided the planning and control process in a firm into three activities: strategic planning (i.e., setting the
firm’s overall objectives), management control (i.e., making sure scarce resources are obtained and used effectively and
efficiently in the firm’s accomplishment of its objectives), and operational control (i.e., making sure specific tasks are carried out
effectively and efficiently). These ideas were first put forth in R. N. Anthony, Planning and Control Systems: A Framework for
Analysis, Boston: Harvard Business School, Division of Research, 1965.
It is interesting to note that “managers” or “management skills” was not delineated as a separate factor of production by early
economic theorists. The four traditional categories of resources are land, labor, capital, and entrepreneurship. The last category
can be treated as broad enough to include management, but the two classifications do involve different characteristics or skills.
The term entrepreneurship is generally associated with the ownership of the means of production. In addition, it implies
willingness to take certain risks in the pursuit of goals (e.g., starting a new business, producing a new product, or providing a
different kind of service). Management, in contrast, involves the ability to organize and administer various tasks in pursuit of
certain objectives. An important part of a manager’s job is to monitor and guide people in an organization. In the words of Peter
Drucker, who has been called “the founding father of the science of management,”
It is “management” that determines what is needed and what has to be achieved [in an organization]. . . . Management is work.
Indeed, it is the specific work of a modern society, the work that distinguishes our society from all earlier ones. . . . As work,
management has its own skills, its own tools, its own techniques.11
11 Drucker, Management, p. xi.
The Case of Globel Foods, Inc.: Situations and Solutions
Prior sections of this chapter cited various reasons why an understanding of economics is important to managerial decisionmaking. An effective way of demonstrating this importance is to cite real-world examples gleaned from the popular press and
distilled from the findings of research studies on the use of economics in managerial decision-making. All other texts in
managerial economics do this, and this book is no exception. In addition, we want to show how economic terms and concepts
can be applied to managerial decision-making through the use of a series of hypothetical situations such as the one presented at
the beginning of this chapter. In fact, each chapter begins with a situation requiring some sort of decision or action relating
directly to the subject matter of the chapter. For example, in this chapter, a decision must be made about whether to enter the
soft drink market. This is a fundamental business decision involving the allocation of a firm’s scarce resources, a major theme of
this chapter.
At the end of each chapter, a solution for the situation is presented based on the knowledge gained from reading the chapter. We
use the term solution rather loosely because it may not involve a specific answer, as one might expect in the solution to a
mathematical problem. In our view, the ambiguity of a solution is very much in keeping with conditions in the real world. Often in
an actual business problem, there is no unique formula that one can use to compute the answer. Either the formula does not
exist or is not entirely applicable to the problem, or the problem itself is not amenable to a straightforward quantitative solution
technique. Even when a specific numerical solution is achieved—as is the case in Chapter 12 on capital budgeting—there may be
other considerations of a qualitative nature that temper the acceptability of the solution. Therefore, the solutions offered at the
end of the chapters are only suggested outcomes of the situations. (You may want to consider alternative ways for the managers
depicted in the situations to deal with their tasks or problems.)
The situations used throughout the book are based on one industry and one firm in that industry. As you have already learned,
we use the soft drink industry. Moreover, we follow the trials and tribulations of the managers of Global Foods, Inc., and, in
certain cases, the managers of firms that do business with Global. This helps tie together the disparate aspects of economic
analysis. Also, we believe that a focus on one firm in one industry creates added interest in the
