1. ASSIGNMENT ( NO MORE THAN 300 WORDS)
Why study managerial economics? The most important task of a business manager is to make decisions. Decisions are the means by which organizations turn ideas into action and can have a positive or a negative impact. However, decision making can be a complicated process, especially in a business setting. Solving a problem requires comparing alternatives and thinking about the probable results. Furthermore, successfully implementing a decision can be just as much of a challenge. Every business decision will have direct and indirect results, influencing the future of the company. Consequently, a structured process for decision making takes away much of the uncertainty embedded in the decision making process. The six step decision making process is one such approach.
The steps included in this are
1. defining the problem,
2. determining the goals and the objectives of the firms,
3. exploring the alternatives,
4. evaluating the alternative solutions,
5. selecting the optimum solution and
6. performing sensitivity analyses.
The influence of the Macroeconomic Environment
The general health of the economy has, of course, an influence on the firms. As we experienced in 2008-2010 when an economy enters a recession, consumers demand tends to be reduced for all products, and all businesses suffer. This is part of what is called the
business cycle, which describes the succession of recessions and economic booms that all economies go through.
Clearly, business managers have no power in this macroeconomic environment. It is important for them to be aware of it, however, if only because many governmental policies are decided as a response to the economic environment, and they directly affect all businesses.
For instance, during the recent recession, the Federal Reserve (who is the central bank of the U.S. responsible for monetary policy) has decided to keep interest rates as low as possible. The goal was to stimulate the economy by encouraging consumers to consume (and borrow), and firms to invest which is what interest us here. Managers need to keep a close eye on these policies since the level of interest rates at which they can access credit has a direct influence on the costs of their projects.
The mechanism used by the Federal Reserve (Fed) is also worth considering. The market for money operates just like any other market, with the price adjusting to find the equilibrium between demand and supply. The price of money, so to speak, is the interest rate. Thus, when the Federal Reserve wants to lower the price of money (the interest rate), it increases the money supply. This is done mostly by purchasing securities on the open market, which is the way the Fed injects money into the economy. Because of the depth of the recession of 2008-2010, the Fed has purchased several trillions worth of securities, pushing the money supply to very large levels. If the money supply is not reduced, it will result in high inflation over time – following a process that would be too long to discuss here.
The answer may seem easy: the Fed can reverse its policy, sell the securities it purchased, and take the money out of the market. The risk of inflation would disappear, and high inflation is never good news for business since it tends to reduce consumption.
Things are not that simple, of course. Remember that the Fed kept interest rates low by purchasing securities. Selling them would result in a rise in interest rates, which would increase the cost of investment.
In other words, the Fed needs to find the balance between avoiding inflation, and not raising interest rates too high. If the actions of the Fed seem to indicate that interest rates are likely to increase soon, a well-informed manager could anticipate on investments that were planned for a future date, and thus benefit from lower borrowing costs.
Let us leave these macroeconomic considerations and discuss an important assumption we will make throughout this course: profit-maximization is the objective of private firms. We will then end this lesson by a presentation of the focus of this week’s readings and assignment, a model for optimal decision-making.
Do Firms Seek to Maximize Profits?
Generally speaking, the search for profit optimization is considered the main goal of all private sector decisions. Thus, in its simplest version, any firm is assumed to have
profit maximization as its primary goal. In other words, the firm’s owner or manager is assumed to be aiming at maximizing the firm’s short-run profits.
This assumption has been shown to be very effective in explaining decision-making. There are of course situations in which the objective of the manager is not as clear-cut, which has led to the development of alternative theories of firms’ behavior. For instance, size or growth maximization could be the manager’s objective – especially if his or her salary is directly linked to the growth of the company, which happens quite often actually.
Other models assume managers are mostly concerned with their own welfare maximization, which leads to the issue of risk tolerance. They may prefer a safe investment that provides a relatively small profit, to one that may generate much higher profits, but that would be riskier. The risk component generates stress that the manager may want to avoid.
As a consequence, if you were on the Board of a company, you should ask yourself: when a risky venture is turned down, is this because of inefficient risk avoidance, or does it reflect an appropriate decision from the standpoint of profit maximization? Or, in other words, is our CEO doing his job?
Let us go back to the concept of profit maximization. Even though alternative models have their merit, it is clear that managers are forced by market competition to seek value maximization in their decision-making. Furthermore, stockholders are very much interested in value maximization since it affects the value of their portfolio and the returns on their stock investment. Clearly, managers who would pursue their own interest, instead of those of stockholders, risk losing their job.
In summary, the goal of profit maximization is at the root of firm’s behavior and will guide our reasoning through this course.
2.
Respond to this discussion. (No more than 250 words with a question)
In Managerial Economics, profit is defined as the difference between total revenue and total cost. While it may seem logical to increase production to the maximum capacity, profit is actually maximized at the optimal output level, not the maximum output.
The optimal output occurs where marginal revenue (MR) equals marginal cost (MC). Producing beyond this point leads to higher costs than revenue, reducing profit. As explained in the Principles of Managerial Economics textbook
(Saylor Academy), “as long as the marginal revenue is greater than the marginal cost, the firm increases its profit by producing more” (Chapter 4, Section 4.3).
This demonstrates that understanding marginal analysis is key. The maximum profit is not achieved by producing the most units, but by producing up to the point where MR = MC, where the additional revenue from producing one more unit exactly equals the additional cost.
3.
Respond to this discussion. No more than 250 words with a question)
As mentioned in the prompt, a company maximizes its profit at the level where the difference between its total revenue and the total cost is the largest. This means that the company is earning money after paying off all costs. To find the profit maximization level, it becomes really important to understand how much the company is able to sell, the price at which customers are willing to buy the product and how much it costs the company to produce the product.
It is often believed that increasing production might result in maximum profits, but that is not entirely true. Profit maximization occurs at the optimal level of output where the Marginal Revenue equals the Marginal Cost. This means that the cost of making one more item is equal to the revenue the company makes by selling that one extra item. Producing above or below this point might result in the company not making maximum profit.
Profit maximization is also very essential for a company’s long-term success. If the company keeps on producing more units to maximize profits rather than producing at the level where the MR = MC, it might start seeing losses. Hence, understanding the optimal level of output and producing at that point will result into profit maximization.
