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Dr. Daniel SimonsBuilding 250 - Room 416

Lectures: W: 8:30 – 11:30Building 250 – Room 205

Office Hours: T Thu : 11:45 – 12:45W: 11:30 – 12:30OrBy appointmentEmail: simonsd@viu.ca

Dr. Rosmy Jean LouisBuilding 250 – Room 464

Lectures: W: 9:00 – 12:00Building 200 – Room 238

Office Hours:

Suggestions for Best Individual Performance

• Attend all classes• Take notes. Course covers a lot of material

and your notes are essential• Complete all assignments (not for grade)• Read the book• Participate, enrich class discussion, provide

feedback and ask questions• Revise materials between classes, integrate

concepts, make sure you understand the tools and their application

• Don’t hesitate to contact me if necessary

Evaluation Method

Tests have a mix of problems that evaluate• Concepts• Problem sets (assignments)• Class applications• Readings• New applications• 3 closed book time constrained tests to reward

knowledge and speed• Each test covers slides, assignments, and

required readings.• Evaluation system may not be perfect but it

works

Main Course Objectives

1. Present relevant tools for effective management of organizational processes and resources

2. Show the application of core concepts to typical business problems and management decisions

3. Provide the foundation for late in-depth coverage of business issues in Economics

4. Present a general framework to better understand and meet the challenges faced by organizations

5. Contribute to the generation and implementation of strategies to create economic value and sustain competitive advantage in organizations

Introduction, Basic Principles and Methodology

The central themes of Managerial Economics:

1.Identify problems and opportunities2.Analyzing alternatives from which

choices can be made3.Making choices that are best from the

standpoint of the firm or organization

• Not true that all managers must be managerial economists

• But managers who understand the economic dimensions of business problems and apply economic analysis to specific problems often choose more wisely than those who do not.

• Manager-:A person who directs resources to

achieve a stated goal

Economics-:Study of making decisions in the

presence of scarce resources

Managerial Economics Defined

Is the study of how to direct scarce resources in the way that most efficiently achieves a managerial goal

Main thrust of Managerial Economics is to provide you with a vast pool of skills that will allow you to make sound decisions and to determine the right incentives within your company

• Methodology, data and applicationMethodology- is a branch of

philosophy that deals with how knowledge is obtained.

How can you know that you are managing efficiently and effectively?

You need some theory to do some analysis.

Without theory, there can be no good analysis

Microeconomics (probably more than other disciplines) provides the methodology for managerial economics

Managerial Economics is about both methodology and data

You need data to plug into some model to do some analysis.

This gives you the information to manageManagerial Economics lends empirical

content to the study of effective management

Decisions are always among alternatives.

Decision alternatives always have costs and benefitsOpportunity cost = next best alternative foregone.Marginal or incremental approach

Review of Economic Terms

• Resources are factors of production or inputs.– Examples:

• Land• Labor• Capital• Entrepreneurship

• Relationship to other business disciplines

– Marketing: Demand, Price Elasticity– Finance: Capital Budgeting, Break-Even

Analysis, Opportunity Cost, Economic Value Added

– Management Science: Linear Programming, Regression Analysis, Forecasting

– Strategy: Types of Competition, Structure-Conduct-Performance Analysis

– Managerial Accounting: Relevant Cost, Break-Even Analysis, Incremental Cost Analysis, Opportunity Cost

• The Economics of Effective Management

– An effective manager must• Identify goals and constraints• Recognize the nature and importance of profits• Understand incentives• Understand markets• Recognize the time value of money• Use Marginal Analysis

Identify Goals and constraints

Well-defined goals and recognize constraints such as available technology, prices of inputs used in production, decisions made by competitors etc.

• Because of scarcity, an allocation decision must be made. The allocation decision is comprised of three separate choices:– What and how many goods and services

should be produced?– How should these goods and services be

produced?– For whom should these goods and

services be produced?

– What: The product decision – begin or stop providing goods and/or services.

– How: The hiring, staffing, procurement, and capital budgeting decisions.

– For whom: The market segmentation decision – targeting the customers most likely to purchase.

• Three processes to answer what, how, and for whom– Market Process: use of supply,

demand, and material incentives– Command Process: use of

government or central authority, usually indirect

– Traditional Process: use of customs and traditions

• Profits are a signal to resource holders where resources are most valued by society

• So what factors impact sustainability of industry profitability?

• Porter’s 5-forces framework discusses 5 categories of forces that impacts profitability

1. Entry

2. Power of input sellers

3. Power of buyers

4. Industry rivalry

5. Substitutes and Complements

Entry:Heightens competitionReduces margin of existing firmsAbility to sustain profits depends on

the barriers to entry: cost, regulations, networking, etc.

Profits are higher where entry is low

Power of input suppliers:Do input suppliers have power to

negotiate favorable input prices?Less power if a. inputs are standardized, b. not highly concentratedc. alternative inputs available

Profits are high when suppliers power is low

Power of buyers:High buyer power ifa. buyers can negotiate favorable

terms for the good/serviceb. Buyer concentration is highc. Cost of switching to other

products is lowd. perfect information leading to

less costly buyer search

Industry rivalry:Rivalry tends to be less intensea. in concentrated industriesb. high product differentiationc. high consumer switching cost

Profits are low where industry rivalry is intense

Substitutes and complements:Profitability is eroded when there

are close substitutesGovernment policies (restrictions

e.g. import restriction on drugs from Canada to US) can affect the availability of substitutes.

Understand Markets

• Power or bargaining position of consumers and producers in the market is limited by 3 sources of rivalry:

• Consumer – consumer rivalry Because of scarcity, consumers compete

with each other for the right to purchase the available goods

Those willing to pay higher prices will outbid others for the right to consume the product

• Consumer-Producer Rivalry– Consumers attempt to locate low

prices, while producers attempt to charge high prices.

The ability of each party to achieve its goal is limited.

Offer too low a price and producer will refuse to sell the product

Charge to high a price and consumers will refuse to buy the product

• Producer-Producer Rivalry– Scarcity of consumers causes producers to

compete with one another for the right to service customers.

• The Role of GovernmentWhen agents on either side of the market feel

aggrieved in the market process, they attempt to induce government to intervene on their behalf,– Disciplines the market process.

The Firm and Its Goals• The Firm• Economic Goal of the Firm• Goals Other Than Profit• Do Companies Maximize Profits?• Maximizing the Wealth of

Stockholders• Economic Profits

Profits• Profit is the difference between

revenue received and costs incurred.

Economic vs. Accounting Profits

• Accounting Profits– Total revenue (sales) minus dollar

cost of producing goods or services.– Reported on the firm’s income

statement.

• Economic Profits– Total revenue minus total opportunity

cost.

Cost• Accounting Costs

– The explicit costs of the resources needed to produce produce goods or services.

– Reported on the firm’s income statement.

• Opportunity Cost– The cost of the explicit and implicit

resources that are foregone when a decision is made.

• Economic Profits– Total revenue minus total opportunity

cost.

Economic Goal of the Firm

• Primary objective of the firm (to economists) is to maximize profits.– Profit maximization hypothesis– Other goals include market share,

revenue growth, and shareholder value

• Optimal decision is the one that brings the firm closest to its goal.

Goals Other Than Profit– Market share maximization (as

measured by sales revenue or proportion of quantity sold to total market

– Growth rate maximization (increasing size of the firm over time. Higher rates of growth in other variables than profit)

– Profit margin

– Return on investment, Return on assets

– Shareholder value

– Technological advancement

– Customer satisfaction

– Maximization of managerial returns (manager’s own interest subject to generating sufficient profits to keep their jobs)

• Non-economic Objectives

– Good work environment

– Quality products and services

– Corporate citizenship, social responsibility

Do Companies Maximize Profit?

• Criticism: Companies do not maximize profits but instead their aim is to “satisfice.”

– “Satisfice” is to achieve a set goal, even though that goal may not require the firm to “do its best.”

– Two components to “satisficing”:• Position and power of stockholders• Position and power of professional

management

• Position and power of stockholders

– Medium-sized or large corporations are owned by thousands of shareholders

– Shareholders own only minute interests in the firm

– Shareholders diversify holdings in many firms

– Shareholders are concerned with performance of entire portfolio and not individual stocks.

– Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management.

– Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

• Position and power of professional management

– High-level managers who are responsible for major decision making may own very little of the company’s stock.

– Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.

– Management incentives may be misaligned• E.g. incentive for revenue growth, not

profits• Managers may be more interested in

maximizing own income and perks

– Divergence of objectives is known as “principal-agent” problem or “agency problem”

• Counter-arguments which support the profit maximization hypothesis.

– Large number of shares is owned by institutions (mutual funds, banks, etc.) utilizing analysts to judge the prospects of a company.

– Stock prices are a reflection of a company’s profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights.

– The compensation of many executives is tied to stock price.

• Company tries to manage its business in such a way that the dividends over time paid from its earnings and the risk incurred to bring about the stream of dividends always create the highest price for the company’s stock.

• When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objectives.

Maximizing the Wealth of Stockholders

• Views the firm from the perspective of a stream of earnings over time, i.e., a cash flow.

• Must include the concept of the time value of money.

– Dollars earned in the future are worth less than dollars earned today.

• Future cash flows must be discounted to the present.

• The discount rate is affected by risk.

• Two major types of risk:•Business Risk – up and down of the economy•Financial Risk – due to a leverage

Maximization of stockholder’s wealthvs

Maximization of profits

MSW seems to be a more comprehensive goal because

• It is a long-run concept• It considers the timing of benefits• It incorporates the concept of risk

The Time Value of Money

• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

PV

FV

i n1

• .

• Examples:– Lotto winner choosing between a single

lump-sum payout of $104 million or $198 million over 25 years.

– Determining damages in a patent infringement case

Present Value of a Series

• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

PV

FV

i

FV

i

FV

inn

1

12

21 1 1. . .

Net Present Value• Suppose a manager can purchase a stream of

future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision

Is

NPV

FV

i

FV

i

FV

iCn

n

11

22 01 1 1

. . .

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept project

Present Value of a Perpetuity

• An asset that perpetually generates a stream of cash flows (CF) at the end of each period is called a perpetuity.

• The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is

i

CF

i

CF

i

CF

i

CFPVPerpetuity

...111 32

Firm Valuation

• The value of a firm equals the present value of current and future profits.– PV = t / (1 + i)t

• If profits grow at a constant rate (g < i) and current period profits are :

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Firm

Ex DividendFirm

iPV

i g

gPV

i g

• If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

• Control Variables– Output– Price– Product Quality– Advertising– R&D

Marginal (Incremental) Analysis

Net Benefits

• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

• Net Benefits = Total Benefits - Total Costs

• Profits = Revenue - Costs

Marginal Benefit (MB)

• Change in total benefits arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total benefit curve.

Q

BMB

Marginal Cost (MC)

• Change in total costs arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total cost curve

Q

CMC

Marginal Principle• To maximize net benefits, the

managerial control variable should be increased up to the point where MB = MC.

• MB > MC means the last unit of the control variable increased benefits more than it increased costs.

• MB < MC means the last unit of the control variable increased costs more than it increased benefits.

The Geometry of Optimization

Q

Total Benefits & Total Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

Conclusion• Make sure you include all costs and

benefits when making decisions (opportunity cost).

• When decisions span time, make sure you are comparing apples to apples (PV analysis).

• Optimal economic decisions are made at the margin (marginal analysis).

Maximizing the Wealth of Stockholders

• Another measure of the wealth of stockholders is called Market Value Added (MVA)®.

• MVA represents the difference between the market value of the company and the capital that the investors have paid into the company.

Maximizing the Wealth of Stockholders

• Market value includes value of both equity and debt.

• Capital includes book value of equity and debt as well as certain adjustments.– E.g. Accumulated R&D and goodwill.

• While the market value of the company will always be positive, MVA may be positive or negative.

Maximizing the Wealth of Stockholders

• Another measure of the wealth of stockholders is called Economic Value Added (EVA)®.– EVA=(Return on Total Capital – Cost of

Capital) x Total Capital

• If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.

Lessons

• There is no free lunch• The cost of an action is the

alternative that is sacrificed• The relevant costs and benefits

are the marginal ones• People respond to incentive• Things aren’t always what they

seem